Global Markets Weekly – 8^th January 2007

Key Macro economic developments

• A curtailed week of trading saw investors looking back over the holiday period, eager to catch-up with any market-moving events, just as much as they peered ahead to what 2007 may hold in store. In the event, the balance of the data releases of the past week or so provided some belated festive cheer, showing the US economy to be in reasonable shape and with further encouragement also coming from a sharp decline in German unemployment. The labour market in the US also looks to be holding firm, given the stronger than expected gain in non-farm payrolls during December (+167k). However, there is a chance that such strength may have been distorted by the unseasonably warm weather of late. The minutes of the December 12^th Federal Open Market Committee meeting showed policymakers to be reasonably guarded about the economic outlook, particularly with regard to the build-up of inventories across industry that could hamper growth around the turn of the year, although for the moment at least inflationary concerns still appear to be dominating.
• At the beginning of any year the market is typically awash with a stream of predications - some designed to alarm and others to reassure - and 2007 is of course no different. But the current data look to be more consistent with a mid-cycle slowdown than anything more ominous, and we believe that the macroeconomic environment of the coming year - although not without risks - should again prove positive for equities.

Key global market developments

• The UK equity market looks to have started the year in the same vein as 2006, with the merger & acquisition (M&A) theme taking centre stage and pushing the FTSE100 to a six-year high last week. Moreover, with the gap between equity returns and debt funding costs remaining attractive, and investor funds continuing to flow into the private equity sector, the current level of M&A activity appears unlikely to slow anytime soon. The UK market is seen to benefit from its more ‘open’ nature and, in turn, the greater ease with which deals can be brokered. But it is also important to recognise the role played by the UK economy - both in terms of its current performance and its possibly enhanced potential growth rate - in encouraging such activity.
• The M&A factor was of course a key determinant of sterling’s robust performance in 2006, but after moving sharply lower against both the dollar and the euro last week, there are signs that the currency may be beginning to lose some of its allure amongst investors and we expect these losses to persist into 2007. A further hike in UK rates already appears to be ‘in the price’, and a closer analysis of the true benefits on offer from the M&A boom may also take some of the shine off the pound. Firstly, while sentiment towards the pound and UK assets in general will be boosted by the positive newsflow, the extent of the increase in transactional demand for the currency that follows the rising level of M&A activity is highly uncertain. Many of the deals will have been financed via the City of London, with the capital presumably being raised in sterling, thereby allowing companies to match asset and liability streams and minimise currency risk. Secondly, unless foreign acquirers have clearly ‘overpaid’ for a UK company, there is little theoretical reason for rising M&A activity to boost a currency, given that any initial increase in demand will be offset by the future, repatriated flow of returns on that investment. A key reason for the further deterioration in the UK balance of payments in the third quarter, for instance, was the increased flow of investment income going overseas. Whilst it may be difficult to call a top in sterling given the ongoing speculation of a February rate hike in the UK, the degree of support provided by the M&A factor could well be subjected to enhanced scrutiny as 2007 progresses.

Indices, Interest rates and Inflation

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