Chaos theory dictates that seemingly small actions can have huge effects. A butterfly flapping its wings in Brazil can spark a tornado in Texas, for instance. But some butterflies are bigger than others. And in financial markets, there is no bigger bug than the U.S. Federal Reserve Board.

Its recent decision to stand pat on interest rates for the first time in more than two years is a major macroeconomic event that is expected to echo throughout world economies, markets and individual business sectors.

In fact, many market-watchers see the Fed’s lack of action on Aug. 8 as a sign of the possible completion of a prolonged rate-tightening cycle in the U.S. The inaction put an end to a string of 17 consecutive rate hikes that have taken the Fed’s benchmark rate to the current 5.25% from a mere 1% in mid-2004. The pause came as the U.S. economy began to show signs of slowing in the second quarter.

It’s not certain that rates won’t go even higher. The decision to finally take a break was not unanimous, and the Fed warned in the accompanying policy statement that inflation risks remain. Indeed, economists at Royal Bank of Canada are forecasting one more rate hike in October, in order to dampen inflation expectations.

Still, most analysts seem to expect that the U.S. central bank is either finished or almost finished tightening monetary policy and that the next move will be a rate cut. Some see that happening before the end of the year; others don’t expect it until some time in 2007.

So, while this apparent end of a rate-tightening cycle suggests that the Fed believes it has done enough to keep the U.S. economy from overheating or inflation from running rampant, any slowdown in the U.S. (a major engine of the global economy) is felt dearly in the rest of the world. The big question, then, is whether the U.S. slowdown can be countered by growth in other regions, or whether the global economy will simply be dragged lower.

Not surprising, opinions differ.

TD Bank Financial Group economists stress that although it looks like the global economy will slow, the underlying fundamentals remain positive. In a new report, TD concedes that slowing U.S. growth will impact other economies. “However, given the momentum in world expansion, the overall pace of global growth is expected to remain above its historical average, and there is little chance that the Chinese and Indian boom could be derailed,” it says.

Canada’s growth is expected to moderate in 2007, TD forecasts, and the current regional disparity — strong growth in the West, with weakness in Central Canada and the East — is expected to continue.

Bank of Nova Scotia echoes TD’s view. In a report issued after the latest Fed decision, it lowered its estimate for U.S. GDP growth slightly for 2006 and 2007. “A gradual improvement in America’s net trade position, abetted by a more competitively valued greenback, should help limit the extent of the economic slowdown,” it says.

Others take a more pessimistic view. Stephen Roach, chief economist at Morgan Stanley Capital International Inc. , argues bearishly in a recent research note: “The global boom of the past four years was never sustainable.”

It was driven by excess liquidity injected into the system by overly loose monetary policy, which in turn created “unprecedented global imbalances,” he writes.

“Excess liquidity bought time for a precarious world,” Roach continues. “As central banks move to normalize monetary policy, that time has run out. Without the unsustainable support of asset bubbles, it is back to basics, with aggregate demand supported by more modest labour income generation rather than the excesses of wealth creation. So much for the artificial boom of an unbalanced world. It could be about to fizzle out.”

Although market-watchers may differ on the depth and significance of the looming slowdown, there appears little doubt it is coming. The most recent version of Merrill Lynch & Co. Inc. ’s global fund manager survey, released in mid-August, says there’s consensus among the world’s money managers that conditions in the global economy will deteriorate over the next 12 months. They aren’t anticipating a worldwide recession, but a slowdown does appear to be in the cards.

The slowdown will manifest itself in both weaker corporate profits and in equity markets. The survey shows 52% of fund managers expect profits to weaken over the next 12 months, up from about one-third of managers in June. A similar percentage believe that margins will deteriorate. Less than a third of money managers expect earnings growth of more than 10%.

@page_break@TD agrees that weaker economic growth suggests growth in corporate profits will be modest in 2007, and cautions that commodity prices are vulnerable to a further correction as the slowdown softens demand for raw materials. “Having said that,” the TD report adds, “price levels should remain high, supported by strong demand from Asia.”

The relatively gloomy outlook for earnings translates into a dim view of equities generally. About 43% of fund managers in the Merrill survey expect equity markets to be lower in six months and a small majority anticipate increased market volatility. At the same time, their view of bonds is brightening.

Just 22% of managers now believe that global bond markets are overvalued, down from almost 50% in the spring. Their bond weightings are also increasing. Fewer than half are now underweighted in bonds, compared with almost two-thirds in June.

There is a good deal of uncertainty, however, as evidenced by the fact that one-third of managers report that they are overweighted in cash.

The uncertainty is no doubt fed by the fact that the direction of U.S. monetary policy is unknown and market-watchers are bracing for increased volatility. In another report, TD notes that with the Fed at or near the end of its rate-hiking cycle, volatility in global financial markets will intensify.

TD marvels that from 2002 through mid-May of this year, “global financial markets enjoyed an unprecedented, uninterrupted, universal streak of stellar returns with little volatility.” Mature markets enjoyed strong returns, but emerging markets really boomed, it observes: “Returns were strong; they were global and they were steady.”

Since then, however, many markets have faltered and sharp volatility has re-emerged, a development TD attributes largely to tightening by the Fed. “The crucial source of volatility is the end of one of the most stimulative global monetary cycles in history,” it states.

As rates have increased and asset prices have slipped, markets have become increasingly skittish, TD notes, adding that there is a strong historical relationship between the U.S. monetary cycle and financial market volatility. “More important, history suggests that even more financial market volatility is in store for global markets, especially emerging markets, once the Fed establishes they have reached their peak.”

TD says volatility will remain, if not increase — “At least, until interest rates begin to fall, which is unlikely to come until late this year or, more likely, early next year…. Financial markets may be in for a bumpy ride.”

Where should investors be sitting in order to ride out the bumps?

Montreal-based BCA Research says U.S. equities are typically a good place. In a recent research note, it observes that U.S. stocks tend to underperform other markets when the Fed is hiking, but then outperform once it has stopped and begins cutting rates.

“With the U.S. economy decelerating, the Fed’s recent pause probably represents the end of its tightening campaign,” the BCA report says. “The implication is that U.S. stocks should outperform the global benchmark in the coming months, especially [as] interest rates are rising in most other major markets.”

As for Canada, a report by UBS Securities Canada Inc. looks back at the performance of various Toronto Stock Exchange sectors in the 12 months following the Fed pauses in 1984 and 1995. It finds that there was a different crop of winners each time — except for gold stocks, which outperformed the rest of the market each time.

“Only gold stocks noticeably outperformed the TSX in both cases, something we expect to be repeated as we look for the U.S. dollar to resume its structural decline,” the UBS report says. “Moreover, with the group still 20% below its spring peak, and a tendency to outperform in the volatile (and often negative) August-September period, now may be a good time to increase exposure.”

Apart from gold stocks, UBS notes that the two other sectors that either held up or went higher after previous Fed pauses were consumer products and financials.

Focusing on financials, Genuity Capital Markets recently issued a report that examines the performance of the Canadian banks after the end of previous Fed tightening cycles. It found that the last two times the Fed finished a rate-hiking cycle, bank stocks made gains. In 1995, the Fed’s pause was followed by an aggressive rally. In 2000, the response was less impressive, but the markets were also affected by a variety of other unusual events at that time, including the disputed U.S. presidential election, the emergence of corporate scandals, a brief U.S. recession and the 9/11 attacks on New York and Washington.

This time around, the Genuity report says, “Given the narrow premium the Canadian banks trade at relative to the U.S. banks, we believe that Canada’s banks are likely to participate with U.S. [banks] in what we expect to be a strong rally related to a Fed pause.” IE