Global Markets Weekly – 16^th July 2007

Key global market developments

• The woes of the US sub-prime mortgage market returned to the fore last week, as ratings agency Standard & Poor’s downgraded hundreds of classes of residential mortgage-backed securities (RMBSs) backed by sub-prime collateral. Credit spreads widened sharply, even for the most trustworthy borrowers, and the cost of credit protection suffered its biggest increase in three years. Equity markets briefly took fright, with many down close to 2% in the immediate aftermath. The US dollar dipped to fresh multi-year lows against several currencies.
• An element of calm was restored to credit markets towards the end of the week. But the episode again highlighted the central role played by the US housing market in shaping investor sentiment. In late 2005, concerns centred on the direct impact of a lower level of home-building on US GDP growth. That was before the possibility of falling house prices undermining consumer confidence and spending assumed a greater importance. These two threats have largely failed to materialise. But the difficulties within sub-prime mortgages could finally provide a medium for the housing downturn to cause more serious and lasting alarm among investors.
• A key worry for credit markets is that there’s little available information on how sub-prime mortgages are likely to perform in terms of delinquencies over the coming months. That has clouded the outlook for RMBSs and the value of the various debt instruments based on them. From 2004 onwards, sub-prime mortgage lending grew at a record rate. That was driven by, on the one hand, increasing affordability constraints within the housing market (which led to looser lending criteria) and, on the other, yield-hungry investors’ demand for RMBSs. What remains unknown is how such borrowers will react when adjustable-rate mortgages are reset at much higher interest rates over the coming months and years, which has left holders of RMBSs facing major uncertainties. So these developments could in time have a greater impact on financial markets, with investors forced to reappraise the slim spreads across the credit spectrum just as corporate bond markets’ fundamentals reach a plateau.
• The prospect is starting to have some impact on equity markets. However, investors have taken comfort from the low starting point for any widening of spreads. In addition, equity valuations remain conservative, which should support further mergers and acquisitions. Equity markets also received a timely boost towards the end of last week with some more upbeat news from Wal-mart, which announced better-than-expected sales in June.
• However, Home Depot, the world’s largest home-improvement retailer, warned that its earnings were likely to fall by more than previously forecast. And at the end of the week came the news that US retail sales in June were down by the most in almost two years, re-fuelling concerns that higher energy prices and the housing market may be slowing consumer spending more broadly. Overall, however, earnings revisions – based on consensus views from equity analysts – are improving. For the S&P 500, the blended earnings growth rate – which includes numbers already announced as well as forecasts for companies yet to report – has increased to 4.4%, up from 4.1% at the start of July, primarily thanks to a substantial rise in estimates for the energy sector. 
• The US dollar appears to be another victim of the problems in the sub-prime market: the dollar fell to a new record low against the euro last week. Foreign investors’ demand for RMBSs has been an important source of demand for the dollar in recent years, but that is now clearly at risk. Interestingly, the interest rate futures markets have reacted to last week’s events by starting to price in the possibility of a cut in US rates during the early months of 2008, thereby eroding the dollar’s yield attraction.

Indices, Interest rates and Inflation

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