Global Markets

The return of some willingness to accept risk in financial markets worldwide Wednesday ended abruptly Thursday as more negative news surfaced in the subprime mortgage area. The chief catalyst this time came from the French bank BNP Paribas which said it had suspended three of its funds with exposure to the subprime area. Paribas joined Bear Stearns Cos. and Union Investment Management GmbH in stopping fund redemptions. This in turn triggered a new round of risk aversion. Equities sank and there were upheavals in credit spreads and currencies. Earlier in the week in the absence of hard new economic data, investors took comfort from broadly soothing remarks on the U.S. economy by the Federal Reserve which also recognized the risks posed by recent market turmoil at its policy meeting on Tuesday. But unease was not entirely dispelled and markets continued to be hypersensitive to any mention of subprime concerns.

Worries about further credit-related problems sent banks scrambling for cash and drove overnight euro and dollar deposit rates to their highest levels in about six years. U.S. dollar overnight interest rates jumped by more than 50 basis points to 5.86 percent, while overnight euro deposit rates reached 4.7 percent. This in turn prompted the European Central Bank to surprise the markets and inject a record €94.8 billion into the money markets to stem fears of a liquidity crunch. The Federal Reserve also pumped a significantly larger than normal amount of cash into financial markets as well, while the Bank of Canada issued a statement of reassurance. Later in the day, the Bank of Canada also added to fund availability. The Bank made use of Special Purchase and Resale Agreements (SPRAs) which it has with major dealers in Government of Canada debt markets, and explained that the day's purchase was higher than normal, but nothing extraordinary. Overnight, the Banks of Japan and Korea and the Reserve Bank of Australia followed its Western Hemisphere colleagues. And on Friday, the Fed, Bank of Canada and the ECB intervened yet again.

On the currency markets, the yen benefited from the heightened risk aversion as investors unwound carry trades, where purchases of higher-yielding assets are funded by sales of low-yielding currencies. Commodity prices retreated across the board amid heightened concerns that turmoil elsewhere could lead to lower growth and reduced demand.

Global Stock Market Recap

Europe and the UK

European stocks enjoyed the biggest two-day rally in four years on Tuesday and Wednesday after corporate earnings exceeded estimates and the FOMC said losses in the U.S. mortgage market probably would not hold back economic growth. But stocks plummeted Thursday and Friday after the two days of solid gains and after BNP Paribas SA halted withdrawals from three investment funds because the bank could not determine the value of the holdings. Despite the indexes’ declines Thursday, all ended the day still in positive territory for the week. However, on Friday, the declines accelerated and plunged the CAC, DAX and FTSE into negative territory on the week. And the FTSE and CAC fell below their end of 2006 levels as well.

On Thursday, the European Central Bank said it would provide unlimited cash in response to banks’ sudden demand for cash. The ECB loaned €94.8 billion ($130 billion) to ease the credit crunch after overnight rates banks charge each other to lend in dollars soared to the highest in six years. The ECB said it provided the largest amount ever in a single so-called “fine-tuning” operation (analysts question that description), exceeding the facility given on September 12, 2001.

Bank of England Inflation Report

The Bank of England issued its quarterly Inflation Report on Wednesday. The Bank said that inflation would stay above its 2 percent target until 2009. The forecast assumes that there would be another increase to the bank rate of a quarter-point from the current 5.75 percent by the first quarter of 2008. The Bank of England has increased interest rates five times in the past year and has indicated that it is keeping its focus on inflation fighting despite the turmoil that is currently engulfing the financial markets. The Bank lowered its economic growth projections from its May report. Growth in 2009 has been reduced to about 2.5 percent from May’s forecast of 2.8 percent. The expansion will be slower than it previously estimated because of the rate increases. The economy grew at a stronger than forecast 3 percent on the year in both of the first two quarters of this year.

The U.K. benchmark is the highest among the Group of Seven countries. The rate is 5.25 percent in the U.S., 4.5 percent in Canada and 0.5 percent in Japan. Italy, France and Germany — all members of the European Monetary Union — have an interest rate of 4 percent.

Asia/Pacific

Asian/Pacific stocks started and ended the week on a down note. Asia’s reaction to events elsewhere in the world generally lag and it was no different on Monday. Shares here were pulled down by the continued convulsions caused by the subprime failures in the U.S. that had sent equities lower on the preceding Friday (August 3). But Asian stocks rebounded from an eight week low on Wednesday in response to — what appeared at the time — a return to risk-taking after the Federal Reserve said the U.S. economy would probably continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy. The Fed's comments appeared to have a calming effect on the market. According to analysts, the Fed’s comments led investors to believe the subprime problem is an isolated one. And that would be a positive for Asia as there was a question mark over whether the mortgage problems would slow the U.S. economy. The Hang Seng Index gained the most in three years after the FOMC statement. The Hang Seng Index added 628.68, or 2.9 percent — its biggest advance since May 19, 2004.

