GLOBAL MARKETS WEEKAHEAD-Investors share Fed's dilemma

Sun Jun 22, 2008 11:00am EDT

By Jeremy Gaunt, European Investment Correspondent
LONDON, June 22 (Reuters) - There is little doubt what the main focus for financial markets will be this week -- the U.S. Federal Reserve meets to discuss interest rates after a burst of hawkish rhetoric about inflation risks.
It is not, however, simply a question of whether the Fed policymakers hike rates or, as most analysts expect, keep them steady at a low 2.0 percent to stave off economic decline [FEDWATCH].

What is of crucial importance for financial markets is how the Fed -- and others such as the European Central Bank and Bank of England, for that matter -- sees the balance between slowing economic growth and rising inflation.

The growing dilemma for policy makers between wanting to cut rates to stimulate growth and wanting to raise them to squelch inflation is shared by investors trying to decide what to do with their money.

As the first half of 2008 ends, many market players find themselves torn between embracing a potential economic recovery and seeking shelter from a storm of continuing moribund activity newly spiked with inflation. "This is the conundrum we have. Are we in a structural bear market or are we in a bull market?" said Charlie Morris, head of absolute returns for HSBC Global Asset Management.

The investment bank Lehman Brothers was particularly open with their clients about it last week.
"As a team we try to stay focused on a medium- to long-term view of investment policy, but we've found ourselves checking our market screens and newswires much more frequently than usual," Aaron Gurwitz, a senior strategist, wrote in a note.

"This isn't just idle interest," he continued. "We're trying to discern whether the dramatic market moves we've been seeing are simply the heightened volatility typically surrounding a turn in the business cycle or whether we're in the midst of a fundamental structural shift in the way asset classes behave."

SOFTLY, SOFTLY

From an immediate standpoint, including this week's trading, the dilemma has triggered a search for safety, but with the added twist that inflation worries have also driven investors away from government bonds, a usual haven in times of trouble.

A survey of fund managers by investment bank Merrill Lynch made this clear last week. It found that institutional investors had cut back on both their equity and government bond holdings during the first part of June.
Instead, they were loading up on cash, the first port of call in times of trouble and an asset that can be easily converted into something else if a clear market trend becomes evident [ID:nL18513705].

All of this has been reflected on financial markets.

Heading into this week, global equities as measured by MSCI .MIWD00000PUS have lost more than 6 percent since the beginning of the month. The U.S. S&P 500 .SPX is off more than 5 percent and the pan-European FTSEurofirst is down more than 8 percent.

At the same time, government bond yields, which move inversely to prices, have been on the rise since April as investors have sold.

Volatility is also on the rise, with the VIX .VIX, a so-called fear index, up more than 27 percent this month.
The dilemma is also having an impact on longer-term decision making, with investors showing little consensus other than a desire for caution.

CLEVER, CLEVER

With this as a background, it is no shock the Fed meeting will be centre stage during the week. But it would equally be no surprise if the volatility that has been seen on financial markets recently continues.
"The dominating theme is to be a very active investor," said William De Vijlder, Fortis Investments' chief investment officer, meaning investors who normally would stick with a position are likely to dip in and out more often.

In the meantime, the main beneficiaries of the situation are likely to be those who can find or afford alternatives to mainstream stock, bond and cash investing.

HSBC's Morris, for example, is steering his clients towards emerging market and domestic inflation-linked bonds, gold bullion and instruments that do well with inflation such as currencies in emerging economies with current account surpluses.

He is also on the look-out for corporate convertible bonds, which offer a coupon payment for now but with the promise of equities at a later date.

In a similar vein, Mike Hollings, chief investment officer at wealth manager Ansbacher, is avoiding risky stocks and vulnerable government bonds in favour of hedge funds, cash and various structured investments where capital is protected.

Such investments might include, for example, a bet that a specific stock index will fall in price over a period of time but with a guarantee of money back if it doesn't. Overall, however, Hollings reckons the direction of financial markets is just up for grabs.

"It's a very difficult call right now," he said.

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