The first hint of higher interest rates in the States arrived after this week’s FOMC meeting.  Thomas Hoenig (President of the Kansas City Fed) emerged as the first interest rate hawk on the FOMC and voted against an unchanged monetary policy.  Hoenig “believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the Fed funds rate for an extended period was no longer warranted”.  In plain English Hoenig wants the Fed to signal to the markets that it is going to begin hiking interest rates at some stage in the not too distant future.

At the moment Hoenig is the only dissenter on the FOMC.  It will pay to keep a close eye on whether his view gathers support at future FOMC meetings.

The market’s reaction thus far to Wednesday’s announcement has been most evident in the US Dollar.  Its rally, which began after the 4 Dec 2009 Employment Report, has continued and the Dollar Index (DX) has now broken above its 200-dma.  The 50- and 200-week moving averages are the next resistance levels to be surmounted and they lie just above the current 79.59 level of the DX.  Hoenig hankering after US rate hikes will only serve to help the Dollar to extend its recent rally.  Commodities (as measured by the CRB index) have reacted badly, the US stockmarkets have remained under pressure (but they started falling two weeks ago) but the all-important US Treasury bond market has traded sideways despite Hoenig hinting at higher rates sooner rather than later.

However it is difficult to believe that the Fed is going to implement the first rate hike until the US economic recovery has gained significant traction which results in a very visible fall in the unemployment rate from its current 10%.  There is so much spare capacity in the States that the Fed can afford to let growth continue to build momentum without worrying about higher inflation resulting anytime soon.  Any premature rate hikes would be a serious policy error which would impact the economy & stockmarkets severely.

A more likely explanation for Hoenig’s action in voting against the others is that it allows the Fed to test the market’s reaction to a proposed change in the current policy stance of “low rates for yonks”.  If markets react badly over the next few weeks (particularly if the US bond market tanks) then we can expect all the other FOMC members to very publicly bang the drum that interest rates are not going up anytime soon.  The FOMC knows full well that it will eventually have to tell the markets that rates are not going to stay at “exceptionally low levels for an extended period” and this is a low risk way for it to prepare the markets for an eventual change in monetary policy.

I still think that the first US rate rise is out of view and over the horizon (and more likely to take place in 2011 than 2010) but will be paying close attention to future FOMC statements for clues as to when policy is likely to change.

With consumers set to be squeezed after the 2010 election, supermarket shares may not prove to be as defensive as they used to be.  Stockmarket folklore has it that supermarket shares are defensive because people always need to eat and this held true in the days when supermarkets only sold groceries.  But these days supermarkets sell far more than just groceries.  With Tesco taking one pound in every eight spent by British consumers, they will not be able to escape the effects of consumers battenning down.  It is true that food retailers are shifting their offering downmarket in an effort to follow their customers as they trade down in tough times.  However not every food retailer will be able to protect their sales volumes & profits in this way.

Sales of organic produce fell 14% in 2009, indicating that consumers are already trading down, with organic meat sales being hit hard (beef down 25% and chicken down 28%).  Consumers may buy organic & ethically produced food when they feel they can afford it but with the Food Standards Agency stating that there is no scientific evidence that organic food has health benefits, when the squeeze comes consumers will trade back down quickly.

The pain thus far has been felt most by those people who have lost their jobs during the recession.  As interest rates have been cut sharply, the vast majority who are employed have seen their monthly budgets improve as mortgage payments have fallen.  However any post-election tax increases are going to be felt by all 29 mln employed people in the UK (and their families) and this effect will be very broad-based indeed.  The supermarket shopper is going to look to cut back even further and now that the weaker retailers have already gone bust, the one-off boost to the survivors’ sales has already been seen and all are likely to suffer.

The counter-argument to this is that consumers will cut back on eating & drinking out and spend more on their weekly grocery shop instead. This will affect the pub & restaurant sector (which has already de-rated in anticipation and offers better value than supermarket shares).  It remains to be seen what consumers will choose to do when the squeeze is applied by a government seeking to get the budget deficit back under control, but investors should choose to invest where the risks have at least been somewhat discounted and upside is on offer.

However with Tesco, Sainsburys and Morrisons all trading on 13x estimated 2010 earnings, yielding 2.9%, 4.1% and 2.1% respectively, these shares are not a Buy.  If you feel compelled to hold a food retailer then SBRY yields the most and benefits from periodic bouts of takeover speculation.  Much better value is available elsewhere in the market and owners of TSCO, SBRY or MRW should sell out of them as they are too highly rated, still trading within 8% of last year’s highs, and do not offer sufficient upside to compensate for the risk that their sales start to suffer later this year as consumers begin to be squeezed.

