Investors have been defensive and anxious about how deeply the economy would fall before the Federal Reserve ends its tightening cycle. Markets found another clue Wednesday in the Fed's beige book, which investors read as signaling the end to the two-year campaign of rate hikes.

The beige book reported "evidence that the pace of growth has slowed" and that consumer spending on retail goods weakened. Also, while labor markets tightened, the report said increases in both wages and prices of final goods and services remained modest.

The beige book largely reiterated the emphasis of Ben Bernanke's July 19 congressional testimony and the June 29 FOMC minutes; both noted that the economy is moderating, evidenced by the deflating housing market and weaker consumer spending.

"There seems little justification for a rate hike with such characterizations," wrote Anthony Crescenzi, Miller Tabak's chief fixed-income analyst, and a contributor.

The fed funds futures market immediately dropped the odds of an Aug. 8 rate hike to 40% from 54% prior to the beige book release. The fed funds futures market puts the likelihood of another rate hike in August, September or October at 64%, down from 74% prior to the beige book.

The stock market's major averages attempted another late-day rally following the 2 p.m. release of the data, but this time it didn't hold. The Dow Jones Industrial Average closed down 0.01% at 11,102.51, while the S&P 500 dropped 0.04% to 1268.40 and the Nasdaq fell 0.17% to 2070.46.

Minor moves in the major averages aside, the pattern of stocks with disappointments being disproportionately punished continued, with names like ( AMZN), Norfolk Southern, ( NSC) and Corning ( GLW) suffering big declines, while UPS ( UPS) lost another 5.5% after Tuesday's disappointment .

The Treasury market, meanwhile, was able to sustain its rally. The 10-year Treasury bond gained 8/32 to yield 5.03%, while the five-year bond gained 5/32 to yield 4.98%. The two-year Treasury note gained 3/32 to yield 5.06%.

It's a Small World

The beige book rubber-stamped what the market was already telegraphing -- a turn in the economic cycle. As expected at such turns, the defensive sectors of the stock market, such as health care and consumer staples, have outperformed.

The Amex Pharmaceutical Index closed up 0.5% Wednesday at a new 52-week high. The Morgan Stanley Consumer Index and the Consumer Staples Select Sector SPDR ( XLP) both closed just slightly off of the 52-week highs reached Tuesday.

Defensive-led rallies don't make for lasting advances, however. "This means people are parking their money," says Marc Pado, chief investment strategist at Cantor Fitzgerald. "It means the market isn't faithful that this is a real rally."

Pado predicts a stock market peak sometime in August after the FOMC meeting on Aug. 8, and contingent upon a ceasefire in the conflict between Lebanon and Israel.

Even assuming the Fed pauses, the 17 consecutive 25-basis-point rate hikes are still winding their way into the economy. During his testimony, Bernanke spoke of "policy effects still 'in the pipeline,' " leaving investors fretting over how hard the economy might fall. Strength in the global economy is a relatively new factor in the equation. While a slowdown in the U.S. economy would undoubtedly impact global growth, the rest of the world has, and may continue, to cushion the U.S. economy's fall.

"The question becomes: In the face-off between global growth amid still-low interest rates vs. slowing U.S. growth in the face of higher interest rates, where is the tipping point?" says Thomas McManus, chief investment strategist at Banc of America Securities.

The U.S. has led the pack in terms of restrictive monetary policy. Central banks around the world have, until very recently, kept their feet on the accelerator when it comes to growth. While emerging-market countries like India, China and countries in Latin America are still mostly export nations, they are generating more internal strength, which is helping them contribute to consumption.

One surprise contributor to U.S. GDP is more exports. Many economists revised their expectations for second-quarter GDP growth to 3% or higher, based on the Commerce Department's report that exports grew 10% year over year through the first five months of 2006.

The world's most stunning growth comes from China, which will likely overtake Japan sometime this year as the third-largest export market for U.S. goods, says Franklin Lavin, undersecretary for international trade, according to published reports. China, which saw 11.3% GDP growth through the first half of the year, also reported that imports rose 21%. In the same period last year, imports rose only 14%, according to newswire reports.

While China's trade imbalance remains problematic due to its weak currency and labor practices, the country once again increased its reserve requirements last week. The move will likely increase the value of China's yuan, making imports all the more attractive.

China isn't the only country in a buying mood. The Bank of Japan recently started to undo its 0% interest rate policy as years of economic weakness are finally giving way to growth. India, which lifted its overnight borrowing rate by 25 basis points overnight Tuesday, is growing at 7.5% a year. Europe, which has struggled to come back, is expected to grow 2.2% this year.

But growth in these nations doesn't automatically translate into the power of consumption. Recreating the U.S. consumer, which comprises 71% of overall U.S. GDP, is a Herculean task. Last year, Chinese consumption comprised only 38% of its GDP. Overall, emerging-market consumption is 50% of U.S. consumption, up from 40% in 2001, so five to 10 years from now we'll have "cloned a new consumer to grow the world," says James Paulsen, chief investment strategist at Wells Capital Management.

Emerging markets are already catching up. Emerging-market consumption grew at a faster pace than U.S. consumption each year since 2002. In 2005, emerging-market consumption grew at 17.1% in 2005, compared with 6.1% consumption growth in the U.S.

Several U.S. companies have acknowledged their increasing reliance on exports or overseas operations to fuel their bottom lines as growth in the U.S. slows. General Electric ( GE), long considered a proxy for the U.S. economy, grew 18% in emerging markets, according to a transcript of its second-quarter earnings conference call.

General Motors ( GM), which reported a relatively strong second quarter based on cost-saving measures, highlighted its revenue growth in Europe, Latin America and the Middle East. GM's shares gained 4.4% Wednesday.

Rival Ford's ( F) chief executive Bill Ford said at the annual shareholders meeting in May that Ford's source of growth and profits going forward centers on the "expansion of the global marketplace."

While investors fiddle with their calculators to assess the depth and breadth of the U.S. economy's turn, the positive impact of global growth may still be at the margins. But the weight of the trend is undeniable.
In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click here to send her an email.

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