New Year's hangover A International Perspectives : January 17, 2000 By Anne D. Picker, International Economist, Econoday

Markets steam ahead despite interest rate jitters

Financial Markets

Equities
Equities in Asia and Europe ended the week mixed as profit taking continued in some Asian markets after the end of year run up. In Europe, all markets ended on the plus side despite inflation and interest rate concerns. The America Online and Time Warner merger affected overseas trading as well as U.S. trading. The overseas markets continue to watch U.S. markets and new economic data very closely. They fear potential ripple effects from events in the United States on their own economies.

Europe
European market participants faced a skittish week. They were confronted with the probability of a Bank of England interest rate increase and the unveiling of the first of the major labor union contract proposals in Germany. However, the markets shrugged off the 25 basis point increase by the Bank of England — and they pretty much ignored the large wage increase requested by the union. Certainly the proposed merger between America Online and Time Warner attracted attention away from the other issues.

Traders everywhere were buoyed by tame U.S. inflation figures and investors' apparent indifference to the prospect of an imminent rise in U.S. interest rate increase. Analysts overseas said they were impressed that Federal Reserve chairman Alan Greenspan, in Thursday night's speech, indicated that he will not let inflation get in the way of a surging U.S. economy.

The Financial Times Stock Exchange 100-Share Index (FTSE) ended the week up 127 points or 2.4 percent after the Bank of England raised its key interest rate from 5.5 percent to 5.75 percent. The French CAC jumped 248 points or 4.5 percent, continuing its positive streak to end the week at 5787.

The German DAX index scored sharp gains on four of five trading days to close the week at a record level of 7173, up 217 points or 5.8 percent on the week. The DAX was driven by sharp gains in telecom and technology stocks as the market's fascination with all things internet related continued unabated. And with all the talk of interest rate increases elsewhere, the equity markets on the continent became concerned that the European Central Bank would raise rates as well because of improving European growth.

Asia
Asian markets have been wary ahead of the Federal Reserve Open Market Committee meeting on February 1^st and 2^nd. Some fear the Fed could raise interest rates by as much as 100 basis points to cool the hot U.S. economy. A large interest rate hike would hurt Asia by luring money away from the region's riskier emerging markets and into safe havens such as U.S. Treasuries. The recovering economies are extremely sensitive to U.S. interest rate movements.

The Hong Kong Hang Seng index, after a huge 443 point gain on Monday because of the America Online and Time Warner merger, gave most of it back on profit taking as the market ebbed lower on Wednesday, Thursday and Friday. The market was exceedingly jittery about U.S. interest rates and concern that the U.S. producer and consumer price reports would be inflationary. (They weren't.)

The Nikkei 225 average finished the week up 763 points or 4.2 percent. Foreign investors continued to be net buyers of Japanese securities. Their persistent bargain hunting kept shares well supported despite a poor outlook among many local investors, traders said.

The Australian All Ordinaries index soared to a record closing high Tuesday on the coattails of rallying media stocks. The index gained 87 points or 2.9 percent to end the week at 3131.6, a record high. News on Monday of the merger between America Online and Time Warner sent local media stocks flying offsetting the weight of profit taking in the broader market. The index's performance is an indicator of the good Australian economic performance.

Currencies
The currency markets were dominated by a number of factors last week. Variously, they were the mega merger between America Online and Time Warner and accompanying profit taking; disappointing German economic statistics and the beginning of the union bargaining season there; inflation and interest fears because of increased oil prices and central bank actions and expected actions; exuberant stock markets around the world; Alan Greenspan; and the up coming G-7 meeting. And the list goes on…

Asia
Yen
The dominant talk about the yen last week centered on whether the Japanese Finance Ministry would push its G-7 partners (United States, Germany, France, the United Kingdom, Italy and Canada) for help in weakening the yen further at the upcoming January 22^nd meeting in Tokyo. Japan continually voices concern about the currency's strength, which could slow exports and hamper the country's nascent economic recovery.

The recent weakening of the yen has been attributed to several factors including rumors of covert Bank of Japan intervention, hedge funds buying short dated dollar calls, Japanese asset managers lifting some of the currency hedges on foreign investments, and foreign profit taking on the Nikkei's rise. In addition, the fact that the Bank of Japan has been draining Y2K related excess liquidity from the money markets at a much slower pace than the other central banks has been interpreted as easing by the Bank of Japan.

The yen rises in value against the dollar and euro when Japanese companies convert overseas proceeds. During last week, exporters and trust banks have sold dollars and euros to take advantage of more favorable rates to convert overseas earnings and bring proceeds home.

Australian Dollar
The Australian dollar rose against the U.S. dollar as the strongest hiring outlook among Australian businesses in 10 years indicated further economic growth and fed expectations of higher interest rates. The Australian economy is in its ninth year of growth, the longest period of expansion since record keeping began four decades ago. The Reserve Bank of Australia last increased interest rates on November 3^rd, lifting its official cash rate 25 basis points to 5 percent. The policy setting board next meets on February first and analysts widely expect another increase because of the strong economy. Higher interest rates attract investors to a currency because of the prospect for higher returns. Investors, betting the Reserve Bank will raise rates next month, are watching for any indication on the size of the increase.

Euro
The euro was sinking even before the release of the U.S. inflation data and the Bank of England's announcement of a 25 basis point interest rate increase. The favorable U.S. inflation data combined with positive market reaction to Fed chairman Alan Greenspan's remarks pushed the euro lower. Weaker than expected German data along with higher than expected wage demands by the German metalworkers union IG Metall on its 2000 pay round wage demands contributed to the decline. The European Central Bank is watching the progress of the German wage negotiations carefully for inflationary implications. These negotiations are a precursor for other German labor contracts and impact other countries' labor negotiations as well.

