Global Markets

Equities headed south during the week on dire forebodings that the U.S. economy is slipping into recession and worse — stagflation — where prices rise but growth is weak to non-existent. Trading was volatile reflecting investor mood swings. But at week’s end all Asian/Pacific stocks were down. Elsewhere, the German DAX and the U.S. Nasdaq were also down for the week.

There was relatively little new economic news last week, but most of it underlined weakening growth and higher prices, especially in the U.S. The demise of the consumer in the UK and Canada will have to be put off for a while — retail sales data were stronger than anticipated for both. And the minutes of the last Bank of England and Federal Reserve policy meetings indicate that there will be more interest rate cuts to come (see below). This cheered equity investors somewhat for a day but then they reverted to their gloom.

Commodity prices continue to hit new all time highs and add to worries about global inflation. Gold is up 12.7 percent so far in 2008 while oil prices (West Texas intermediate spot) closed above $100 a barrel for the first time on Tuesday and Wednesday before edging down in Thursday’s trading.

Four sets of central bank policy meeting minutes were released mid-week including the Reserve Bank of Australia, Banks of England and Japan and the Federal Reserve. The Fed released its revised growth forecast at the same time.

Federal Reserve

At their January 29 and 30 meeting, the FOMC lowered its growth forecast and raised its inflation outlook for this year. The Fed said the economy will grow between 1.3 percent and 2 percent — down from a 1.8 percent to 2.5 percent forecast made in October. Core inflation expectations were revised to 2 percent to 2.2 percent this year, compared with October’s 1.7 to 1.9 percent. At the meeting, FOMC members were concerned that declining equity prices, coupled with the ongoing drop in house prices, imply reductions in household wealth that would likely dampen consumer spending. The fed funds target rate is now 3 percent after an intra-meeting decline of 75 basis points and the 50 basis point reduction at the meeting. The Fed releases minutes three weeks after its meeting.

Bank of England

All members of the Bank of England’s monetary policy committee voted to lower interest rates at the February 6^th meeting. Monetary Policy Committee members decided by a majority of eight to one that the risk of sharply slowing growth outweighed that of higher inflation expectations. The minutes also show that most members felt interest rates were still restrictive, partly because tighter credit conditions limited the impact of rate cuts. The Bank’s key interest rate is now 5.25 percent. Expectations are that the Bank will continue lowering rates at a measured pace. The Bank releases minutes two weeks after its meeting.

Reserve Bank of Australia

Although elsewhere interest rates are going down, the Reserve Bank of Australia’s board members considered raising the key interest rate by 50 basis points rather than the 25 basis points that they decided upon to cool the fastest inflation in almost two decades. Turmoil on credit and equity markets prompted the RBA to limit the increase to 25 basis points and taking the key rate to an 11-year high of 7 percent. Expectations are that the RBA will raise rates once again when they meet the first week of March. According to the minutes, members said that a significant slowing in demand from the pace observed through 2007 would be required for inflation to return to the target, which is between 2 percent and 3 percent. The RBA releases its minutes 2 weeks after its meeting.

Bank of Japan

Minutes from the Bank of Japan's January Monetary Policy Board meeting showed increasing worry about the economic outlook at home and abroad. There was no indication that board members would consider cutting interest rates to stimulate growth. The board noted that overseas economic developments had become more uncertain due to the slowdown in the U.S. economy. The vote was unanimous once again to keep its key interest rate at 0.5 percent. Market consensus is that the board has abandoned its upward interest rate path for the foreseeable future and some market players have even begun to speculate that the BOJ might cut rates to stimulate economic growth. The BoJ releases its minutes about four weeks after its meetings.

Global Stock Market Recap

Europe and the UK

The FTSE and CAC were up for the second week in a row but the DAX was down. Positive margins from earlier in the week were eroded as European and British equities were dragged down Friday by declining U.S. stocks. However, these earlier gains provided sufficient leeway to allow the FTSE and CAC to stay positive for the week. The three indexes were up three of five trading days. On Wednesday, European stocks fell for the first time in the week on concerns about expanding losses in the credit markets and the resulting negative impact on banks. Investors were worried that these losses combined with higher than expected inflation readings in the U.S. and elsewhere could inhibit central banks from cutting borrowing costs to boost growth. The prospect of lower interest rates after the release of the Bank of England’s meeting minutes did not buoy sentiment. Rather investors were wary of the impact of better than expected retail sales on the Bank of England’s actions going forward. The DAX (down 15.6 percent), which had been the best performer of the three indexes in 2007, has declined more than either the CAC (down 14.1 percent) or FTSE (down 8.8 percent).

Asia/Pacific

Major stock indexes resumed their declines last week after weak U.S. economic data revived concerns about the strength of the U.S. economy. Countries in this area rely on U.S. for economic growth because it is the destination for much of the region’s exports. On the week, the Hong Kong and Shanghai indexes led declines with the STI not far behind them. Shanghai Composite plummeted 3.5 percent Friday. A flood of shares is expected to hit the Chinese market soon as the lock-up periods for certain institutional shareholders, who own shares from initial public offerings, are due to expire.

