Global Markets Weekly - 13th August 2007

Key global market developments

·Signs of a credit crunch caused equity markets to fall sharply at the end of last week. If they can find a foothold, a variety of timing indicators point to a rally. For example, the difference between bullish and bearish advisor sentiment has contracted to just 12.3%, a potentially bullish level. Just two weeks ago, it was 35.9%. A bull-bear difference that narrows to around 15% or less and then expands has historically been a buying signal. That was shown in June 2006, when it fell to 0%, and again on 14^th March 2007, when it fell to 16%.

·If we can get through the short run, then valuation offers a more fundamental support for equity markets. At times like these, it is instructive to fall back on valuation, even though negative market sentiment and fears of a liquidity crunch may drive equity markets down further over the next few weeks. Our analysis shows that, when trying to forecast year-ahead returns from equity markets, the best measure to use is a comparison of price-earnings ratios (PEs) and corporate bond yields. The current reading is similar to those in 1989 and 1996, which heralded buying opportunities.

·An unprecedented level of intervention by the European Central Bank (ECB) raises the probability of a rate cut. Last Thursday, after a sudden liquidity squeeze and a spike in interbank lending rates, the ECB injected €94.8 billion in a special refinancing operation. Intervention on that scale has not been seen since the aftermath of the terrorist attacks on New York in 2001. The trigger for the action was a sharp rise in overnight interest rates moving them to a six-year high of 4.7%, well above the ECB’s main rate of 4%. This episode suggests that European banks suspect that, as a group, they are as exposed as US banks, if not more, to the sub-prime implosion. The odds of this becoming a systemic problem have gone up and, along with them, the odds of a rate cut. The big problem is we just don’t know how bad things could get. It will take a number of trading days to work through this.

·This is a crunch time not just for markets but also for central bankers. Every major rate-tightening cycle in the past 20 years has ended with a financial crisis. For the past couple of years, central banks have been slowly tightening monetary policy to stop strong growth generating excessive inflation pressure. The real economy data – growth rates, inflation rates and output gaps – suggests that they have more work to do over the coming months. Nevertheless, in the light of the liquidity squeeze in the interbank market, we may be witnessing the interest rate cycle turning. It is often forgotten that central banks are tasked with protecting financial stability and confidence in the banking system, as well as monetary stability. Safeguarding the financial system by injecting liquidity and perhaps even cutting rates will now take priority over controlling inflation.

·This is a crisis of confidence in the financial sector, not a crisis of confidence in the real economy. Last time the global economy experienced a liquidity crunch of this nature ­– in 1998, when Russia defaulted on its debt and the large US hedge fund Long Term Capital Management failed – global growth forecasts were in the process of being revised down because of weakness outside the US. This time around, global growth forecasts are being revised up despite a weak US economy, thanks to persistent strength in Asia and emerging markets. The developing world is also in far better financial health than it was ten years ago.

	Selected Global Indicators	Consensus Forecast	Previous Result		Date	Time
JN	Gross Domestic Product	0.2%	0.8%	qoq	13 - Aug	00:50
US	Retail Sales Less Autos	0.4%	-0.4%	mom	13 - Aug	13:30
UK	RICS House Price Balance	9.60%	10.60%	yoy	14 - Aug	00:01
UK	Consumer Price Index	2.3%	2.4%	yoy	14 - Aug	09:30
EC	Euro-Zone GDP	0.5%	0.7%	qoq	14 - Aug	10:00
US	Trade Balance	-$61.0B	-$60.0B	month	14 - Aug	13:30
US	PPI Ex Food & Energy	2.5%	1.8%	yoy	15 - Aug	13:30
UK	Bank of England Minutes	-	-	-	15 - Aug	09:30
US	Consumer Price Index	2.4%	2.7%	yoy	15 - Aug	13:30
US	Empire Manufacturing	18.3	26.5	month	15 - Aug	13:30
US	Industrial Production	0.30%	0.50%	mom	15 - Aug	14:15
UK	Retail Sales	3.4%	3.4%	yoy	16 - Aug	09:30
US	Building Permits	1410K	1406K	month	16 - Aug	13:30
US	Initial Jobless Claims	312K	316K	weekly	16 - Aug	13:30
US	U. of Michigan Confidence	88.3	90.4	month	17 - Aug	15:00

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