Global Markets Weekly – 18^th December 2006

Key Macro economic developments

• The November US retail sales data proved surprisingly strong last week and prompted a degree of scepticism within some sections of the market. The headline figure rose by a much larger than expected 1% during the month, while the strength of the auto and building materials sub-sectors of the series contrasted starkly to the widely assumed weakness of these industries. December’s retail sales data may therefore feature a sizeable decline or backward revision, but the November report did at least buck the recent trend of disappointing US releases and the industrial production data also featured a welcome increase in output during the month. News of a large inflow of foreign capital into US assets during October provided further support, although question marks clearly remain over the dollar’s underlying strength and the sustainability of the trade deficit.
• In the UK meanwhile, the disappointing November inflation data rekindled speculation of a further interest rate hike during the early months of 2007, but we believe the outcome of the New Year pay negotiation to be the key to the rate outlook and expect the current debate around UK monetary policy to rumble on for a few months yet.

Key global market developments

• The dollar managed to regain its poise last week, registering small gains against both the pound and euro, and while the US data were seen to have lent a touch more support than has generally been the case during recent months, some essentially technical factors may also have been influential. Most simply, the extent of the dollar’s decline over the past month may have prompted profit taking by traders as the year-end approaches. But the most recent market positioning data, which show an especially negative speculative position to have developed against the dollar, may in fact provide the greatest insight into the dollar’s consolidation last week. The speculative positioning data can often be used as a contrary indicator when extreme positions are established, on the assumption that both market sentiment and flows are unlikely to deteriorate any further and, in turn, that some of the pressure upon a currency may be about to abate.
• But such factors can only provide support for a limited period and the US data releases of the coming week - the third quarter current account figures in particular - certainly have the potential to place the dollar on the back foot once more. The current account data have hardly been a prime ‘market mover’ over the past couple of years, given that the growing US trade gap has been viewed by many as a symptom of the US economy’s often superior growth rate vis-à-vis the other developed economies, which by extension has led to US import growth outstripping export demand. Dollar investors would naturally highlight such cyclical strength as a counter to the currency’s structural vulnerabilities, but with the prospects for the US economy now less certain, such an argument seems less valid. The Q3 current account figures may therefore be the most eagerly awaited for some time, and will demand the market’s attention.
• But whilst the possibility of a record deficit being announced will no doubt create headlines, the most significant data for the dollar’s longer-term prospects could well relate to the balance of income generated on the various international assets and liabilities of the US economy. Even while the deteriorating current account has caused a deficit to the tune roughly $2.5 trillion to develop on the international investment position, the net flow of international investment income has until recently remained slightly positive. This anomaly relates to the fact that US investments overseas (equities, direct investments) tend to yield a far higher return than foreign investments in the US (government debt), encouraging many in the market to believe that even a large US current account deficit can be managed effectively. But with net investment income having turned negative during the final quarter of last year, further scrutiny has been placed on the sustainability of the US current account deficit and such doubts will intensify should a further negative net investment income figure be reported for the third quarter.

Indices, Interest rates and Inflation

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