However, the positive note did not last as investor perspective of the subprime loan problem veered to the negative after French bank BNP Paribas said it had suspended three of its funds with exposure to the subprime area. The credit crunch had intensified with several central banks (the ECB, Fed and Bank of Canada) providing overnight funds to ease the situation. And on Friday, several Asian/Pacific central banks including the Banks of Japan and Korea and the Reserve Bank of Australia also extended their lending facilities. Stocks sank Friday with the high flying Kospi plunging 4.2 percent, the All Ordinaries, 3.6 percent and the Hang Seng, 2.9 percent. 

Reserve Bank of Australia interest rate at 11 year high

As expected, the Reserve Bank of Australia increased its key interest rate by 25 basis points to 6.5 percent. This is the first rate increase since November of 2006. The move comes on the back of stronger than expected underlying inflation in the June quarter and unrelenting strength in some areas of the broader economy. Employment continues to grow and unemployment remains low. Consumers and companies are facing the prospect of the highest borrowing costs in 11 years. Consumer prices surged 1.2 percent in the three months ended June 30 from the first quarter, when they advanced just 0.1 percent. Prices climbed 2.1 percent from a year earlier, more than the central bank's May forecast of 1.75 percent. The RBA has an inflation target range of 2 percent to 3 percent. Adding to signs of stronger growth and inflation pressures, retail sales soared 1.4 percent in June, the largest increase in two years. Credit provided to households and companies jumped 1.8 percent, the biggest gain since 1989. Business and consumer confidence are close to record levels.

Currencies

The yen was down against both the euro and dollar and erased earlier gains after the Federal Reserve, European Central Bank and Bank of Japan pumped cash into money markets to help allay credit crunch concerns. Previously the yen touched its highest in almost four months against the euro as investors became risk averse and bailed out of carry trade investments that were funded by loans in Japan. Central banks in the U.S., Europe, Japan, Canada and Australia added about $132.7 billion to the banking system to avert a crisis of confidence in global credit markets. Earlier in the week, the yen benefited from the heightened risk aversion as investors unwound carry trades, where purchases of higher-yielding assets are funded by sales of low-yielding currencies.

Earlier in the week, the pound sterling was up against the U.S. dollar after the Bank of England’s Inflation Report signaled further increases in UK interest rates.

Indicator scoreboard

Germany — June manufacturers orders soared 4.6 percent and were up 16 percent when compared with last year. The monthly increase was the largest since December 2004. Foreign orders jumped 8.7 percent on the month and were led by a 38.5 percent leap in investment demand by other eurozone countries. This was more than enough offset a fall in orders to non-eurozone countries and swamp a gentle 0.3 percent increase in total domestic orders. Within the broad categories of foreign demand there was also an increase in basic goods (2.5 percent) while a weakening in the consumer goods sector (0.7 percent) was no surprise following the 4.8 percent jump in May. Domestically, there were advances in both basic goods (1.0 percent) and capital goods (0.3 percent) and a fall in the consumer sector (2.3 percent). 

June total industrial production was down 0.4 percent and up 5.1 percent when compared with last year. Excluding construction, output was down 0.3 percent and 5.5 percent on the year. A sharp decline in the always erratic construction sector (2.1 percent on the month) may have been in part weather-related but a 0.5 percent drop in manufacturing industry was genuinely disappointing. However, energy output jumped 2.2 percent. Consumer goods dropped 2.5 percent — durables were down 1.1 percent while nondurables sank 2.8 percent.

June merchandise trade surplus narrowed to €14.9 billion from €17.4 billion in May. Imports soared 6.7 percent while exports were up a modest 2.1 percent. The modest shrinkage in the surplus in part reflects higher import prices (up 0.6 percent versus May), itself a function of higher crude oil and petroleum product costs. Compared with their respective year ago levels, total exports grew 11.2 percent within which sales to the other Eurozone members rose 11.2 percent and to non-EU countries, 8.6 percent.  Measured similarly, overall imports grew an annual 7.6 percent, encompassing purchases from the Eurozone states of 11.6 percent and from outside of the region, just 0.6 percent.

France — June merchandise trade deficit was €3.0 billion, down slightly from the €3.2 billion shortfall registered in May but still large enough to ensure annual growth of some 17.5 percent over the first six months of the year. Exports were up 6.2 percent from May while imports were up 5.0 percent. By sector, the largest deficit as usual was in energy (€3.4 billion) followed by non-military industry (€1.9 billion) and consumer goods (€0.7 billion). Sizeable surpluses were registered in food (€0.7 billion) and capital goods (€0.4 billion). By region, significant bilateral deficits were posted with Germany, Belgium/Luxembourg, Japan and Asia. Notable surpluses were achieved with the UK, Spain and Greece.

