Global Markets Weekly - 28th April 2008

• The ECB has not cut rates, confounding our prediction at the start of the year.
  That we have almost reached May without the European Central Bank (ECB) cutting interest rates is very surprising. On a few occasions, the short end of the euro yield curve has moved to price in rate cuts, but these prospects have always melted away in the face of the ECB’s tough anti-inflation rhetoric.

• Markets still expect no cuts this year; we disagree.
  Investors currently expect no movement in interest rates during 2008. If all we did was listen to the ECB, this market pricing would make sense. Yet we have three main reasons for thinking the ECB will cut rates sooner than expected. 

• Wage settlements are not reflecting higher commodity prices...
  Firstly, although commodity prices have risen, they show little evidence of feeding through to wages – a necessary condition for the upward inflationary spiral some ECB Council members seem to fear. The ECB has particularly cited collectively negotiated wage settlements in Germany. German unemployment has fallen by 1.8 million over the past two years to 7.8%, near what the OECD considers its natural rate.
• …and unit labour costs are in fact falling, largely thanks to productivity gains.
  This week, German chemical workers won a wage deal equivalent to 3.7% a year over the next two years. This may initially seem inflationary (current core inflation is 2%) but should be set against productivity improvements of around 5% a year in the chemicals industry. Indeed, for the labour market as a whole, unit labour costs are falling by 1% a year. This is deflationary and suggests that recent measures such as the Hartz IV and Agenda 2010 labour market reforms – and competition from Eastern Europe – are keeping wage inflation lower than at similar points in previous cycles.
• Higher lending rates and the strong euro have tightened monetary conditions...
  Second, leaving rates on hold at a time of wider credit spreads and aggressive US rate cuts has raised both term lending and foreign exchange rates, thus tightening monetary conditions for European companies. There is no single determinant of foreign exchange values, but the change in the dollar/euro interest rate spread has over the past five years been a key driver of euro strength. The euro has appreciated a remarkable 15% against the dollar over the past year. In trade-weighted terms, the rise is a little less extreme, at 9%, but the euro is still at a record high.
• …and business confidence has suffered as a result.
  Third, higher borrowing costs and a loss of export competitiveness are predictably affecting business confidence surveys. The surveys have been falling for around a year now, and the pace of decline has recently accelerated. The closely watched German IFO business confidence number is at its lowest level for two years.
• Euro strength has offset European equities' disappointing returns...
  Currently, investors are ignoring these indicators of economic contraction and focusing instead on the ECB’s rhetoric. The euro’s consequent strength has also benefited holders of European equities. In local currency terms, Europe has underperformed the S&P 500 this year by 8%, largely because of the stronger euro’s impact on export growth and forward-looking macro-economic indicators. For dollar-based investors, however, European equities have outperformed by 5%, thanks to the euro’s rise.
• …but that effect is unlikely to continue.
  Our concern now is that, faced with increasing signs of slowing growth and weaker European earnings, any euro strength may not be enough to offset equity underperformance. With the euro 17% above its previous (November 2004) peak, it looks increasingly optimistic to count on continued euro strength to bail out European equities' relative returns.

Indices, Interest rates and Inflation

	Close 04-Apr-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,097	0.2	6.4	3.6	-5.8
FTSE 100	6,091	0.6	7.1	3.8	-5.7
S&P 500	1,398	0.5	3.3	5.1	-4.8
Nasdaq Composite	2,423	0.8	3.5	4.2	-8.7
DJ Stoxx (Europe)	364	0.0	5.1	1.0	-12.4
Nikkei 225	13,863	2.9	8.8	1.7	-9.4
Hang Seng	25,517	5.5	13.6	1.6	-8.3

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Jun-08 Forecast	Sep-08  Forecast	Current	Next Date
US (Fed Funds)	2.25	1.50	1.50	4.0	30-Apr
UK (Base rate)	5.25	5.00	4.75	2.5	08-May
Euro-zone (Repo Rate)	4.00	3.75	3.50	3.6	08-May
Japan (Call rate)	0.50	0.50	0.50	1.2	30-Apr

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