Global Markets

The optimistic mood seen in stock markets around the world gave way once more to jitters, with sharp net declines in many markets. Asian equities indexes generally outperformed major European and North American indexes, with most posting net gains. Hong Kong stocks benefited from China’s liberalization of rules for foreign investing. The Japanese Nikkei 225 stock average touched a 7-year high on Thursday. In Europe, the German DAX did touch a record high on Wednesday, but otherwise the dominant picture in the major countries’ indexes was of declines. North American stock markets fell sharply on Wednesday and Friday, ending the week notably lower.

Swings in oil prices seemed to be an unsettling factor in the markets, with light sweet crude oil trading close to $70 a barrel and ending the week just above $69. Worries about supply disruptions from Nigeria as well as persistent indications of strong worldwide demand contributed to the price pressures. Ongoing worries about higher interest rates in the United States, which have been a concern ever since rates ran up early this month, led to discussions of whether still higher rates might be in the offing. Credit quality issues also returned to the fore in the U.S. where lenders holding collateral of two highly leveraged hedge funds that had been active in the sub-prime mortgage market planned to begin liquidating the collateral. Negotiations between the fund managers and the lenders were ongoing, keeping the situation unsettled. 

On another front, the latest round of world trade talks, held in Potsdam, Germany, collapsed, as the acrimonious tone seen in previous talks continued. The four entities at the center of the so-called Doha round of negotiations – the EU, US, Brazil and India – broke up with sides still far apart on cutting agricultural subsidies and goods tariffs. The collapse makes it unlikely that an outline deal can be agreed before the summer, a step necessary to complete a detailed agreement by the end of the year.

Global Stock Market Recap

Europe and the UK

Stock price declines were widespread in Europe for the week as a variety of concerns worried investors. Slight signs of softness in the German economy, as displayed by two different sentiment measures, caused uneasiness. Also, banking shares suffered as investors worried about the potential exposure to the U.S. sub-prime mortgage market. Higher oil prices and the potential that interest rates could climb further were also cited. Despite the gloom, the German DAX actually touched a record high on Wednesday before selling off sharply the next day.

Bank of England — dissenters include governor

 Minutes of the Bank of England's monetary policy meeting, held on June 6 and 7 and released on June 20, showed a sharp split as members voted 5 to 4 to leave the cost of borrowing at 5.5 percent. Bank of England Governor Mervyn King was among the four dissenters who wanted to increase policy rates by 25 basis points. This marked the second time of his tenure that King has been outvoted. Those favoring no change in policy cited stable inflationary expectations and signs of softness in household spending, the housing market, and employment. Those arguing for a tightening believed that the balance of risks to the outlook for inflation was on the upside. They indicated that the economy was still growing robustly and rapid growth of money and credit in part reflected the easiness of credit conditions. The split left some questions about the likely outcome of the meeting to be held on July 4 and 5, when a rate increase had been generally expected.

Asia/Pacific

Many Asian stocks, especially those of Hong Kong, benefited from liberalized rules by Chinese regulators that will allow fund managers and brokerages to invest clients’ funds abroad. Previously, only mainland banks and selected fund managers were able to invest client money overseas.

Japan’s Nikkei 225 stock average reached a seven-year closing high on Thursday, just surpassing the previous recent high set on February 26, 2007, not through any dramatic move but on the basis of gradual gains in recent weeks. The level was not sustained on Friday, however, partly because talk of the new high encouraged reassessment, but also because interest sensitive sectors such as banking and property development were hurt by discussions of a prospective central bank tightening move.

The South Korean Kospi index lagged others in the region. A report issued by the OECD was critical of a number of regulatory practices adversely affecting the Korean economy. The softness was partly attributed to concerns that the economy might be weakening and to reports of ongoing foreign withdrawal from the market.