June industrial production excluding construction was down 0.5 percent and down 0.8 percent when compared with the same month a year ago. Manufacturing was also down 0.5 percent on the month. Dragging down the headline figures was the auto sector which slumped 2.3 percent following an even larger 2.7 percent collapse in May. Production in this area is now nearly 7 percent below the year ago level. The other principal sectors registering significant declines were food and agriculture (1.6 percent), clothing (2.8 percent), textiles (1.3 percent) and chemicals (2.9 percent). Weakness here was only partially offset by respectable increases in pharmaceuticals and household durables (both 1.1 percent), boats, aircraft, trains and motorcycles (2.5 percent), machinery (1.2 percent) and utilities (2.3 percent).

Italy — June industrial output dropped 0.5 percent and was down 0.1 percent when compared with last year. Excluding construction, output also was down 0.5 percent but up 0.1 percent on the year. Among the major sectors, consumer goods were down 1.5 percent on the month while capital goods dropped 1.0 percent and energy goods, 1.8 percent. The only gain was registered by intermediates which were up a modest 0.4 percent.  Manufacturing dropped 0.7 percent but at least still shows positive growth (1.3 percent) for the first half of the year compared with the same period in 2006.

Second quarter gross domestic product edged up 0.1 percent and was up 1.8 percent when compared with the same quarter a year ago. The quarterly advance was the smallest since GDP contracted by 0.1 percent at the end of 2005. As with all preliminary releases, little detail was available other than the fact that what growth there was came out of services while agriculture and industry weakened. 

United Kingdom — June industrial output was up 0.1 percent and 0.8 percent when compared with last year. Among the major sectors, manufacturing was up 0.2 percent on the month for its fourth consecutive monthly gain while electricity gas and water jumped 1.1 percent. Against this there were declines in production in both mining & quarrying (1.1 percent) and oil & gas extraction (1.3 percent). Durable goods output jumped an impressive 3.5 percent although this was largely just catching up for previous declines. Non-durables dropped 0.6 percent while capital goods were up 0.4 percent. Intermediates edged up 0.1 percent. Manufacturing output was up 0.2 percent and 1.0 percent when compared with last year. The most prominent gains on the month were posted by coke & gasoline (1.5 percent), textiles & clothing (1.4 percent) and engineering (0.8 percent). Declines were registered in chemicals (0.8 percent), food & drink (0.2 percent) and other manufacturing (0.4 percent). 

June merchandise trade deficit edged down slightly to £6.3 billion from £6.4 billion in May. The total shortfall on goods and services was smaller at £3.6 billion reflecting the usual surplus on services (£2.7 billion). Within the overall goods deficit, the minor improvement was attributable to oil which posted a surplus of £0.3 billion, in part reflecting the impact of Buzzard N. Sea oil which has recently come on stream. Excluding oil and erratics, the trade gap actually widened slightly to £6.4 billion from £6.2 billion. Exports rose 4.9 percent on the month while imports grew 2.9 percent. The deficit with the EU was unchanged at £2.9 billion and narrowed slightly to £3.4 billion with the non-EU bloc, helped by record exports to the U.S. that more than offset falls to some other G7 countries including France.

Asia/Pacific

Japan — July corporate goods price index was up 0.6 percent and was up a more than expected 2.1 percent when compared with the same month a year ago. The consensus forecast was for an increase of 1.7 percent on the year. Prices for petroleum and coal products were up as was electric power, gas and water. Textile products including clothing for women were down. Export prices were down 0.1 percent on the month, while import prices were up 0.1 percent.

Australia — July employment increased by 21,700 jobs after a revised 9,100 gain in June. Full time employment increased by 21,700 while part time employment remained virtually unchanged. The unemployment rate remained at 4.3 percent for the third month. Miners are hiring workers as they expand to meet soaring Asian demand for commodities, and retailers are opening new stores as consumer spending picks up. Business confidence is high. The official employment report may be distorted by new rules introduced on July 1 by the government to increase participation in the workforce among people receiving welfare. The participation rate was unchanged at 65 percent.

Americas

Canada — July employment increased by 11,300. Full time employment jumped by 19.700 while part time employment declined by 8,400. The unemployment rate edged down to 6 percent — the lowest rate since 1974 — from 6.1 percent where it has been since February. Significant within the payroll itself was a surprisingly large 19,600 increase in manufacturing jobs that more than offset a probably overdue correction in the previously very robust services sector (down 13,100). Utilities added 6,000. 

Bottom line

With a paucity of new economic news investors focused on the travails in the subprime market. After a couple of quiet days, more disturbing news emerged as subprime woes spread and equities sank as investors stampeded to the doors to escape heretofore acceptably risky investments. Only time will tell whether the sizable central banks’ injection of funds into the short term market will be sufficient to dispel investor qualms.

This week's data releases include inflation numbers for the U.S. and the UK along with other key economic reports. Other data include merchandise trade for the U.S. and Canada. But most investors will look to the spate of preliminary second quarter gross domestic product from Europe and Japan.

Looking Ahead: August 13 through August 17, 2007