Global Markets Weekly - 20th August 2007

Key global market developments

·Uncertainty about where the bodies from the US sub-prime implosion are buried is likely to remain a source of downward pressure on equity markets over coming weeks. We are in the midst of a large de-leveraging process. The provision of short-term liquidity by central banks – though necessary to forestall a more widespread financial crisis – may not be enough to rectify matters, at least in the immediate future. That’s because the root of market worries is the potential for counterparty failure. In this sense, today's scenario is quite different from the collapse of Long Term Capital Management (LTCM), a large US hedge fund, in 1998. Back then, the problem was largely contained to LTCM and, with the US Federal Reserve (Fed) co-ordinating, the major counterparties co-operated to ensure an orderly unwinding of LTCM's sizeable positions. Today, in contrast, there is no single focus for concerns. Losses on US mortgage-backed securities and their derivatives have been suffered all around the world across an array of hedge funds, investment banks and insurance companies. Many institutions, particularly hedge funds, are lightly regulated and supervised. That makes insolvency and illiquidity risks opaque and almost impossible to measure. Hence, identification and recognition of any losses will take weeks, months or perhaps even longer, leaving a residual angst overhanging markets and acting as a continuing source of volatility.

·Financial markets are showing signs of extrapolating the current crunch into a sharp global slowdown. Cyclical equity markets and sectors have abruptly reversed track, with defensive stocks outperforming. Yet inferring economic expectations from the markets is a more uncertain process than usual, because de-leveraging is hurting previously outperforming assets. General reductions in positions will inevitably hit areas where investors are long much harder than areas where people have no positions or are short. In a deleveraging phase, fundamentals rarely count for much. So it is not clear whether the new underperformance of the more cyclical assets and markets is being driven by a technical weight of longs or a genuine downgrading of global growth expectations.

·Unless the credit crunch gets much worse, it is primarily a market rather than a macro-economic event. One interpretation of recent developments is that the markets know something about the economy that economists don’t, and we should be cutting our forecasts for growth, inflation and interest rates. At face value, the sell-off reflects a deterioration in the credit quality of the corporate sector, which is now likely to retrench, cutting investment and employment and slowing growth. This may be true, but it seems hard to square with the current health of the corporate sector, where balance sheets are strong and profitability remains good. The recent results season in the US bears this out, with earnings on the S&P set to rise by 7.5% for the second quarter, compared with just under 8% for the first.

· Because of moral hazard concerns, the Fed will continue to talk tough until the moment it thinks rate cuts are required to stop this turning into a macro event. The Fed’s job is not to bail out over-leveraged institutions or investors; its job is to protect the financial system and the wider economy. At present, the Fed sees no evidence that the credit crunch is spreading into the real economy. The dilemma is that, if it waits for clear evidence that the economy is being affected, it will have left it too late. So, even though William Poole, president of the St Louis Fed, said on Thursday that only a calamity would justify a rate cut now, the odds of a September cut have gone from close to 0% a month ago to about 65% now.

Indices, Interest rates and Inflation

	Close 17-Aug-07	1 Week%	1 Month%	3 Months%	YTD %
FTSE all share	3129	-0.0	-9.0	-8.5	-2.9
FTSE 100	6064	0.4	-8.9	-7.8	-2.5
S&P 500	1446	-0.5	-6.7	-4.4	1.9
Nasdaq Composite	2505	-1.6	-7.6	-1.4	3.7
DJ Stoxx (Europe)	397	-1.1	-9.7	-7.8	0.2
Nikkei 225	15274	-8.9	-16.2	-12.7	-11.3
Hang Seng	20387	-6.5	-11.6	-2.9	2.1

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Dec-07 Forecast	Jun-08  Forecast	Current	Next Date
US (Fed Funds)	5.25	5.50	5.50	2.4	18-Sep
UK (Base rate)	5.75	6.00	6.00	1.9	06-Sep
Euro-zone (Repo Rate)	4.00	4.25	4.25	1.8	06-Sep
Japan (Call rate)	0.50	0.75	1.25	-0.2	23-Aug

	Selected Global Indicators	Consensus Forecast	Previous Result		Date	Time
JN	All-industry activity index (June)		-0.3%	mom	20 - Aug	23:50
US	Leading Indicators (July)	0.4%	-0.3%	mom	20 - Aug	12:30
UK	M4 Money Supply (July)		12.9%	yoy	20 - Aug	08:30
JN	Trade balance surplus (July)	Y765bn	Y1,227bn	month	21 - Aug	23:50
EC	Euro-Zone Trade Balance (June)		€1.7bn	qoq	21 - Aug	12:30
EC	German ZEW Survey (August)	0.0	10.4	month	21 - Aug	09:00
EC	Industrial New Orders (June)	1.7%	1.7%	yoy	22 - Aug	09:00
JN	Bank of Japan meeting	0.5%	50.0%	rate	23 - Aug	06:00
US	Durable Goods (July)	1.0%	1.3%	mom	24 - Aug	13:15
EC	Advance Manufacturing PMI (August)	54.5	54.9	month	24 - Aug	12:30
EC	Advance Services PMI (August)	58.0	58.3	month	24 - Aug	12:30

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