Global Markets Weekly - 25th September 2006

Key Macro economic developments

• Last week’s FOMC meeting passed off largely without incident as rates remained unchanged and the Committee made only a minor, fairly insignificant change to the accompanying policy statement. In any case, the bond market appears to be increasingly looking beyond the Federal Reserve’s current musings and concentrating instead on the risks to activity, and the likely policy response, in 2007. Treasury yields fell significantly across the maturity spectrum once more last week and while hedging activity relating to Mortgage-backed securities may have contributed to the extent of the decline, the recent movements still appear excessive. Next week’s consumer confidence figures may corroborate reports of an enthusiastic response by consumers to the ongoing drop in gasoline prices, and GDP growth for the current quarter still looks to be holding around the 3% level.
• The September IFO survey, released on Tuesday, arguably represents the highlight of the Euro-Area releases of the next few days, particularly after the ZEW survey last week generated further debate over how the region’s economy will fare in the event of cooling global growth. The ZEW survey has assumed a captive audience during recent months, given its more forward-looking nature and past tendency to signal turning points in the economic cycle, but the message provided hitherto has been one of extremes.
• While the ZEW’s current conditions component has edged steadily higher, reaching a six-year high in the process, its expectations element has plunged, surpassing even the lows seen during the 2003 recession. That a survey of investor sentiment has continued to fall even while equities have rebounded and oil prices have edged lower is surprising, and naturally questions the quality of signal being provided. But it has nevertheless encouraged the debate around the outlook for 2007, and raised the profile of this week’s IFO survey release.

Key global market developments

• One of the more notable trends of recent months has been the decline in equity market volatility, with the benchmark VIX index having returned to the levels witnessed prior to the May/June market shakeout. Other risk indicators such as emerging market and credit spreads also remain at unusually low levels, suggesting that the broader investment environment is currently exceptionally calm. However, such trends would appear to be inconsistent with the recent movements in the major yield curves, and in particular the increasingly inverted position of the US curve, a development which has preceded each of the last six US recessions.
• Importantly, we believe that the yield curve-based probability models showing a rising risk of a US recession are less likely to be proved correct over the coming year than in previous interest rate cycles. The reduced level of economic volatility and improved monetary policy transparency of the past decade have reduced the term premium demanded by investors, while the relative shift in demand for financial assets that offer increased duration (due to pension reform, demographics) has also contributed to a structurally flatter yield curve.
• As such, the level of economic information provided by yield curve shifts has been diluted over time. Moreover, while the slowdown in the US housing market is a key downside risk to the economic outlook, the factors that typically precede a housing slump – rising interest rates and unemployment – are clearly not in place. Indeed, with the consensus estimate of 2007 US GDP growth having now fallen to just 2.6%, a sizeable housing market impact may already be ‘in the price’. Overall, with the market seemingly becoming more comfortable with a US slowdown next year and the conservative valuations attached to equities providing an additional support, the currently benign market conditions do not appear to be under any significant, imminent threat.

Indices, Interest rates and Inflation

	Close 21-Sep-06	1 Week%	1 Month%	3 Months%	YTD %
FTSE all share	3015.95	0.49	0.34	4.72	5.93
FTSE 100	5896.73	0.33	-0.31	4.09	4.95
S&P 500	1318.03	0.13	1.58	5.26	5.59
Nasdaq Composite	2237.75	0.40	4.19	4.51	1.47
DJ Stoxx (Europe)	363.41	1.42	2.77	9.74	10.49
Nikkei 225	15834.23	-0.68	-0.84	8.13	-1.72
Hang Seng	17619.97	2.54	3.60	12.52	18.44

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