China wants to handle trade their way

In the ongoing disputes relating to China’s large trade surpluses, and pressures from the U.S. and others to allow its currency to appreciate, the People’s Bank of China issued a critical press release. It responded negatively to the recent action of the International Monetary Fund to expand its coverage of currencies to “all major emerging market currencies.” The Bank suggested that the IMF moves could lead to a “large and disorderly exchange rate adjustment [that] will not only exacerbate external instability, but also affect the sustainability of a country's domestic economic growth.”  It also suggested a big exchange rate adjustment would undermine stability of international financial markets. Meanwhile, U.S. Treasury Secretary Hank Paulson hailed the IMF move in testimony to Congress on Wednesday, saying it will “permit firmer surveillance in areas such as insufficiently flexible exchange rate regimes”. On Thursday, the central bank's vice governor, Wu Xiaoling, reiterated Beijing's stance of keeping the yuan exchange rate "basically stable" and said China will work on structural changes to resolve its large trade surplus.

Taiwan — Central bank raised its key interest rates

Taiwan's central bank raised its key interest rates by a higher-than-expected 0.25 percentage point on secured and unsecured loans to 3.50 percent and 5.375 percent, respectively, citing concerns about inflation and signaling its determination to stem outflows that have weighed on its currency. For the first time since 2002, the central bank also raised the required reserve ratio on foreign-currency deposits in order to narrow a wide gap between that ratio and the required reserve ratio on Taiwan dollar deposits. The ratio on foreign deposits was lifted to 5 percent from 0.125 percent. The required reserve ratio on Taiwan dollar deposits remains at 5.5 percent.

Americas

Sharp sell-offs on Friday brought an end to choppy trading in North American stock markets, leaving them down on the week by between 1 percent (Toronto) to 2 percent (Dow Jones Industrial Average) . These markets faced similar nervousness about credit quality, interest rates, and oil. Another potential threat is legislation being considered in the U.S. Senate to raise tax rates on limited partnerships.

Canada — policy questions because of strong currency

Some regional Canadian finance ministers have expressed concern about the Canadian dollar’s strength to Bank of Canada Governor David Dodge and have put pressure on the central bank not to raise interest rates at their next rate-setting meeting on July 10. They were apparently responding to complaints from Canadian manufacturers who export to the United States.

While the Canadian dollar has slipped off recent highs, it has continued to trade relatively close to parity with the U.S. dollar and far above levels prevailing for many years. Past statements by Governor Dodge have suggested that higher rates may be in the offing since the Bank’s preferred price measure has been above the midpoint of the specified band, but he has acknowledged that strength in the exchange rate is a source of concern. Softer retail sales reported for April have also led to questions about whether a policy move is imminent. The key interest rate has been on hold for a year, at 4.25 percent.

Currencies

Weakness in the Japanese yen continued during the week, with late selling Friday extending the pattern. As was the case the week before, the weakness was attributed in part to an appetite for carry trades, in which the purchase of riskier, high-yielding assets is funded by selling the low-yielding yen. Individual Japanese investors have been reported to be active sellers of yen in order to invest in countries with higher interest rates. June bonus payments may have increased such activity. Many analysts perceive that the Bank of Japan cannot address its low interest rate policies until at least August after the upcoming July elections. In contrast, the policy moves by Taiwan’s central bank helped to strengthen the Taiwan dollar, which had also been subject to selling by those seeking higher nominal interest rates. By week’s end, the yen had dropped to a record low against the euro, a 20-year trough against the New Zealand dollar and respective 15-year and 4½-year lows against sterling and the dollar.

The Euro regained some of its recent lost ground against the U.S. dollar as investors continued to see a greater likelihood of a near-term policy-tightening move by the European Central Bank than by the Federal Reserve. The Swiss National Bank also fed expectations of higher rates in Europe. Last week’s policy tightening was followed this week by a speech from Jean-Pierre Roth, the president of the Bank, in which he remarked that the Swiss economy is close to full employment, that price stability has been maintained for almost 13 years, and that economic prospects were favorable in almost all respects. The primary attention, however, was on euro-yen trading rather than euro-dollar trading, stemming from the yen selling.