In Japan, the yen strengthened raising concerns about exporters’ profits especially as the end of the fiscal year on March 31 approaches and which were already weighed down by weakening U.S. demand. And the domestic side of the economy provided no cheer either as supermarket sales fell for the 25^th consecutive month. The Ministry of Finance said that foreign investors turned net buyers of Japanese stocks for the first time in seven weeks in the week to February 16.

The Japanese Cabinet Office downgraded its assessment of the country’s economic performance for the first time in 15 months. It said that while the economy was expanding, the pace is slowing thanks to weaker exports and production. Although saying that their economy was still on an expansion cycle — now 73 months and counting — the U.S. slowdown has dented Japanese exports and consequently capped growth in Japan's industrial output. The report also said individual consumption in Japan is almost flat, consumer prices are climbing because of higher oil and food prices and that housing construction remains at a low level although showing signs of a pickup.

Currencies

 The dollar was down against most major currencies after the Federal Reserve lowered its estimates for U.S. growth. The FOMC minutes from January meeting emphasized that the Fed remained far more concerned over a looming slowdown than increasing price pressures. This opened the way for more rate cuts. And on Thursday, a surprise weakening in the Philadelphia Fed’s February regional business activity survey underlined the economic gloom. In contrast, strong UK retail sales and a European service sector survey dampened expectations that the Bank of England or the European Central Bank are going to follow the Fed’s footsteps and aggressively ease monetary policy.

 The Australian dollar surged to a three-month high Tuesday after the minutes of the Reserve Bank of Australia’s policy meeting boosted expectations for further interest rate increases. In the minutes, the RBA said its decision to raise interest rates by 25 basis points to 7 percent rather than 50 basis points was “finely balanced,” as they continued their fight against inflation. The spread between Australian and U.S. interest rates now stands at 4 percent. With U.S. interest rates expected to go lower, high yield Australian assets will be even more attractive to investors for carry trades. In a carry trade, investors get funds in a country with low borrowing costs and invest in another with higher interest rates, earning the spread between the borrowing and lending rate. The risk is currency moves will erase these profits.

Indicator scoreboard

Germany

January producer price index was up 0.8 percent and 3.3 percent when compared with last year. While surging energy costs (up 2.1 percent) had an important impact on the headline gain, there were strong increases elsewhere and very few categories saw declines. Among the major sectors, the largest increases outside of energy were posted in basics (0.7 percent) followed by consumer goods (0.5 percent) and then capital goods (0.1 percent). Within the consumer sector, prices for durables rose 1.0 percent and for nondurables, 0.4 percent. Further hefty gains in raw oil & fat and in refined oil & fat prices saw their annual growth rates surge to 41.3 percent and 44.6 percent respectively. Excluding energy, the PPI rose a more modest 0.4 percent, lifting the 12-month rate to 2.5 percent.

France

January household spending on manufactured goods dropped 1.2 percent but was up 2.2 percent when compared with the same month a year ago. The most significant negative impact came from autos (8.7 percent) where consumption posted its steepest monthly drop since July 2006 (9.0 percent). However, this did follow a particularly hefty 6.7 percent surge in December and in part reflect the introduction at the start of the year of sanctions on high-emission vehicles. Excluding autos, spending edged up 0.2 percent. The other notable declines were in durable goods (3.9 percent) and other products (0.5 percent). Against this, there were gains in household goods (0.8 percent) and textiles (2.3 percent).

Italy

December merchandise trade deficit was €1.3 billion. For the year 2007, the deficit declined to €9.5 billion from €21.4 billion in 2006. In the year to December, global exports fell 4.8 percent while imports were off 0.8 percent. The annual drop in exports was the first April 2006 and is testimony to the extent to which Italian industry has struggled in the face of record levels for the euro. Weakness in imports on the other hand reflects the sluggish performance of domestic demand during much of the period. On the year, few export sectors managed to keep their head above water, the most significant exception being coke & petroleum products (15.8 percent) where growth held up particularly strongly, leather (8.8 percent) and agriculture & fishery products (4.4 percent). Double-digit declines were experienced by non-metallic minerals (17.8 percent), metals (13.4 percent), electrical machinery (12.0 percent), furniture (11.7 percent) and clothing (10.5 percent). Overall manufactured goods dropped 5.5 percent.

United Kingdom

January retail sales were up 0.8 percent and 5.6 percent when compared with last year. The monthly gain was the largest since February 2007. The most significant contribution to the monthly gain was made by non-store retailing which surged 5.2 percent, most likely on the back of heavy internet sales. Food sales were up 0.7 percent while non-food was up 0.4 percent. Household goods posted an impressive 4.3 percent advance but there were declines at both non-specialized stores (1.5 percent) and other stores (2.1 percent).

