Market Faces Two Major Obstacles: Interest Rate Climb, Oil Concerns Generate Uncertainty

Market Faces Two Major Obstacles
Interest Rate Climb, Oil Concerns Generate Uncertainty

By Noel Lamb, Chief Investment Officer — North America
Russell Investment Group
August 15, 2005

Two major obstacles stand in the way of further stock market gains.

The first, and foremost, is the rise in short-term interest rates and how long it will continue. The Federal Reserve is raising rates because it wants to head off higher inflation, but investors are concerned that it will keep raising the Fed Funds rate until it hurts.

The market consensus, based on the Fed Funds Futures Contract Yield, appears to be pricing in three quarter-point rate raises by the end of the year, but if the Fed raises rates more than that consensus, it might slow economic growth and possibly even induce a recession. That is why, in June when Russell asked investment managers what their main concern was, one in four replied "interest rates," putting that worry at the top of the list of concerns in our quarterly survey of investment sentiment.

Higher short-term rates mean consumers face higher amounts on such payments as adjustable-rate mortgages and credit cards, leaving them with less discretionary cash, which, in turn, could dent both the housing market and corporate revenues.

Sending a Sign
The market is waiting for Greenspan to signal an end to the tightening cycle. If he does, equities might rally as such a move would indicate that the Fed is confident that inflation is under control and the U.S. economy faces less danger from overheating.

A second worry is the price of oil. Some analysts note that it takes 12 months for the price of oil to filter through to the economy, so we may not yet have seen the impact of $60-a-barrel oil.

High energy prices suppress corporate profitability and stifle equity returns. If the Fed underestimates the impact of the oil price and continues raising short-term rates beyond a consensus reasonable level, both the economy and stock market may suffer.

Positive Indicators
Another concern is that earnings growth, although still likely to be 8% to 10% for the second quarter, is slowing.

At the same time, however, positive news is helping to alleviate investors' concerns.

For example, the July unemployment rate at 5% was 0.5 percentage points lower than it was a year ago, inflation appears to be benign, housing remains strong, and companies appear to have considerable cash on their balance sheets that can be used for future growth.

In addition, large-cap growth stocks look attractive. Their valuations are relatively low, particularly when compared with value stocks, which have had a good run over the past five years.

For these positive factors to take full effect, however, investors might have to push aside their concerns about interest rates and high oil prices.

Copyright© Russell Investment Group 2005. All rights reserved. See Important Legal Information. First used: August 2005.

Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide and is a subsidiary of The Northwestern Mutual Life Insurance Company.

The Fed Funds Futures Contract is a key benchmark interest rate barometer that reflects the forward overnight effective rate for excess reserves that are traded among commercial banks in the U.S. federal funds market.

RFD 05-5297

Copyright© Russell Investments 1998 - 2009. All rights reserved.

This is a publication of Russell Investments. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company.

Related INFO