Indicator scoreboard

The week was marked by relatively light data calendars in most of Europe, with the exception of Germany where a mix of sentiment and price indicators pointed to a flattening of the expansion. The ZEW Institute’s economic sentiment index for the Eurozone as a whole also declined for June (19.0 from 22.3) but current conditions improved quite sharply (86.0 from 81.8).

On Tuesday, Italy announced another decline in the unemployment rate to 6.2 percent. The number of people out of work fell 3.3 percent quarter over quarter, falling faster than those in employment which fell 0.3 percent. The 0.2 percentage point decline in the headline rate matched the pace seen in the previous period when the rate was revised down a notch to 6.4 percent. The most recent fall mainly reflected fewer job seekers in the south of the country. The national rate of joblessness is now at its lowest level since the data series began in 1992. 

Germany — Sentiment mixed, producer prices rise

According to the ZEW Institute, economic sentiment, released Tuesday, unexpectedly fell in Germany in June to 20.3 from 24 in May. The index was well below market forecasts and it remains far short of the historical average of 33.0. The decline stemmed largely from weakness of incoming orders in April and reflected some give back from the sharply improved assessment of current economic conditions in May. Nonetheless, sentiment is still at its second highest level in a year and while the economy is no longer expected to gain momentum, neither is it seen slowing significantly. Indeed, current conditions continue to improve, rising slightly from May’s level of 88.0 to 88.7.

Business sentiment, released on Friday, was also softer than expected. Against expectations for essentially no change, the IFO measure of German business sentiment slipped in June to 107.0 from 108.6 in May. However, the decline was marginal, attributable to small declines in both current conditions (-0.9 to 111.4) and expectations (-1.3 to 102.8); the levels of all the major headline indices remain high enough to signal continued robust growth in economic activity. Indeed, the new three-month average (108.1) is still above the first quarter average (107.5). Reflecting the movement in the overall climate index, there were limited declines in sentiment in manufacturing (23.9 from 27.5), construction (-16.0 from -14.6), wholesale (14.3 from 18.3) and retail (-3.2 from -5.0). There was also a minor drop in sentiment in the service sector (26.0 from 26.5). Significantly however, the survey did not find current levels of the Euro a major problem for industry but equally, IFO participants did not favor any more ECB tightening. Taken together with the ZEW survey, the IFO report is considered consistent with a stabilization in German growth. 

The German PPI rose more quickly than anticipated in May. This marks the first acceleration in PPI inflation since last November. Even so, the 0.3 percent month over month increase only lifted the annual pace to 1.9 percent, the second slowest reading since the middle of 2004. Favorable base effects have helped to hold down the PPI, but they are beginning to fade. Basic goods prices continued to climb steeply last month, rising 4.8 percent year over year, but elsewhere the increases were still modest: capital goods posted a 1.2 percent year-over-year rate while consumer goods prices were up just 1.7 percent. 

Excluding energy, core PPI inflation picked up a couple of notches to 2.9 percent year over year, but ex-petroleum products, fell to 2.0 percent. Core prices have been remarkably stable this year. Any significant and sustained acceleration in the PPI from current levels would not sit well with the ECB, but for now the bigger threat is in wages where strike activity has already been seen in some areas of the engineering and metalworking sector.

France — a sluggish consumption picture

Consumer spending on manufactures was significantly weaker than expected in May, leaving annual growth at 1.7 percent year over year, well short of forecasts. Even with a small upward revision to April (-0.1 percent month over month from -0.3 percent month over month), the April/May average was 0.4 percent below the first quarter. The surprise drop in total sales – the largest in eight months – was led by a slump in textiles (-8.5 percent month over month). While other areas held up much better, the fall would have been still steeper but for another solid increase in purchases of autos (1.6 percent). Excluding autos and auto parts, demand was down 1.6 percent following a 0.5 percent decline in the previous month.

