Capital Thoughts as Q1 Winds Down

The first quarter is winding down. For most investors it has been a good quarter. The performance of the US stock indices have risen more than they did all last year. Major bourses in Continental European bourses, like Germany, France, and Italy rose 10% thus far. The UK’s FTSE posted a respectable 7% gain. Japan’s Nikkei was rallied nearly 40% in the second half of last year managed to tack on almost another 3%.

Global bonds, on the other hand, fell amid US and ECB rate hikes and signals from the BOJ that the days of extraordinary monetary accommodation are nearing an end. In addition, data suggests that after a disappointing Q4 05, growth in the US and Europe recovered in Q1 06 and the most indications suggest the Japan’s economic recovery continue to broaden and deepen.

Don't Discount the Dollar

The US dollar has fallen about 2.25% against the euro and the yen over the past week, its poorest weekly performance in a couple of months. Every one has their own pet theory to explain the move, but the risk is that the move has been exaggerated and that a more stable dollar tone will emerge in the coming days.

Many explanations of the dollar’s slide focus on the larger than expected US current account deficit and the less than expected foreign demand for US securities, as picked up in the Treasury’s monthly portfolio flow report (TIC), within the context of indications from a couple Middle East countries that they are considering reducing the dollar component of their reserves. Others suggested that the criticism over the apparently ever growing US current account deficit by a few G7 officials raises the possibility of a mini-Plaza-like agreement to force a dollar-adjustment.

The Dollar and Emerging Markets - Is the Rally Over?

As the first quarter winds down, the sharp rise in G7 interest rates, especially in the US and Europe, and expectations of future tightening of monetary policy, have undermined equity markets and sparked a violent sell-off in many emerging markets.

There are two key concerns for investors. The first relates to the outlook for the US dollar. Can the dollar resume its rally which seems to have largely stalled out here in Q1 after posting what appear be cyclical highs in Q4 05? The second is about the outlook for emerging markets given the high interest rate environment. Is the rally in emerging markets over or is this just a hiccup as the asset class periodically experiences.