Global Markets Weekly – 10^th April 2007

Key Macro economic developments

• There was a collective sigh of relief across the UK markets last week as the Bank of England left interest rates unchanged, but at best this appears to be a brief stay of execution, with a hike next month widely expected. The decision to leave rates unchanged for now is likely to have been a close call. The inflation data have disappointed, retail sales remain at robust levels and house price inflation has now breached the 10% level. But the Monetary Policy Committee (MPC) is arguably focusing on a broader range of indicators at present – relating to developments around inflation expectations, pricing power and wage demands – which by their nature are more difficult to monitor and assess. This may help to explain why most MPC members were content to leave rates on hold this time around, to allow a more thorough discussion in May when the Committee’s inflation and growth forecasts are renewed.
• The Bank of Japan’s March Tankan survey offered a slightly mixed picture on release last week, but did little to challenge the perception that a steady, if unspectacular recovery, is underway. That some weakness developed during the first quarter was perhaps unsurprising. With industrial production having increased by close to 3% during Q4 2006, some temporary weakness at the beginning of the year was always a possibility as inventories have been run down, not just in Japan, but also globally. With last week’s German factory orders data showing a surge in demand during February, the prospects for a rebound in global manufacturing activity during the second quarter appear good, and the recent jump in industrial metal prices may in part be a reflection of this.
• While the market impact of the strong US payroll figures was obscured by closures for Easter, they still underline a positive view about the prospects of a ‘soft landing’ for the US economy.  Payroll figures jumped by 180,000 during March, above expectations, supported by upward revisions that added 32,000 to the current year’s total.  The broader unemployment figure reinforced the positive measure by falling back to 4.4%.

Key global market developments

• While equities have now regained much of the ground lost during the recent bout of market volatility - particularly in Europe, where the Dax index reached a six-year high last week - it is noticeable that corporate bond spreads have so far failed to narrow to the levels observed before last month’s correction. This is especially true for the riskier end of the credit spectrum, where spreads are still around 20 basis points above their February lows. The previous, steady drop in spreads towards a historically low level has been a source of some angst within sections of the market, with many suggesting that such skinny compensation for risk was correct only for near-perfect economic and financial conditions. The key question now is whether the events of the past month have shaken investors’ confidence in this optimistic scenario, ultimately leading to a widening out of credit spreads and the under-performance of high yield bonds?
• It is important to recognise that default rates - the ultimate determinant of the degree of compensation offered in exchange for credit risk - are at unusually low levels, both within the high yield and investment grade areas. The actions of the major credit rating agencies are also a source of comfort, given that upgrades are still outnumbering downgrades. Overall, the robust health of the corporate sectors of the major economies will continue to offer substantial support, but the potential for some deterioration nevertheless exists, and the scope for credit spreads to compress below the February lows may now be limited. The currently accelerating pace of debt growth, and the subsequent increase in corporate leverage, has historically proved to be a good guide to turning points in the credit cycle. Even if such a reversal is not imminent, and the likely increase in spreads arguably limited, a more cautious attitude may well benefit investors over the coming months.

Indices, Interest rates and Inflation

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