The key issue for the markets to contend with in 2010 is the risk that the economy slips back into recession (the so-called “double-dip”).  As the banks have now been largely fixed, should the economy double-dip then it is likely the retailers will be foremost amongst the suffers.   

The retail sector had a strong rally last year as the stockmarket discounted a recovery.  If we use MKS as a proxy for the sector, they rallied from just above 200p in Dec 2008 to finish at the 400p mark, with the annual dividend cut to 15 pence along the way.  The risk now is that the consumer gets squeezed after the May election and consumer spending suffers as a result.  Even if consumer spending does manage to hold up, the sector has already priced in a recovery and there is not enough upside left to reward investors sufficiently to risk owning the shares.  If the sector continues to trade lower then at some point it will make sense to buy back in for the next recovery trade.

A second sector to be very careful of in 2010 is the pub & restaurant sector.  Wet-led tenanted operators such as ETP and PUB are going to continue to struggle whilst their food-led competitors MAB and MARS may fare relatively better.

It is likely that a newly elected government will both cut spending and signal tax rises once the economy is strong enough to bear them. The Government has a massive hole to fill in, net borrowing will end up somewhere around £175 bln in 2009/10 and £180 bln is forecast for 2010/11.  The fact that this is 12.5% of GDP does not tell the whole story as it also represents 39% of pre-credit crunch tax receipts.  The government’s income has fallen by 12% over the past two years but spending has yet to be cut by a single penny.  The emperor has no clothes – Gordon Brown will not countenance spending cuts and doesn’t have any money to “invest in services”, whilst the best David Cameron will be able to do is maintain spending on the NHS and cut spending significantly everywhere else. 

Take a minute to think about the mountain that needs to be climbed in the UK.  Central government total tax income is forecast to be £397 bln in 2009/10.  Adding on £175 bln net borrowing implies total government spending of £572 bln.  In the best year ever, total taxes raised were £451 bln (2007/8).  Its going to be a long, hard slog to get back onto an even keel and it will take years to fill in this particular hole via a combination of spending cuts, tax rises and hopefully renewed economic growth causing the tax base to grow as well.  The Bank of England will wait a very, very long time before risking any rate rises against this backdrop – it is more likely that QE will be resumed (from its current £200 bln) to support the economy/gilts market before any QE exit strategies are implemented.

At the moment the retail sector carries all the risk of being first in the firing line should consumer spending weaken and lead the wider economy into a double-dip recession.  Avoid retailers until the sector offers patient long-term investors a much better risk/reward.

UK politicians have started the new year with their eyes firmly focused on the upcoming General Election, which will most probably be held in May.  This week’s Hoon-Hewitt challenge on Gordon Brown’s leadership has only served to increase the uncertainty surrounding the result of the General Election.

Markets hate nothing more than uncertainty and although the Conservatives are tipped to win this year’s election there is the distinct possibility of the result being a hung parliament.  In such an eventuality the correct course of action for David Cameron would be to call another immediate snap election, seeking a clear mandate from the British public.  However, politicians enter politics in order to gain power so do not expect him to risk losing his grip on power (however slender) by risking another election.  The only upside of a hung parliament would be that the very competent Vince Cable would become a Cabinet minister.

What the Gilts market (in particular) needs from this election is a clear mandate for one party to go ahead and tackle the UK budget deficit in a decisive manner for the duration of the next parliament.  With 10-year Gilts now yielding 4% and Base Rates stuck at 0.5% until at least the other side of a post-election budget (and likely a lot longer if spending cuts & tax rises are sketched out in the post-election budget – as they should be), a sharp sell-off in the Gilts market ahead of the election is not likely so the pressure will be felt most in the currency markets.  Sterling depreciating will be beneficial to the stock market as a result of translating overseas earnings and a lower currency making UK assets cheaper to foreign buyers (retailers who source their product from overseas, as well as relying on UK consumers who will likely be squeezed by a post-election budget, would miss out on this particular party).

Uncertainties about an indecisive hung parliament are likely to surface first in the currency markets and we can expect Sterling to wobble seriously ahead of the General Election.  The Bank of England is unlikely to worry too much about a further slide in Sterling unless it becomes disorderly (as the UK economy, which is still officially in recession, will benefit from cheaper Sterling), so expect parity to be tested against the Euro, although it is doubtful Sterling will stay below parity for very long.