Interest Rates and Global Growth

By: Hans_Wagner

If investors want to beat the market, they need to understand how global growth is affecting interest rates and inflation. Bill Gross of Pimco Bonds, the world's largest bond management firm, stated in his most recent investment outlook that “With the possibility of creeping inflationary tendencies, especially in weak currency countries including the U.S., combined with the potential reduction of financial flow subsidies which to this point have favored fixed income vs. equity and real commodity investments, we come to the following range forecasts for the secular timeframe from 2007 to 2011.”

Source: Pimco Bonds Investment Outlook May/June 2007

While not the only cause of the rise in the 10 year U.S. Treasury rate, Bill's comments are closely followed. Rising rates are further evidence that the Federal Reserve will not be lowering rates in the next six months. On June 7, 2007, the Bank of England decided to leave its benchmark rate steady, after New Zealand's central bank surprised markets by raising its rate to a record high 8 percent from 7.75 percent to curb inflation. On June 6, 2007, the European Central Bank raised its own rate as well.

Now we are seeing a positive sloping yield curve for the first time in more than a year. The rise in longer term rates is driven by the expectations for significant global growth which will cause slightly higher inflation.

As a result stock markets throughout the world fell. Markets do not tend to rise when interest rates are climbing. Once rates settle down, I expect the stock markets will find a new base to start up again. After all global growth is the primary driver for the higher rates and slightly higher inflation. Once the markets adjust to this perspective then I expect money to flow into stocks that will benefit from global growth.

Inflation

Regarding inflation, on the surface it looks to be under control, though there are some underlying problems with food and energy. Global growth will drive higher demand for energy. Eric Bolling, a well know energy and commodity trader, mentioned in a recent CNBC Fast Money that there are 1.2 cars for ever person in the U.S., 1.7 cars for every person in Germany and 43 people for every car in China. As the Chinese people gain more wealth and buy cars, even fuel efficient cars, it will generate new demand for fuel to run the cars. Energy costs are going to continue to climb with global growth.

Much of the inflationary rise in food costs is because of high grain prices, driven by demand for ethanol from corn and ethanol subsidies. According to the USDA the preliminary estimate for average corn prices in May was $3.48 a bushel, up 9 cents from the prior month and $1.31 from May of 2006. That is a 60% increase for a product that is used in many other foods, as animal feed and consumed by people.

Currently, there is a $0.53 per gallon subsidy for corn ethanol in the U.S. and a $0.50 duty on imports of ethanol (primarily sugar based). So the U.S. government is contributing to the higher prices we see for corn and gasoline. Given that prices have risen even higher recently, that means there is even more food inflation in the pipeline. This is just another unintended consequence of what happens when government starts meddling in the markets. We make a few farm-state senators happy and the rest of the world gets higher food prices. While of us can afford to pay a little more for basic food necessities, it is a very tight squeeze on the poor of the world.

Now on to a little personal philosophy. We need to start phasing out these subsidies as soon as possible, recognize that the market will encourage the right investments to overcome the current energy problems. The longer this goes on, the more pain it is going to cause to people who are not able to afford it. I am all for creating new ways to reduce our need for foreign oil, but let's not do it on the backs of the poor in developing countries. A better way to drive innovation in new energy sources is to provide R&D funds to interesting potential ideas, much like the Venture Capitalists do.

U.S. Economic Growth

Back to the economy. GDP in the US has fallen to 0.6% in the first quarter 2007 from 2.5% in the fourth quarter 2006. The higher interest rates will hurt the already slumping housing sector further. Higher rates increase borrowing costs for potential homeowners and for builders. The higher rates will also cause more adjustable rates to move up further taking more money away from consumers and causing more problems in the mortgage market. In other words, housing is getting hit again.

Unemployment certainly looks like the economy is doing better, with both continuing and initial job claims falling. There are various signs which suggest manufacturing may be picking up from the doldrums it has been in.

But there are signs of weakness. Dr. Lacy Hunt (Van Hoisington Management) found that railcar loadings are down 4.3% year over year (y/y) for 2007-to-date (thru first week of May) and the first week of May is down 4.9% y/y, and trucking tonnage has declined y/y in 4 of the past 5 quarters.

Does this mean the U.S. economy is going to get weaker, or will it rebound like many hope? To me it looks like the sectors and companies that have a significant international presence will do well. Those sectors and companies that depend primarily on the U.S. will continue to struggle. Global growth will continue to be the dominate force. As investors, we need to position our portfolios to take advantage of this trend.

If you are interested in learning more about stock market cycles I suggest reading Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling. It is one of the best, easy-to-read, studies of stock market cycles of which I know.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

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