Global Markets Weekly – 9^th July 2007

Key global market developments

• UK peak still some way off. The Bank of England’s Monetary Policy Committee (MPC) raised the bank rate by a further 25bp to 5.75% last week, its highest level since March 2001. The May Inflation Report provided a clear indication that a further tightening of monetary policy was likely, and even though we believe that this process is drawing to a close, recent data releases and the MPC’s own statements suggest that another hike will be forthcoming during the next few months. In particular, Committee members will be concerned by the enduring strength of monetary growth and suggestions from the various survey data that companies are enjoying a revival in pricing power, factors which point to medium term inflationary risks. Last week’s statement from the MPC made explicit reference to these factors, and while the Committee deny any suggestions that they operate monetary policy by code-word, the overall thrust of the statement was consistent with some further policy tightening.
• We have therefore revised our forecast for UK interest rates, and look for a peak in rates at 6% (possibly at the October MPC meeting), instead of the previous target of 5.75%. The risks that we have highlighted to UK consumer spending, such as the high debt burden and the decline in the household sector savings ratio to a near-fifty year low, all suggest that the MPC will have to act cautiously when raising rates from current levels. But in the present environment, with inflation now having been above-target for fourteen successive months, the MPC appear intent on protecting their credibility and a final rate hike towards the end of this year appears likely.
• Housing remains the centre of attention. The June employment report from the United States showed a solid 132k gain in payrolls during the month, and a host of upward revisions to the previous releases also helped reaffirm the perception that the US labour market continues on a strong footing. Although analysts are fearful that a slowdown in consumption occurred in Q2 (see below), the ongoing strength of employment growth has proved all-important in avoiding a collapse in sentiment towards the US housing market, even while housing sales figures have proved weak. This is particularly welcome at present given the concerns over asset-backed securities based upon sub-prime mortgages, and investors – particularly within the credit markets – will be hopeful that a healthy labour market can prevent any further increase in mortgage arrears and therefore implied losses.
• Not so great expectations. The 1Q earnings figures for the S&P 500 produced an annual increase of less than 10% for the first time in four years. However after a still respectable 7.9% growth, the current expectation for 2Q earnings is for a still lower 4.3% growth, reflecting the deceleration of the US economy in the current year. Forecasts are highest for the industrial sector (+14%), which is benefiting from the improved competitiveness that has resulted from a weak dollar, while a further decline (-9%) is forecast for the consumer discretionary sector, reflecting the impact of the downturn of the housing market on consumer spending. Such low expectations for earnings are also reflected in the relatively unenthusiastic view of US equity investors. The Coutts view is that, with the US economy already recovering, US equities are attractive when compared with bonds or cash, even if even more favourable opportunities are available in other equity markets around the world.
• Market rally. An easing of the spate of upbeat reports on economic growth from around the world allowed bond markets to rally from their June lows (high in yields). This also triggered an equity market rally, with global indices hitting new all-time highs. However, while equity markets have held onto their gains, bonds have fallen back again, with yields close to their highest levels for five years. This seems to reflect that, while for equities the better outlook for global growth outweighs the negative of higher rates, there are no such offsetting benefits for bonds. The current environment therefore continues to favour equities over bonds.

Indices, Interest rates and Inflation

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