These data contrast with consumer confidence surveys, which have shown modest improvement since the beginning of the year. Some analysts predict that actual spending will bounce back in June as previous caution associated with the presidential election dissipates and consumers look forward to more tax cuts. Even so, the current quarter is not shaping up too well for the French economy and the sluggishness in consumer spending cannot be good news for the manufacturing industry where production rates in recent months have already disappointed.

Asia/Pacific

Japan

Japan’s trade surplus on a not seasonally adjusted basis expanded 9.3 percent to ¥389.5 billion in May from ¥356.3 billion in May 2006. On a year-on-year basis, exports were up 15.1 percent while imports were up 15.5 percent. The greatest expansions in exports were to China, which climbed 24.5 percent from the month before, and to the European Union where they jumped 17.9 percent. Japan’s surplus with the United States, at ¥543.7 billion, gained a minimal 0.4 percent from April and fell 12.9 percent compared with the May 2006 surplus. Once seasonal adjustment is taken into account, however, the trade surplus actually narrowed noticeably in May.

Americas

Canada—consumer prices, new series, similar growth rates

Consumer prices rose by 2.2 percent for the year ending in May, in line with expectations and the same rate as for the year ending in April. These data reflect an adjustment to the basket year to 2005 from 2001 and the base year to 2002 from 1992. The changes made for a 0.1 percentage point increase in the all-items index from the former 2001 basket. Within the new series, the largest major category increases for the month came from energy, 2.1 percent, transportation, 1.8 percent, and recreation 1.3 percent. The largest monthly declines were in clothing, by 1.7 percent, household operations, 0.3 percent, and shelter, 0.2 percent. Inflation in the goods sector continues to lag well behind prices in services at 1.1 percent and 3.2 percent year over year, respectively.

Core consumer prices also rose in line with expectations in May. The 0.3 percent month over month rise in the Statistics Canada index (CPI less food and energy) put inflation at 1.9 percent year over year, while the same sized gain in the Bank of Canada’s own measure (CPI excluding eight volatile elements) put the core rate at 2.2 percent year over year. As with the total CPI, these data series reflect revisions to both the CPI basket year and the base year. The Bank of Canada measure has now been above the 2 percent midpoint of the central bank’s 1-3 percent target range since July 2006 and continues to lead analysts to predict a policy move this July.

Retail sales in April rose by less than half the market consensus, tempering the strong performance that has characterized the retail sector since the end of last year. The auto sector accounted for all of the expansion in the month, with a 1.6 percent month over month increase (2.0 percent at new car dealers), broadly confirming market estimates but only partially offsetting the January/February losses. Excluding autos, sales were flat with only two categories showing increases: furniture, home furnishings and electronics up 1.1 percent month over month and food and beverages up 0.8 percent. Elsewhere, declines were surprisingly widespread and most marked in building and outdoor home supplies (-2.7 percent month over month), miscellaneous retailers (-2.1% percent) and clothing (-1.0 percent). In volume terms, total sales were up 0.5 percent month over month.

Despite the relative sluggishness of retail demand in April and early signs of little change in auto demand in May, the underlying trend is considered firm and these data are unlikely to be seen soft enough to deflect speculation about possible Bank of Canada tightening at the central bank’s next meeting on July 10.

Bottom line

Equities markets were volatile to the downside in many parts of the world, although parts of Asia showed gains. Worries about higher interest rates and oil prices provided the background, while local factors were important in a few places. Exchange rates moved against the yen, most notably as investors continue to seek investments denominated in higher yielding currencies. Most countries had relatively light economic data calendars in the week with the notable exceptions of Germany and Canada. Both showed upticks in price reports, but a little softness in sentiment (Germany) and retail sales (Canada).

Looking Ahead: June 25 through June 29, 2007

Ann-Marie Meulendyke is the author of U.S.Monetary Policy and Financial Markets