Global Markets

Good news on the U.S. housing sector boosted the dollar but put downward pressure on equities because of potential interest rate ramifications. Recent data are indicating that the U.S. economy could be more resilient than some had feared, while inflation pressures remain subdued. This in turn lessens the need for the Federal Reserve to cut interest rates, a disappointment for equity investors. This subtle point was not lost on Asian/Pacific equity investors who sold stocks as a result. However, Friday’s disappointing existing home sales report tempered enthusiasm for the dollar while stocks rallied.

With few important data releases last week, equities flirted once again with record highs on mergers and acquisitions before giving way to profit taking. Positive data on U.S. housing and durable goods turned out to be a negative for equities. Fresh merger and acquisition speculation and some positive earnings news mid-week offset a rebound in oil prices. And the S&P 500 index was trading above its record close, set seven years ago, while European stocks closed at fresh six-and-year peaks and several Asian markets touched lifetime highs.

But after a record-breaking run, global equities faced selling pressures on Thursday, and not even upbeat U.S. economic data could spare equities from sharp losses. U.S. durable goods orders data that showed business spending had gained for the third straight month joined positive housing numbers. Sentiment for risky assets was tempered in the wake of former Federal Reserve Chairman Alan Greenspan who warned on Wednesday of a possible correction in China’s stock market. Five indexes followed here — Nikkei, Kospi, Topix, DAX and Bolsa — were up on the week.

OECD focuses on central bank interest rates

The Organisation for Economic Cooperation and Development, in its May Economic Outlook said that the world's central banks (with the exception of Japan) should “err on the side of tightness” in the face of inflationary pressures. OECD said central banks should either increase interest rates or take their time before cutting them, because strong domestic demand had increased the risk of higher inflation.

Jean-Philippe Cotis, OECD's chief economist, said U.S. inflation had been “more persistent than expected” while in many other OECD countries, notably in Europe and the UK, he warned that the amount of "residual economic slack is also uncertain....This constitutes a challenge for central banks which, on both sides of the Atlantic, should probably err on the side of tightness.” Further, OECD said that in the U.S., the Federal Reserve should wait until early next year before cutting its fed funds rate unless the housing downturn were to lead to wider economic distress. In the eurozone, robust economic growth and rising core inflation suggest that the European Central Bank should raise its main interest rate by two more quarter-percentage points to 4.25 percent by the end of the year. While acknowledging that the Bank of England had “already tightened significantly”, the OECD said that additional tightening might be necessary. Only in Japan, where deflation has not been entirely rooted out, did OECD recommend that interest rates should remain at 0.5 percent until the second half of 2008 when the Bank of Japan could raise them by a quarter-point.

Regarding inflation, the organization said that strong underlying global inflationary pressures could still feed through into headline inflation. OECD expects strong demand, a reflection of the robust economic expansion, to continue. This expectation was reflected in their forecast for above-average economic growth this year and next. OECD predicted that Europe and Japan would outpace the U.S. for the first time in 16 years.

While neither China nor India are members of the OECD, the organization predicted Chinese growth will likely remain above 10 percent this year and next, while India's expansion will cool to 8 percent next year from a forecast of 8.5 percent this year as taxes and interest rates increase. Chinese authorities should pursue a stronger currency and inject more flexibility into the banking system.

Global Stock Market Recap

Europe and the UK

The FTSE, CAC and DAX began the week flirting with their six-and-a-half year highs. However the FTSE quickly relinquished the gains while the CAC and DAX built on them — at least until Thursday. Oil stocks continued their recent strength as some investors took the view that the sector could move still higher while mining stocks were up on price increases for base metals. But the FTSE weakened on profit taking and interest rate concerns. All three indexes retreated Thursday after a warning from former Federal Reserve Chairman Alan Greenspan that China's market faced a sharp correction.

The FTSE, DAX and CAC tracked U.S. losses after the comments on China. Another negative for these indexes was the stronger than anticipated U.S. data for durable goods orders and housing and their implications for U.S. interest rates. It was interpreted to mean that the Fed would not have to lower interest rates. European economic news didn't provide optimism, either. An index of French business sentiment slipped and the German Ifo sentiment index disappointed.

The last day of the week saw European mining shares rise after copper, nickel and zinc prices increased. However, construction stocks were down on concern that accelerating growth in Europe will keep interest rates rising. Merger and acquisitions in Europe that have sparked much of the stock markets’ climb have reached $1.24 trillion so far this year according to Bloomberg. On the week, the CAC and FTSE were down while the DAX continued to climb.

