Global Markets Weekly - 27th August 2007

Key global market developments

·The dust seems to have settled a little over the past few days, allowing us to step back and consider how the world may evolve over the next few months. Every Federal Reserve (Fed) tightening cycle over the past 20 years has ended in some form of crisis – Black Monday, the Savings & Loans Crisis, the Peso Crisis, Asia/LTCM, the bursting of the Tech bubble and now the US sub-prime market and its associated alphabet soup of credit derivatives. Of course, history never repeats itself exactly. But looking back at those episodes and their aftermaths has helped us to consider possible scenarios for the coming months and to evaluate which is the most likely to play out. In summary, we think central banks will inject enough liquidity into the system to revive market confidence and prevent the credit crunch having any material impact on the global economy. That has given us the confidence to adjust our clients’ portfolios at this point.

·The first scenario – and in our view the most likely – is that the Fed does what it needs to and that both the economy and riskier assets respond. Yet this outcome, which would be similar to what happened after the LTCM crisis, is not a certainty. This time around, the problems are larger, less transparent, more widespread and harder for central banks to resolve. The bad news is likely to continue for some weeks. Consequently, the fear and aversion that investors have experienced in recent weeks may not pass quickly. If this scenario does play out, any cuts in interest rates will probably have to be reversed later in the decade as inflation pressures rise.

·The second scenario is that the economy responds but the market takes a considerable time to pick up. This scenario, which should not be ruled out, is what happened after the bursting of the tech bubble at the start of this decade. Then, the Fed slashed rates quickly and the economy picked up, because households were in a position to borrow, even though companies weren’t. However, the equity market didn’t respond until the invasion of Iraq in the spring of 2003. That was because valuations were high, the collapse of Enron and other companies had shown some corporate accounts to be untrustworthy, and the fear of war hung over us. This time around, companies are in better shape to borrow than households, equities aren’t expensive in absolute terms and look positively cheap against bonds and property, and it’s credit ratings and pricing models that can’t be trusted, not company accounts.

·The third scenario is that neither the economy nor the markets respond to the medicine. We view this scenario as unlikely. Central banks aim to control the price of money, but they can’t force lenders to lend or borrowers to borrow if they don’t want to. That is clear from what happened in Japan during the 1990s, after the bursting of the late-1980s bubble in equities and property. Arguably, Japan is still in the recovery room today. There were three main reasons why the medicine didn’t work there. First, with the benefit of hindsight and revised data, it’s clear that the Bank of Japan was too slow and too timid with its rate cuts. Second, the banking system was too weak to lend. Third, the economy was weighed down by ‘zombie’ companies that were not allowed to die. By contrast, the US economy has always responded to the adrenaline shot of liquidity, and there is little reason to believe that it won’t do so now. Certainly, the impact may be blunted by the high level of household borrowing, but the Fed has learnt the lesson of Japan’s experience and has been quick to recognise the magnitude of the current crisis. Moreover, although banks will in future be more discriminating about whom they lend to and at what price, their balance sheets are still strong enough to allow them to lend. As a result, we think it’s hard to lend credence to the notion that the US will follow Japan’s path.

Indices, Interest rates and Inflation

	Close 27-Aug-07	1 Week%	1 Month%	3 Months%	YTD %
FTSE all share	3209	2.3	-0.0	-6.0	-0.4
FTSE 100	6220	2.3	0.1	-5.3	-0.0
S&P 500	1467	1.5	0.5	-3.2	3.4
Nasdaq Composite	2561	2.1	-0.0	0.2	6.0
DJ Stoxx (Europe)	409	2.4	-0.5	-5.8	3.3
Nikkei 225	16301	3.6	-5.7	-6.8	-5.4
Hang Seng	23578	9.2	4.5	14.9	18.1

 

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Dec-07 Forecast	Jun-08  Forecast	Current	Next Date
US (Fed Funds)	5.25	5.25	5.25	2.4	18-Sep
UK (Base rate)	5.75	6.00	6.00	1.9	06-Sep
Euro-zone (Repo Rate)	4.00	4.00	4.00	1.8	06-Sep
Japan (Call rate)	0.50	0.75	1.25	-0.2	19-Sep

 

	Selected Global Indicators	Consensus Forecast	Previous Result		Date	Time
US	Fed Minutes of 7 August meeting	-	-	-	28 - Aug	18:00
US	Conference Board Confidence (Aug)	106	112.6	index	28 - Aug	14:00
GR	IFO Business climate (Aug)	105.6	106.4	index	28 - Aug	08:00
JN	Nationwide CPI (July)	-0.1%	-0.2%	yoy	30 - Aug	23:30
JN	Industrial Production (July)		1.30%	mom	30 - Aug	23:50
US	GDP Q2 (second forecast)	4.0%	3.4%	qoq	30 - Aug	12:30
EZ	Consumer Confidence (Aug)	-3	-2	index	31 - Aug	09:00
EZ	Industrial Confidence (Aug)	4	5	index	31 - Aug	09:00
UK	GfK Consumer Survey (Aug)	-	-6	index	31 - Aug	09:30
US	Core PCE Prices (Jul)	0.2%	0.1%	mom	31 - Aug	12:30
US	University of Michigan Sentiment (Aug)	83.2	83.3	index	31 - Aug	14:00
US	Factory Orders (July)	0.7%	0.6%	mom	31 - Aug	14:00

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