Global Markets Weekly – 2^nd July 2007

Key global market developments

• The major equity markets tended to trade in a sideways fashion over the past week, and the statement from the Federal Open Market Committee (FOMC) didn’t provide any fresh impetus. The FOMC remains in ‘wait and see’ mode. US growth continues at a moderate pace, while inflationary pressures – though perhaps moderating – are still causing policy-makers some concern. As a result, we don’t expect any change in US interest rates until the very end of this year.
• By contrast, other central banks are likely to raise rates, starting with the Bank of England on Thursday. At last month’s meeting of the Monetary Policy Committee (MPC), Governor Mervyn King argued for an immediate rate rise but was on the losing side of a 5-to-4 vote. This time around, he is likely to win the argument. The main reasons for a rate rise are likely to be the strength of the global economy, rapid monetary growth and the lack of spare capacity across the domestic economy. Doubtless, the market will seize on a rate rise as grounds for speculation that rates are heading much higher, largely because of the apparent ineffectiveness of the monetary tightening so far. However, we think the expected move to 5.75% will mark the peak in the current interest-rate cycle.
• Further pressure for a rate rise came last week from a leading survey of UK house prices, which suggested that they re-accelerated in June to the fastest rate since January 2005. Yet we see good reasons to believe that the rising path of interest rates is beginning to bite and that a housing slowdown will eventually emerge. Although mortgage approvals unexpectedly increased in May, the broad trend remains downwards. And mortgage providers, facing pressures on profitability, will not be able to shield borrowers indefinitely from the full extent of rising interest rates.
• Meanwhile, the US market for sub-prime mortgages has claimed its latest – and largest – victims, in the shape of two Bear Sterns hedge funds. Although the US housing market started weakening last year as higher interest rates took effect, mortgage defaults didn’t begin to rise until the end of 2006. Early this year, that led to a wave of collapses around companies specialising in sub-prime mortgages. Only now have losses on sub-prime mortgage-linked bonds held within Collateralised Debt Obligation instruments come to light, forcing the collapse of the two hedge funds backed by Bear Sterns.
• The consequences of the problems in the US sub-prime mortgage market are likely to rumble on. But, as the associated assets have already been re-priced, the impact on markets should be limited – unless we see signs that the problems are spreading to another sector of the economy.
• The upwards trend in the oil price continues. Although the latest rise in the spot oil price has not taken it above last year’s highs, the long-term price of oil has continued to increase. This month, the price of long-dated oil futures has hit new peaks. That reflects both the upward pressures on costs and the constraints on exploration and development of new supplies. In the short term, the oil price may weaken after the end of the late-summer driving and hurricane seasons in the US. However, we expect the longer-term trend to remain positive.
• It has been announced that the $200 billion of funds assigned to China’s new overseas investment agency will be raised by issuing local bonds. Initial interest has been focused on the implications for overseas investment markets, particularly the potential for a disposal of some of China’s holdings of US Treasuries and a switch into equities. However, by issuing bonds to fund the new entity, the Chinese authorities will be withdrawing liquidity from the domestic economy, adding a further instrument to the current raft of measures designed to cool domestic demand.

Indices, Interest rates and Inflation

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