Bank of England contemplated a 50 bp move

Minutes from the Bank of England’s May meeting intimated that borrowing costs might have to keep increasing to contain inflation. The monetary policy committee agreed that “should the economy continue to develop broadly in line with the central expectation, bank rate could be raised further as necessary.” At the May 9 and 10 meeting the MPC lifted the Bank’s key interest rate to 5.5 percent, a six-year high. The vote was the first unanimous decision on a rate move since August 2004, signaling a new consensus among policy makers.

At 5.5 percent, Britain's key rate is above the U.S. federal funds target rate of 5.25 percent, the European Central Bank’s 3.75 percent, Bank of Canada's 4.25 percent and Bank of Japan's 0.5 percent rate. According to the minutes some members wondered whether the bank rate should be increased by 25 basis points or whether there was a case for a rise of 50 basis points, given the upside risks to inflation and the buoyant growth and demand outlook. Some, however, argued that “it was better to move cautiously,” and others said they were concerned any excessive rate move could create “downside risks” to growth. However, the committee's members decided to vote 9-0 to increase the cost of borrowing by a quarter of a percentage point to 5.5 percent.

Asia/Pacific

Last week’s trading began on an upbeat note with indexes followed here all rising Monday. Japanese stocks were also up Tuesday and Wednesday, boosted by continued buoyancy in exporter shares and record profits for a major financial group. Asian stocks advanced after U.S. consumer sentiment unexpectedly improved and shares in China rallied on speculation higher interest rates would not deter investors. Australian stocks were also up thanks to a potential merger in the mining sector and a positive reading for a measure of leading economic indicators that signaled growth would accelerate.

However, the positive beginning led to a mixed conclusion of the week as stocks sagged on Thursday and Friday, in part as a response to former Fed Chairman’s warning about Chinese stocks. Even though he is now a private citizen, his comments still have the power to move markets. On Wednesday afternoon, he said that he feared a “massive contraction” in Chinese stocks and that prices were “unsustainable”. His remarks depressed stocks elsewhere as well. And on Friday, Asian stocks fell the most in five weeks after U.S. home sales unexpectedly surged, damping speculation the Federal Reserve will cut interest rates. Auto manufacturers and mining companies retreated on the news and as a reaction to Thursday’s declines in U.S. stocks.

Currencies

The yen continues to weaken against both the euro and U.S. dollar. It fell to a record low against the euro Monday giving back all of the gains that accrued in the immediate aftermath of China’s decision last week to widen the renminbi’s trading band and raise interest rates. The People’s Bank of China widened the renminbi’s daily trading band from 0.3 percent to 0.5 percent and raised interest rates by 18 basis points on Friday. The yen strengthened on the news as investors reasoned that China’s decision would dampen risk appetite and stifle demand for carry trades, in which the purchase of riskier high-yielding assets is funded by selling low-yielding currencies such as the yen. However, the yen went into reverse, unwinding its rally completely, as equity markets shrugged off the news.

On Wednesday, the yen sank to a three-month low against the dollar on speculation Japanese individuals, due to receive bonuses in June, will invest these funds into higher yielding global investment trusts with overseas holdings. Japanese investors are hungry for higher yields and as a result are sending more money abroad and pushing down the yen’s value. Japanese companies pay bonuses every June and December as part of their overall compensation packages. The yen dropped against all 16 most-active currencies after April core consumer prices, which exclude fresh food, declined 0.1 percent from a year earlier. The yen fell the most in two weeks versus the euro after North Korea test-fired missiles and Japan responded with threats of sanctions.

The U.S. dollar, which had been gaining ground against the euro, suffered a setback on Friday when sales of existing homes declined during April to the lowest level in almost four years. The dollar weakened against most active currencies.

Canada's dollar reached a 30-year high on optimism foreign takeovers of the nation's resource-based assets will fuel currency demand. The currency traded at the highest since October 1977. Possible mergers for metal and aluminum producers fueled demand for the currency while crude oil prices were up on unease about Iranian and Nigerian supplies. Prices for such metals as gold and copper have soared in the past two years. Canada's dollar is the best performer in the last three months among the 16 most-actively traded currencies, gaining over 7 percent against the U.S. dollar on signs that Canada's economy is strengthening.

