Global Markets Weekly - 15th October 2007

Key global market developments

• A possible change of tack from Asian central banks...
  Emerging equity markets hit new highs last week, led by Asia. Their strength is in no small part due to central bank policy.
  Since the Asian crisis a decade ago, the region’s central bankers have focused on controlling their exchange rates. But they can’t control the exchange rate, the money supply and interest rates all at once. So, with Asian currencies kept artificially low, monetary aggregates have grown rapidly, causing soaring property and stock markets - Asian equities are up 40% this year - and creeping inflation.
  
• …as Singapore signals it mayfollow India down the path of currency appreciation.
  Asian countries that are serious about fighting inflation and rampant asset markets have little choice but to loosen their exchange rate policies.
  India chose that path last spring. Since then, the rupee has risen some 10% against the dollar. Now, the Monetary Authority of Singapore has said that growing inflationary pressure has led it to upgrade its expected Singapore dollar appreciation.
  
  So what could end emerging markets’ bull run? Inflation pressures in emerging markets are rising, but not yet enough to prompt drastic action from their central banks. The time to worry is when they start worrying. We think this is more of a concern for 2008 than now.
  
• China's authorities may need additional measures...
  This week, the Chinese Communist Party's bigwigs meet behind closed doors for their fiveyearly congress. In the first half of 2007, China grew faster than its potential growth rate (some 10.5%) for the first time in a decade. Yet excess demand is tiny relative to previous phases of overheating. So soaring inflation is unlikely to cause a hard landing in the near future, and any monetary tightening should be limited.
  
• …to dampen soaring stock markets.
  Still, we expect further measures to cool China's stock-market bubble. Share prices have risen by 400% in just over two years, and average price-earnings (PE) ratios based on historic profits are around 55. Even based on forecast profits for 2008, they are 30. Although this is probably a bubble, share prices could keep rising for a lot longer. After all, both Japan's Nikkei and America's NASDAQ reached PE ratios well above 100 at their peaks. As China’s real interest rates are negative, rate rises won't be enough to cool the bubble. Among the tools at the government’s disposal are capital gains taxes, higher stamp duty, releasing more shares in previously state-owned companies and widening access to overseas markets, as well as faster currency appreciation against the US dollar.
• Weaker UK public spending casts doubt on employment outlook.
  Last week, the UK Treasury forecast that government spending will grow in coming years by just 2.1% per annum on average in real terms. That’s the slowest rate since 1990-2000 and less than half the pace of the past five years or so. If the government sticks to this target, public spending’s contribution to annual GDP growth could be half the recent average. That should have a major impact on employment. In the past five years, the public sector has accounted for 60% of the jobs created in the UK. Worryingly, the other 40% has come from the financial sector, whose employment outlook has also worsened, after this summer’s turmoil in financial markets.
  
• Commodity prices will drive up headline inflation.
  Commodity prices are the way inflationary pressure in emerging markets is transmitted to the developed world. Concerns that commodity-driven rises in headline inflation rates will spread to core inflation will limit how far Western central banks cut rates to offset weakening domestic economies. Consequently, the market is keenly awaiting Wednesday’s release of September US CPI. While core inflation should stay the same at 2.1%, food and energy prices may push the headline rate up from 2.0% to 2.8%.

Indices, Interest rates and Inflation

	Close 12-Oct-07	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,455	2.0	6.0	0.0	7.2
FTSE 100	6,731	2.1	6.7	0.5	8.2
S&P 500	1,562	0.3	6.1	0.9	10.1
Nasdaq Composite	2,806	0.9	8.2	3.9	16.2
DJ Stoxx (Europe)	432	0.7	6.8	-1.4	9.3
Nikkei 225	17,331	1.6	9.7	-3.6	0.6
Hang Seng	28,838	3.6	18.6	26.4	44.5

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Dec-07 Forecast	Mar-08  Forecast	Current	Next Date
US (Fed Funds)	4.75	4.50	4.50	2.0	31-Oct
UK (Base rate)	5.75	5.50	5.25	1.8	08-Nov
Euro-zone (Repo Rate)	4.00	4.00	4.00	1.7	08-Nov
Japan (Call rate)	0.50	0.50	0.75	-0.2	31-Oct

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