Global Markets Weekly – 4^th June 2007

Key macro-economic developments

• The European Central Bank (ECB) is universally expected to raise interest rates again this Wednesday to 4%, the highest level for six years. With the eurozone economy growing by at least its trend rate and money supply growth still high, the risks of further monetary tightening in 2007 are clear. But, while the ECB’s analysis of the situation is unlikely to change much in the next few months, the way they communicate it may. The ECB has for some time operated monetary policy almost by code word, heralding rate rises by reiterating various easily identifiable terms.
• That approach has highlighted policy-makers’ strong conviction about the short-term path of interest rates in recent years, which has been made possible by the low level of rates and the continuing economic recovery. Yet, over the past two years, rates have doubled to more normal levels, and some eurozone indicators are showing signs of peaking. As a result, the current approach now appears less warranted. It looks as if the future path of rates in the eurozone can only become less certain, which may bring greater volatility to markets over the coming months.
• The US economy seems to be re-accelerating, judging by several releases last week, notably the May employment report. GDP growth for the first quarter was revised down to a feeble 0.6% annualised pace, but we think that will mark the trough in growth for the year. Certainly, businesses seem increasingly confident. The Chicago PMI and national ISM surveys for May both surprised on the upside, while the 157,000 gain in non-farm payrolls also suggested that business activity has regained traction in recent months.

Key global market developments

• On Wednesday, the S&P 500 closed at 1530. That was a new record high for the US equity market, beating its close of 1527 on 24th March 2000 at the peak of the 1990s technology bubble. Inevitably, it has raised concerns that markets may be at another peak. So are we on safer ground this time around?
• Back in March 2000, the market had been led higher by ‘new economy’ sectors. If we feed the data from that period into our new tactical asset allocation (TAA) models, we see that they would have been signalling caution on equity markets for almost the previous 12 months. Equity valuations were unattractive, with a price-earnings ratio (PE) of 31, nearly twice the historic average of 16. And analysts were forecasting long-term earnings growth of 18% a year – well above the historic average of 13%. At the same time, the bond market was signalling an economic slowdown.
• This time around, by contrast, the market has been driven by old economy sectors such as energy, consumer services, utilities and materials. Encouragingly, our TAA models are pointing to further upside for equity markets. Valuations don’t look stretched (PEs are at 18), expectations for long-term earnings growth are lower (at 12%), and the bond market is not indicating an economic slowdown. So we view this new peak as a solid step higher in the bull market.
• The future looks less assured in the Chinese equity market, which has fallen by 9% since its high on 29th May, after soaring by 104% this year. The decline was triggered by the government, which raised stamp duty in order to dampen investors’ enthusiasm. Yet the impact on the Chinese economy should be limited. Price movements affect spending less than in other economies, as China's stock market is still relatively small. Despite the surge in share ownership this year, only 7% of the population owns equities, compared with around half of all Americans. And equities account for less than 15% of Chinese households' total financial assets, versus 50% in the US.
• Certainly, any weakness in Chinese equities should have little impact on financial markets elsewhere. The Chinese market is relatively closed to overseas investors, with just $10 billion – a mere 0.6% of the market – available under the qualified Foreign Institutional Investor programme. So any pronounced dip in global equities caused by the Chinese sell-off would in our view represent a buying opportunity.

Indices, Interest rates and Inflation

	Close 01-Jun-07	1 Week%	1 Month%	3 Months%	YTD %
FTSE all share	3466.52	1.55	3.72	9.36	7.61
FTSE 100	6676.66	1.61	4.00	9.17	7.33
S&P 500	1536.34	1.36	3.37	9.49	8.32
Nasdaq Composite	2613.92	2.22	3.25	8.72	8.22
DJ Stoxx (Europe)	442.87	2.03	3.88	12.91	11.94
Nikkei 225	17958.88	2.73	3.96	2.90	4.26
Hang Seng	20602.87	0.40	1.40	6.49	3.20

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Jun-07 Forecast	Dec-07  Forecast	Current	Next Date
US (Fed Funds)	5.25	5.25	5.00	2.6	28-Jun
UK (Base rate)	5.50	5.50	5.50	2.8	07-Jun
Euro-zone (Repo Rate)	3.75	4.00	4.00	1.9	06-Jun
Japan (Call rate)	0.50	0.50	0.75	0.0	15-Jun

	Selected Global Indicators	Consensus Forecast	Previous Result		Date	Time
EZ	PMI services (May)	57.2	57.0	month	05-Jun	09:00
UK	PMI services (May)	57.0	57.2	month	05-Jun	09:30
EZ	ISM Non-Manufacturing (May)	55.3	56.0	month	05-Jun	15:00
GE	Factory Orders (Apr)	-1.5%	2.4%	mom	06-Jun	11:00
EZ	ECB rate announcement	4.00%	3.75%		06-Jun	12:45
UK	MPC rate announcement	5.50%	5.50%		07-Jun	12:00
JP	Machine Orders (Apr)	4.5%	-4.5%	mom	08-Jun	00:50
GE	Industrial Production (Apr)	0.5%	-0.1%	mom	08-Jun	11:00
US	Trade Balance (Apr)	-$63.5bn	-$63.9bn	month	08-Jun	13:30

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