Indicator scoreboard

EMU — First estimate of the not seasonally adjusted merchandise trade surplus with the rest of the world for March was €7.4 billion vs. a deficit of €1.3 billion in February. In February (the latest month for which detail is available), the EMU recorded trade deficits with Russia (€6.3 billion), China (€19.7 billion) and Japan (€3.8 billion). Details lag the overall estimate by one month. On a seasonally adjusted basis, the merchandise trade surplus was €5.1 billion. Exports were up 1.2 percent while imports declined 2.6 percent.

Germany — May ZEW economic expectations index climbed to 24 from 16.5 in April. The current conditions index climbed to 88 from 76.9 in the previous month. Risks such as higher oil prices and the euro’s strength were not seen as deterrents to expectations. The Center for European Economic Research (ZEW) surveyed 301 German financial experts for their opinions on current economic conditions and the economic outlook for major industrial economies between April 30 and May 21.

May Ifo business confidence index was unchanged from April at 108.6. The current conditions index eased to 112.5 from 113.1 in April but the six-month outlook inched up to 104.8 from 104.3. Manufacturing index increased to 27.6 from 27.1 the previous month. However retail sector sentiment dropped from minus 0.5 in April to minus 3.2 in May as the impact of the January value added tax (VAT) continues to work through the economy. Ifo surveys about 7,000 firms in manufacturing, construction, wholesaling and retailing about their assessment of the current situation as well as their six-month outlook.

First quarter gross domestic product was up 0.5 percent and 3.6 percent when compared with the same quarter a year ago. Growth was boosted by equipment investment which was up 5.5 percent on the quarter and 9.5 percent on the year. Construction was up 3.5 percent and 13.4 percent on the year. However, private consumption dropped 1.4 percent and was down 0.5 percent on the year due in part to the increase in the VAT.

France — April consumer spending on manufactured goods declined by 0.3 percent and was up 2.5 percent when compared with last year. Auto spending was up 0.9 percent but down 2.1 percent on the year. Clothing however rebounded by 1.4 percent after sinking 2.1 percent in the previous month. Household equipment dropped 1.7 percent, partially offsetting March’s 2.3 percent gain. Other manufactured goods, a category that accounts for about 40 percent of total outlays, was down 0.7 percent on the month. This category includes cosmetics, drugs, car parts, jewelry and photo & sporting goods.

United Kingdom — First quarter gross domestic product was up 0.7 percent and 2.9 percent when compared with last year. Household expenditures were up 0.6 percent and 3.1 percent on the year while gross domestic fixed capital increased 1.7 percent both on the quarter and on the year. Only manufacturing was down on the quarter by 0.3 percent. The GDP implied deflator was up 0.6 percent and 3.2 percent on the year, revealing inflationary pressures.

Asia

Japan — March all industry index dropped 1.4 percent and was up 1 percent when compared with the same month a year ago. The all industry index takes a reading of activity in the 11 industries that comprise the tertiary index (released last week), along with activity in the construction, agricultural and fisheries industries, the public sector and industrial output. This index is considered a close approximation of gross domestic product growth as measured by industrial and service sector output.

April unadjusted merchandise trade surplus climbed to ¥926.7 billion from ¥649.8 billion a year ago. Exports were up 8.3 percent while imports were up 3.5 percent. Exports to the U.S. dropped 4.8 percent on the year while exports to the European Union were up 9.7 percent. Exports to China surged 16.8 percent. On a seasonally adjusted basis, the trade surplus edged down to ¥1,027.8 billion from ¥1,119.3 billion in March.

May Tokyo consumer price index was up 0.2 percent and unchanged when compared with the same month a year ago. Core CPI excluding only fresh food was up 0.2 and unchanged on the year. Excluding food and energy the CPI was up 0.2 percent and down 0.2 percent on the year. April nationwide CPI was up 0.3 percent and unchanged on the year. Core CPI excluding only fresh food was up 0.3 percent but was down 0.1 percent on the year. Prices for all categories were up with the exception of fuel, light & water charges. Excluding both food and energy, the core CPI was up 0.4 percent on the month but down 0.2 percent on the year.

Bottom line

Last week was dominated by the failure of stock indexes to hold onto their new record highs. While some of the U.S. housing news was positive it was a mixed bag with sub-prime mortgage woes sending existing home sales to four year lows.

This week is shortened by the Monday holiday but the outpouring of new economic data during the remainder of the week will keep analysts and market players on their toes. The remainder of Japan’s key indicators will be released Monday night in the U.S. while key employment data will be available for Europe and the U.S. during the week. And each number will be put in the interest rate equation. Finally, the Bank of Canada will announce its monetary policy decision on Tuesday. No rate increase is expected for now.

Looking Ahead: May 28 through June 1, 2007