Lower oil prices give markets boost

Wednesday, May 25, 2005 at 1:00am

U.S. equity markets experienced their best week in six months following a significant decline in oil prices (which are now around $47 per barrel, representing a 20 percent drop from their highs in April) and a Consumer Price Index (CPI) report that showed consumer inflation did not rise in April (the first month since the fall of 2003 in which inflation was zero). For the week, the Dow Jones Industrial Average climbed 3.3 percent to close at 10,472, the S&P 500 Index rose by 3.1 percent to 1,189 and the Nasdaq Composite advanced by 3.5 percent to finish the week at 2,046. With these advances, stocks are near the halfway point between their 2005 lows, which they hit in April, and the highs they reached in March. For the year, the Dow is down around 3 percent, the S&P is down 2 percent and the Nasdaq has lost about 6 percent. The bond market also reacted positively to last week's news, with the yield on the 10-year Treasury (which moves in the opposite direction of bond prices) falling to nearly 4 percent before ending the week at 4.15 percent, below the 4.24 percent level where it began the year.

Notwithstanding the oil price decline and the placid CPI figure, there was also some bad economic news last week. In particular, the Index of Leading Economic Indicators, which assesses the overall state of the U.S. economy, fell for the fourth month in a row in April, and is down year-over-year, historically a sign that growth will be slowing. So why is the market rallying? We believe investors are beginning to see some light at the end of the tunnel, perhaps thinking the Federal Reserve will soon stop raising interest rates. We are still of the opinion that the federal funds rate will be 3.5 percent at the end of 2005 (it is now at 3 percent), which would mean the Fed would have to elect not to increase rates at one of its future meetings.

So where does all of this leave us? The financial markets enjoyed some relief last week, and the benign CPI report helped ease fears that the Fed would drastically increase interest rates. Additionally, lower oil prices and declining bond yields helped to create a more favorable investing environment. In our opinion, however, inflation is still slowly but surely increasing and the Fed will continue to tighten monetary policy, so the equity market still remains under pressure. We also continue to believe that economic growth will slow in the second half of the year and corporate earnings will be disappointing relative to expectations.

Outside the United States, the economic growth picture seems to be even more tenuous. Economic growth seems to be slowing in most places, even where monetary policy has not been tightened (such as in Europe and Japan) and in places where only minor tightening has occurred (such as in the United Kingdom, Canada and Australia). These trends have served to renew concerns about slowing growth, insufficient demand and the prospects of deflation. While we believe that global growth will slow, we are not forecasting a recessionary environment, and are hoping for a "soft landing." While we will likely see more range-bound equity rallies, such as we witnessed last week, sustained upward moves will probably not occur until we are beyond this slower-growth period.

Bob Doll is president and chief investment officer of Merrill Lynch Investment Managers. For more information on MLIM, e-mail mlim_feedback@ml.com.

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