Global Markets Weekly - 17th December 2007

• Central banks took action last week to inject liquidity…
  The coordinated action announced by five of the world’s largest central banks on 12th December has been met with a mixture of relief and scepticism: relief that monetary authorities are now taking steps to regain control of real economy interest rates, which in many countries have risen well above official policy rates; and scepticism because – at around $50 billion - the total package of liquidity aid falls well short of what would be required to return money market conditions to normal.
• …but it appears that further steps will be needed.
  The six-month term of the currency swap between the Federal Reserve and the European Central Bank suggests that these operations may continue well into the new year, in order to prevent what the Bank of England’s Paul Tucker described this week as ‘a vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply and slower aggregate demand feed back on one another.’
• Despite these measures, an economic slowdown is inevitable.
  Though welcome, the measures announced this week will not be enough to prevent the slowdown over coming quarters which is already baked into the cake. The rapid expansion of banks’ balance sheets over recent months means that credit conditions will remain tight, even if central banks manage to unblock cash markets.
• We are currently in the deceleration phase of the economic cycle…
  Uncertainty about the implementation and scale of central banks’ liquidity intervention contributed to financial markets’ volatility last week. Choppy markets are typical of this deceleration phase of the economic cycle, when growth slows but inflation stays high. Our analysis shows that the S&P 500 is three to four times more likely to see daily declines of over 2.5% during this phase than any other. The main driver of this volatility is investors’ concerns that heightened inflation will prevent central banks from supporting growth as much as they otherwise would. So, in this phase, the best-performing asset classes are usually commodities and government bonds, especially inflation-linked.
• …but the next phase should be better for riskier assets.
  For investment managers, the trick is judging when this sticky spot for riskier assets ends and the slowdown phase begins. In a slowdown, growth remains weak, but an excess of bad growth news is priced into asset markets, and slowing inflation gives investors confidence that central banks have room to lower interest rates. Hence, the next phase typically favours corporate bonds in particular, but equities too. We expect the slowdown phase to start in the first half of 2008, after inflation has peaked in the US and Europe and central banks have succeeded in lowering the yield premium currently attached to illiquid assets.
• Headline inflation is still on the rise...
  For now, higher energy and food prices are pushing up headline inflation rates around the world. German and Chinese inflation data released last week rose to their highest levels for 11 and 12 years, respectively. And oil prices, which have surged over 70% this year, pushed headline inflation in the US above 4% for the first time since July 2006.
• …raising concerns that core inflation will follow suit.
  Though better behaved, core inflation also shows signs of ticking up. That is raising central bankers’ concerns that looser monetary policy at this stage could allow core inflation to rise to current headline rates, rather than vice versa – the policy mistake of the 1970s. Fortunately, higher energy prices' impact on overall inflation should lessen during the second quarter of 2008, contributing to calmer market conditions. At that point, however, any sharp moves in the oil price – in either direction – could have a stronger-than-average impact on financial assets.

Indices, Interest rates and Inflation

	Close 14-Dec-07	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,249	-2.4	-1.6	0.3	0.9
FTSE 100	6,397	-2.4	-0.6	1.7	2.8
S&P 500	1,468	-2.4	-0.2	-1.1	3.5
Nasdaq Composite	2,636	-2.6	-0.3	1.3	9.1
DJ Stoxx (Europe)	415	-1.5	-0.1	2.4	4.8
Nikkei 225	15,515	-2.8	0.1	-3.8	-9.9
Hang Seng	27,564	-4.4	-5.5	10.7	38.1

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Mar-08 Forecast	Jun-08  Forecast	Current	Next Date
US (Fed Funds)	4.25	4.25	4.25	4.3	30-Jan
UK (Base rate)	5.50	5.25	5.00	2.1	10-Jan
Euro-zone (Repo Rate)	4.00	4.00	3.75	3.1	10-Jan
Japan (Call rate)	0.50	0.50	0.50	0.3	20-Dec

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