Global Markets Weekly – 29^th January 2007

Key Macro economic developments

• The Bank of England’s Monetary Policy Committee (MPC) once again provided much of the action last week, with the release of the minutes from the January 10^th/11^th meeting revealing that the surprise rate hike was in fact backed by only the slenderest of margins (a 5 to 4 vote). Given that a full explanation for the shock move had previously been lacking, the financial markets had in many respects been ‘forced’ to assume that the MPC - by acting so aggressively - had adopted a new and more hawkish view of the inflationary outlook. Interest rate expectations were as a consequence adjusted sharply higher, with the market’s best guess of where the base rate will be at the end of June jumping from roughly 5.5% before the MPC’s decision to almost 6% soon after.
• But last week’s release of the MPC minutes, together with a speech delivered by Governor Mervyn King, showed the debate within the Committee to be much more finely balanced than many had feared. The closeness of the vote inevitably dominated the headlines, but the individual voting patterns were also of interest. With Bank ‘heavyweights’ Paul Tucker, Charlie Bean and Rachel Lomax all voting against the hike, partly (and justifiably it seems) because of concerns that the surprise move would push market interest rates excessively higher, the conviction behind the eventual decision appeared even more fragile.
• The key area of debate seems to have been one of timing - whether or not it would be better to delay the move for a month and explain against the context of the February Inflation Report - rather than the need to push rates significantly higher. Indeed, even those that voted for the hike suggested that early, pre-emptive action would help to reduce the level to which base rates may eventually have to rise.
• Upside risks to inflation clearly remain, not least from the upcoming rounds of annual wage negotiations, and at present we believe that the risks of a further (25bp) hike occurring are still greater than not. But with a majority of the MPC seemingly remaining confident that inflation will fall back towards the 2% target level by the end of this year, some of the risks around UK monetary look to have diminished. Indeed, the recent movements in both the oil price and sterling suggest that this process may in fact occur quite suddenly, producing a markedly different inflation outlook than the one currently troubling policymakers.
• On a more general point, however, it remains to be seen just how policymakers will react to the recent slump in oil prices. A lower level of headline consumer price inflation would be expected to alleviate some of the immediate pressure to raise interest rates, particularly amongst central banks (such as the Bank of England) with an explicit inflation target. But the accompanying effects upon business/consumer confidence and activity in general will also have to be considered. It is perhaps no coincidence that a run of stronger data has emerged from the major economies, pushing long-term bond yields to roughly six-month highs, just as the oil price has retreated.

Key global market developments

• Earnings growth deceleration.  After four straight years of each quarterly reporting season of the S&P 500 showing double-digit earnings growth, it appears that the run may be broken.  A little over a third of the way through the reporting of Q4 2006 earnings, the growth rate is ‘only’ 9.4%.  This obviously reflects the deceleration of the US economy last year, with growth forecast to be 2.4% this year after 3.3% in 2006.  However the outlook for US equities remains positive, with the average earnings growth for 2007 still forecast to be around 10%, albeit not consistently above.  Additionally the Price Earnings Ratio at 18 times, is towards the bottom of the 16x to 46x range for the last fifteen years, providing scope for a re-rating if the current deceleration in growth is, as we forecast, just a mid-cycle pause.

Indices, Interest rates and Inflation

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