Global Markets Weekly – 25^th June 2007

Key global market developments

• Calm returned to financial markets last week. A series of rallies in the bond market petered out and yields moved in a far tighter range than of late. A tentative dip in US Treasury yields was encouraged by weak US data for housing starts and homebuilder confidence, suggesting that the correction in the US housing market continues. In the eurozone, the June ZEW survey indicated a moderation in the pace of growth, helping to stem the long-running rise in Bund yields.
• We see scope for a limited rally in bonds in the short term, given their volatility in recent weeks and the perception that it was due as much to technical as to fundamental forces. Yet the upward path of global interest rates remains a major obstacle to a sustained improvement. We still prefer equities to bonds.
• No change in monetary policy is expected from Wednesday’s meeting of the Federal Open Market Committee (FOMC). We think the first quarter marked the trough in growth for 2007. And, with scant spare resources in the US economy, the forecast pick-up in growth should only intensify the FOMC’s concerns about inflation. We expect the next move in US rates to be upwards, but perhaps not until the early months of 2008.
• By contrast, a rate rise looks imminent in the UK. The minutes of June’s meeting of the Monetary Policy Committee (MPC) revealed that higher rates were avoided by a 5-4 vote. The MPC’s hawks were troubled by persistent inflation and rapid monetary growth, which could help to sustain price pressures in the medium term. So the MPC may well act next month, rather than wait for its August meeting.
• That view is supporting the pound, which is again nearing $2. Against most other currencies, the dollar has been more than holding its own of late. The turmoil in bond markets appears to have served it well. One of the forces which sparked the rise in bond yields was improved US data, which should support the dollar in the near term. Yet it’s unclear how a continuation of current trends would affect the dollar in 2008 and beyond. As most of the US’s substantial international liabilities are in the form of debt instruments (largely Treasuries), higher yields will increase interest payments and, hence, the flow of income out of the country. So higher bond yields are likely to place greater strain on the balance of payments in the US and intensify the adverse structural pressures on the dollar.
• Asian and emerging-market equities continue to outperform. Unusually, this month’s correction hit developed and western equities harder than Asian and emerging markets. This reflects two factors. First, the initial cause of the correction was higher-than-expected growth, which favours the more cyclical equity markets. Second, the driver was higher bond yields. And, while emerging-market and Asian equities are no less sensitive to higher bond yields or interest rates, their economies mostly appear well placed to withstand these threats. The key link is their undervalued exchange rates, which enables these countries to control inflationary pressures by allowing their currencies to appreciate rather than by raising interest rates. This approach has already been used by Thailand and India this year. For equity investors, the combination of still-low rates and bond yields plus currency appreciation is an attractive prospect. 
• Asian equities are also likely to benefit from the prospect of a Chinese wall of money. Although Japanese domestic investors and the yen carry trade are seen as the key drivers of international flows, recent moves by the Chinese authorities should increase overseas flows from domestic investors. Under new regulations, renminbi-denominated funds investing in overseas assets can be offered to domestic investors by an increasing number of financial groups from 5^th July. The immediate impact will probably be to reduce the wide discrepancy in valuation between domestic ‘A’ shares and the ‘H’ shares quoted on the Hong Kong stock market. Yet the broader implications are positive for investment markets throughout the region.

Indices, Interest rates and Inflation

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