Asia/Pacific

Japan

December tertiary index, an indicator of service sector performance declined 0.6 percent. The industries that contributed to the decline included finance & insurance (down 3.3 percent), professional services, auto maintenance and miscellaneous living related & personal services (down 1.0 percent) compound services including postal services (down 10.3 percent) and wholesale & retail trade (down 0.5 percent). Industries that were up in December included eating & drinking places & accommodations (up 1.5 percent), real estate (up 1.0 percent), learning support (up 4.0 percent) electricity, gas, heat supply & water (up 0.7 percent) and medical, health care & welfare (up 0.2 percent). Information & communications were unchanged on the month. The 11 service industries tracked by the index account for roughly 60 percent of Japan's economic output. Among them are utilities, transport, telecommunications, wholesale and retail, finance and insurance, real estate, restaurants and hotels, as well as medical, health care and welfare.

December all industry index edged down 0.2 percent as industrial output offsets were not sufficient to offset weakness in the tertiary index which declined 0.6 percent on the month. The all industry index takes a reading of activity in the 11 industries that comprise the tertiary index, along with activity in the construction, agricultural & 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. Overall, weak job creation continues to hamper household incomes and thus consumer spending, while that in turn is dampening investment and production in the domestic economy.

January unadjusted merchandise trade balance recorded a trade deficit for the third straight January. The deficit was ¥79.3 billion. In January 2007, the deficit was tiny, just ¥3.5 billion. Exports were up 7.7 percent when compared with the same month a year ago while imports grew at a faster rate of 9.0 percent. Exports were up 4.6 percent to China while imports were up just 1.6 percent on the year. Both exports and imports with the U.S. were down. Exports declined 3.2 percent while imports dropped 1.9 percent. Trade with Western Europe was up, with exports climbing 11.2 percent and imports by 4.3 percent. With domestic demand expected to remain slack in 2008, the economy will continue to rely on external demand for growth. On a seasonally adjusted basis, the trade surplus was ¥861.9 billion, up from ¥617.2 billion in December.

China

January consumer price index was up 7.1 percent when compared with last year after climbing 6.5 percent in December. Inflation has mainly been driven by high food prices — a trend exacerbated by severe winter storms last month that disrupted the transport of farm produce and coal. Overall food prices were up 18.2 percent for the second month with meat and poultry prices soaring by 41.2 percent. Transportation & communication prices dropped 1.1 percent while clothing was down 1.9 percent.

Americas

Canada

January consumer price index was down 0.2 percent and up 2.2 percent when compared with last year. Inflation benefited from the one percentage point cut made in goods and service tax (GST). Excluding food and energy, core CPI was down a more marked 0.4 percent on the month and 1.3 percent on the year. The Bank of Canada’s core inflation measure which excludes eight volatile items was up 0.1 and 1.4 percent on the year, the lowest level since July 2005. In addition to the GST effects, the main factors driving the headline CPI lower were declines in clothing & footwear (1.6 percent), recreation, education & reading (1.6 percent), household furnishings & operations (0.2 percent) and health & personal care (0.2 percent). In contrast, the most significant monthly gains were posted by food (0.6 percent), energy (0.6 percent) and alcohol and tobacco (0.2 percent). The other man categories were essentially flat.

December retail sales were up 0.6 percent and 5.2 percent when compared with the same month last year. This was the third increase in retail sales in four months and helped make 2007 the year with the second highest retail growth rate since 2002. Excluding autos, however, retail sales were down 0.4 percent — the first decline in five months. On the year, excluding the auto sector, sales were up 6.4 percent. Auto sales were up 3.2 percent. Home furnishings did well (2.6 percent) but there were declines in furniture stores (3.6 percent), computer & software (4.8 percent) and home electronics & appliances (0.3 percent). Declines were also seen in building & outdoor home supplies (1.2 percent), food & beverages (0.8 percent), clothing & accessories (2.7 percent) and miscellaneous retailers (1.2 percent). A modest advance was registered by general merchandise stores (0.5 percent) while pharmacies & personal care was essentially flat (0.1 percent).

Bottom line

Gloomy economic data in the U.S. contrasted with better than expected data in Canada, Europe and the UK. At the same time, four central banks released minutes of meetings that were held recently. While the Bank of England and the Federal Reserve indicated that they would continue to lower interest rates, the Bank of England was clearly not about to follow the Fed’s drastic cuts. The Reserve Bank of Australia indicated that they would increase rates once again as they fight inflation. The Bank of Japan is maintaining the status quo. BoJ governor Toshihiko Fukui’s term expires on March 19. No successor has yet been named for governor or the two deputy governor’s positions that are filled at the same time. This is in stark contrast to appointments of other recent new central bank executives where the lead time is measured in months.

Next week brings a plethora of new economic data including more complete estimates of U.S., UK and German fourth quarter GDP. In addition, two important confidence surveys will be released — the German Ifo and the EU Business and Consumer Confidence Survey. The data undoubtedly will be part of the input for the five major central bank meetings that will take place during the first week of March.

Looking Ahead: February 25 through February 29, 2008