Global Markets Weekly - 10th December 2007

Key global market developments

• It was a bumper week for equities… As we predicted two weeks ago, developed equity markets have rallied. They had looked oversold, after falling 8% between the end of October and the Thanksgiving holiday in late November. The catalysts for this rally were dovish comments from the US Federal Reserve (Fed), better news from the banking sector and US plans to help home-owners who can’t afford mortgage rate resets.
• …with more to come, judging by technical indicators. Technical analysis suggests that equity markets may have several months of advances to come, even though two weeks ago they were perilously close to dropping out of the bull trend they have been in since March 2003. Moreover, sentiment indicators have recovered from over-pessimistic levels but are still well below levels that would signal overoptimism. Hence, sentiment should be no barrier to further near-term gains from equities.
• Now we need to see inflation slowing. But, for equity markets to make new highs, we think not only growth needs to be slowing but inflation as well, so that inflation concerns don’t stop central banks doing whatever it takes to reaccelerate growth and stave off a recession. In recent weeks, we have seen some encouraging signs that we are transitioning to just such an environment.
• The Bank of England cut, citing concerns over growth and inflation… Explaining its quarter-point cut in rates to 5.5% last week, the Bank of England highlighted the impact of financial market strains on lending conditions and the downside risks to both growth and inflation. This is unlikely to be the Bank of England’s last rate cut. Forward-looking indicators are worsening, and even the services PMI, which until recently showed a booming service sector, has declined for the past three months, to a level consistent with only slim expansion. Along with continued tight conditions in cash markets, that should lead to two further quarter-point rate cuts next year, taking rates to 5.0%.
• …whereas the ECB held rates steady. By contrast, the European Central Bank (ECB) did not cut rates, instead continuing its tough talking on inflation. With strong growth and rising inflation, the ECB’s position is not as bizarre as it may seem. Supplying the market with liquidity over recent months has also reduced the need for an interest rate response. Even so, talk of higher rates sounds like sabre-rattling, especially given the euro’s strength. We think that, as the once-hawkish Bank of England has done, the ECB will eventually cave in and cut rates during 2008.
• Now it’s the Fed’s turn, with a cut expected... The focus is currently on the Fed’s December rate announcement, due this Tuesday. The Fed’s recent comments have all but confirmed that rates will be cut; the question is whether by a quarter or half a percentage point. A half-point cut would be hard to justify on the grounds of data. November’s ISM index stabilised at a level consistent with moderate expansion, and payrolls grew by 94,000 in November - low, but hardly disastrous. The six-month moving average for payrolls shows that job growth has been slowing for some time now and, at around 100,000, is currently consistent with a gradual rise in unemployment.
• …but the rhetoric is likely to be just as important. As with the Bank of England, however, US policy-makers are paying increasing attention to tightening lending conditions. Last week, President Bush announced measures to freeze the mortgage rates of over a million Americans in danger of defaulting. So, in setting the tone for markets during 2008, it will be not just the size of the rate cut that matters but the content of the Fed’s statement, particularly any concerns about the likely impact of financial market volatility on the real economy.

Indices, Interest rates and Inflation

	Close 07-Dec-07	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,327	1.4	1.3	3.9	3.3
FTSE 100	6,555	1.9	2.7	5.9	5.4
S&P 500	1,505	1.6	2.0	3.5	6.1
Nasdaq Composite	2,706	1.7	-1.6	5.5	12.0
DJ Stoxx (Europe)	421	0.9	-0.1	4.9	6.4
Nikkei 225	15,956	1.8	-0.9	-1.0	-7.4
Hang Seng	28,842	0.7	-2.9	20.3	44.5

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Dec-07 Forecast	Mar-08  Forecast	Current	Next Date
US (Fed Funds)	4.50	4.25	4.25	3.5	11-Dec
UK (Base rate)	5.50	5.50	5.25	2.1	10-Jan
Euro-zone (Repo Rate)	4.00	4.00	4.00	3.0	10-Jan
Japan (Call rate)	0.50	0.50	0.50	0.3	20-Dec

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