Global Markets Weekly – 11^th June 2007

Key global market developments

• Year to date, it has been right to be underweight bonds – which have produced a negative total return of 1% so far - and overweight global equities, which have returned a positive 8%. But as we warned they would, late last year, equity markets are getting more volatile as companies re-leverage and this bull market matures. This, we thought, would result in more frequent corrections. Daily falls in the US equity market of over 2%, which were common in the late-1990s, did not occur at all in 2004-06, but we have already had two so far this year.
• Last week a rapid rise in bond yields spooked equity markets with the S&P 500 down 2 %, the FTSEdown 3%, the EURO STOXX down 4% and the Hang Seng off just 0.5%. This is the sixth mid-rally correction that the equity market has had since this bull market began in the autumn of 2003. On average, the US equity market has fallen 6% during these episodes. So far in the current move, the US market has fallen 3%.
• Equities have underperformed bonds by 1.2% so far this month, with bonds down 0.6% but equities off 1.8%. Although equities could easily fall by a further 3 percent over the next couple of weeks, we expect equities to recover and outperform over the coming three months. Based on 25 years of historical data, our tactical asset allocation model is forecasting a 75% probability of equities outperforming bonds over the next three months, with a predicted average out-performance of just under 5%.
• Various fundamental and technical factors have been forwarded in explanation of the sudden, extensive sell-off of global bonds that pushed long-term yields in the United States and elsewhere to year-high levels last week. Even the surprise decision from the Reserve Bank of New Zealand (RBNZ) to raise interest rates was cited as a factor! This was of course essentially a coincidence, as we would not normally expect the RBNZ’s actions to spook the global bond market. But in the midst of extremely jittery markets, the RBNZ’s rate hike suddenly assumed a global audience.
• Indeed, the motivation and background for the RBNZ’s move neatly encapsulated the various issues concerning central bankers at present, and many of the factors that last week prompted a mini stampede amongst investors. For some time, policymakers in New Zealand have grappled with the effects of rising commodity costs, strong asset price inflation and growing capacity constraints. The strength of global liquidity growth has also been a complicating factor, with capital inflows (in response to ever higher interest rates) encouraging a more rapid level of monetary growth than would otherwise be the case. These are the very issues facing many of the major economies at present, whether in the US, UK or Euro-Area, and which have finally begun to undermine investor confidence in the inflationary outlook and ultimately cloud the future path of global interest rates.
• In the short-term, the markets will be looking for reassurance from central bankers over inflation and monetary policy, but this is unlikely to be forthcoming and interest rate expectations will remain fluid for some time. The major central banks appear to be concerned about a broad-based pick-up in pricing power and inflation expectations, and currently seem to be monitoring an especially diverse range of indicators in their analysis. As such, a better reading on a single economic news release over the coming weeks will not signal the ‘all-clear’ on the inflation front, and policymakers may well prove to be rather more guarded of their opinions than the markets have become accustomed to in recent years.
• All of this suggests that the current volatility could continue for a while yet. Indeed, some of the movements observed last week – such as the more than 10bp rise and then fall in the 10-year Treasury yield during last Friday alone – look to have been more technical than fundamental in nature, presumably related to fixed income fund managers countering a concept known as negative convexity within the mortgage-backed security market.

Indices, Interest rates and Inflation

	Close 08-Jun-07	1 Week%	1 Month%	3 Months%	YTD %
FTSE all share	3364.66	-2.94	-1.23	4.03	4.45
FTSE 100	6505.11	-2.57	-0.69	4.45	4.57
S&P 500	1507.67	-1.87	-0.00	7.55	6.30
Nasdaq Composite	2573.54	-1.54	0.07	7.78	6.55
DJ Stoxx (Europe)	424.34	-4.18	-0.92	6.64	7.26
Nikkei 225	17779.09	-1.00	0.69	4.03	3.21
Hang Seng	20509.15	-0.45	-0.95	6.96	2.73

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Dec-07 Forecast	Jun-07  Forecast	Current	Next Date
US (Fed Funds)	5.25	5.25	5.00	2.6	28-Jun
UK (Base rate)	5.50	5.75	5.75	2.8	05-Jul
Euro-zone (Repo Rate)	4.00	4.50	4.50	1.9	05-Jul
Japan (Call rate)	0.50	0.75	1.25	0.0	15-Jun

	Selected Global Indicators	Consensus Forecast	Previous Result		Date	Time
UK	CPI (May)	2.5%	2.8%	yoy	12-Jun	09:30
UK	Average Earnings (Apr)	4.6%	4.5%	yoy	13-Jun	09:30
US	Retail Sales (May)	0.7%	-0.2%	mom	13-Jun	13:30
US	Fed's Beige Book				13-Jun	19:00
UK	Retail Sales (May)	3.9%	4.2%	yoy	14-Jun	09:30
EZ	HICP (May, final)	1.9%	1.9%	yoy	14-Jun	10:00
US	PPI (May)	3.5%	3.2%	yoy	14-Jun	13:30
JP	BoJ rate announcement	0.50%	0.50%		15-Jun
US	CPI (May)	2.6%	2.6%	yoy	15-Jun	13:30
US	Empire Manufacturing (Jun)	10.5	8.0	month	15-Jun	13:30
US	Net long-term TIC flows (Apr)	$71.5bn	$67.5bn	month	15-Jun	14:00
US	Industrial Production (May)	0.2%	0.7%	mom	15-Jun	14:15
US	Michigan Consumer Sentiment (Jun-prel)	88.0	88.3	month	15-Jun	14:45

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