Global Markets Weekly – 30^th July 2007

Key global market developments

• There was a distinct whiff of risk aversion across the financial markets last week as the ongoing problems within credit began to influence developments in other asset classes, equities in particular. Credit spreads and other ‘synthetic’ measures of default protection again widened-out significantly as investors headed towards the exit signs. The associated flight towards ‘safe’ assets also caused large-scale losses across the equity markets, the S&P500 falling by 4% during the week on unusually high volume. Given their greater exposure to the apparent driving force behind the troubles in credit – the US sub-prime mortgage market – US equities appear to be the most vulnerable but last week’s losses were fairly evenly spread across the global bourses.
• Equities typically turn more volatile as companies add leverage, something that has turned more obvious over the course of this year. The unusually low volatility that has characterised the past couple of years now looks to be behind us, but the justification for this pronounced weakness in equities is in our opinion a little tentative. A disruption of the credit markets cannot be ruled out, particularly as much of the trading here occurs on an ‘over the counter’ basis without the formal markets to safeguard liquidity during times of uncertainty. But the basis for a severe credit crunch to develop - one that would threaten the availability of finance to even the most trustworthy of corporate borrowers - still appears to be absent. Corporate bond defaults are at unusually low levels and the activity of the major rating agencies remains a net positive. Indeed, the Q2 earnings season in the US, having now reached the halfway stage, has on balance produced profit growth closer to 11% than the 5.8% expected by analysts.
• Lenders will undoubtedly adopt a more discriminating eye than has been the case over the past few years and the more highly leveraged, less obviously ‘value creating’ merger & acquisition activity could well be a casualty here. Loan officer surveys in the United States have already shown a tightening of credit standards within residential mortgages and this could now spread towards corporate lending, but an abrupt shift in lending practices would not appear to be justified. By extension, the speculation that developed last week of an early interest rate cut from the Federal Reserve, prompting an enthusiastic rally by across the government bond markets, appears wide of the mark in our opinion but this will doubtless persist as long as volatility remains at an elevated level.
• The economic data are likely to take a backseat for the time being but the news from the US housing market last week did nothing to calm nerves over the sub-prime mortgage issue. Both the existing and new home sales figures for June made for dire reading, falling by a larger than expected degree with the former slipping to their lowest level since November 2002. The high level of inventories of unsold homes, meanwhile, suggests that the prospects for a housing market rebound also appear rather distant and this factor will continue to cast a considerable cloud over the outlook for the US economy for both this year and next.
• Thursday’s Monetary Policy Committee (MPC) meeting in the UK will be eagerly awaited, particularly given the MPC’s penchant for surprises this year. With this week’s meeting also featuring the quarterly update of the inflation and growth projections for the upcoming Inflation Report - something which traditionally increases the chances of a rate move - the markets will approach Thursday’s announcement with some nervousness, but we do not expect any change in policy to occur at this juncture. With inflation now having been above target since May 2006, however, policymakers remain keen to reinforce their credibility and a further tightening - possibly in October - still appears more likely than not.

Indices, Interest rates and Inflation

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