Why stock markets face an uphill struggle in 2006

The omens are not good for the US economy this year, says Charles Stanley's Jeremy Batstone. The bond market is predicting slower growth, and a series of disappointing earnings reports from major companies such as Google seems to back this up. This is bad news for the global economy, and US small cap stocks in particular....

It has been our view for some time that we are heading into the latter stages of what is, with one or two notable exceptions, a fairly normal economic cycle. Equity markets performed strongly over 2005, despite sharply rising US short-term interest rates. Financial markets are now waiting for a steer from Mr Greenspan as he steps down after eighteen years as Fed Chairman, or from Mr Bernanke, as to where the peak in the US rate setting cycle might be.

Investors should not forget that, unlike the Bank of England or the European Central Bank, the Fed sets monetary policy to regulate the level of nominal demand in the US economy. Having acted aggressively, the Federal Reserve is now widely regarded as having brought the Fed Funds rate back into neutral territory. The economy's reaction is also broadly typical of what might be expected in the wake of ultra-low short-term rates two years ago. The steeply upward sloping nature of the yield curve was indicative of increased activity around the corner. Now the yield curve has inverted a very different picture of what might happen over the next twelve months is being created, a picture investors would be well advised to take on board.

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