 Bank of England…
The first shoe of what could be many fell on Thursday when the Bank of England became the first central bank to raise interest rates in the new century. The Bank raised the repo or major policy making rate by 25 basis points to 5.75 percent, saying that increases in wealth, labor income and household borrowing are suggesting that consumer spending will continue to grow robustly. Economists said it presaged similar rate increases in Europe and the United States to forestall inflation at a time of accelerating global growth.

The increase had been widely anticipated and did little to damp the enthusiasm in financial markets.

 The decision to increase borrowing costs had been widely expected, given Britain's strong economic growth. Although the increase was met with disapproval by many businesses and union leaders, there was some relief that it had not been larger. The decision means higher borrowing costs for homebuyers and businesses on one hand, but also higher income for savers on the other.

The Monetary Policy Committee's (MPC) role is to set interest rates at a level which keeps inflation as close as possible to 2.5 percent. Inflation currently stands at 2.2 percent but the process is complicated by the assumption that interest rate changes take about two years to have an effect. However, members of the MPC have been concerned about rising housing prices, consumer spending and wages. It fears that if the economy is left to grow unchecked, higher inflation will follow.

The latest indicators show that consumer spending climbed in December and the housing market continued to pick up speed. Unemployment is at its lowest level for nearly two decades, which is seen as leading to increased wages as employers aim to recruit and retain workers. Union leaders attacked the interest rate rise, warning that firms will find it more difficult to expand and export. City analysts gave warning that with house prices and consumer spending continuing to rise steeply, the Bank is set to make a series of further rises in the next few months. The first increase could come as soon as next month, when the Bank will be in the process of putting the finishing touches to its quarterly Inflation Report.

Indicator Scoreboard…
European Monetary Union
October workday adjusted industrial production rose 2.1 percent on the year. The result is expected to be revised upward because of statistical difficulties with the German industrial production data. September output was revised up to show a 2.2 percent annual increase compared to a 0.8 percent rise initially reported. All EMU countries reporting data posted annual output increases. The strongest increases were recorded in France (+3.4 percent), Spain (+2.7 percent) and Italy (+2.5 percent). EMU output in October rose in all sectors. The strongest growth rates were recorded in capital goods, up 2.5 percent, and intermediate goods, up 2.4 percent.

November industrial producer prices — excluding construction — jumped three percent from 2.1 percent in October, primarily because of oil price increases.

Third quarter gross domestic product was unrevised from preliminary data showing a one percent quarterly increase and a 2.3 percent increase when compared with last year. The strong third quarter result was mainly due to a pick up in private consumption and gross fixed capital formation. While exports positively influenced third quarter GDP, a slower pace of inventory accumulation had a negative contribution to growth.

Germany
November industrial production declined 0.5 percent on the month. However, the Finance Ministry warned that output data for October and November are likely distorted and are almost certain to be revised up. The data contradict other recent economic indicators, which show that the acceleration in German growth is continuing.

December seasonally adjusted consumer prices increased 0.1 percent on the month and 1.1 percent on the year. Seasonally adjusted CPI increases over the last six months were revised down to an annualized rate of 1.5 percent in December from 1.7 percent originally estimated.

November unadjusted merchandise trade surplus came in higher than most analysts expected. Exports jumped 14.5 percent above a year earlier, while imports were 16.8 percent higher. Both export and import levels were the highest since pan German statistics began to be compiled in 1991. The November seasonally adjusted trade surplus increased both on a monthly basis and when compared with last year. The data suggest that net exports will make another positive contribution to fourth quarter GDP. Seasonally adjusted exports were 8.4 percent higher than in October and imports were up 6.8 percent from a month earlier.

Gross domestic product expanded by a real 1.4 percent in 1999, down from the 2.2 percent growth rate in 1998. This result was slightly higher than the government's revised 1999 GDP forecast of 1.3 percent. While the growth rate this year was below last year's, it was within the range of average annual real growth in the period between 1991 to 1998.

November seasonally and calendar adjusted total real retail sales — including automobiles and gas station sales — fell one percent and 3.1 percent on the year. These data are more disappointing than the unadjusted figures released earlier showing a 1.0 percent increase in real retail sales compared with a year earlier. Calendar adjusted monthly figures fell 2.1 percent, however. This comes as a surprise as retailers' reports suggested early Christmas purchases were relatively strong.

France
December consumer prices increased 0.4 percent, after no change in November and 1.2 percent when compared with last year. Oil product prices increased 5.2 percent on the month and 20.5 percent when compared with a year ago. This boosted energy prices 3.2 percent on the month and 9.6 percent on the year. Excluding energy, the CPI was up 0.2 percent on the month and 0.6 percent on the year.

Seasonally and workday adjusted third quarter gross domestic product was unrevised at one percent, as expected, after a 0.8 percent increase in the second quarter. When compared with last year, third quarter growth was revised to 2.9 percent.

Asia
Japan
December's wholesale price index was flat but was down 0.6 percent on the year. Electrical equipment and transportation items declined but edible agricultural, livestock and fishery products rose, as did prices of petroleum and coal products.

November current account surplus dropped 31 percent when compared with a year earlier. The surplus has dropped year on year for 10 months in a row. Goods and services trade for the month was down 35.3 percent. Exports rose of 4.7 percent while imports jumped 16.2 percent when compared with a year ago.

Australia
December employment jumped a seasonally adjusted 55,800. This was much higher than analysts expected. Full time employment jumped a healthy 46,300. However, December's unemployment rate rose to seven percent from 6.7 percent in November, because of the increased number of people joining the labor market to look for jobs. The participation rate rose sharply to 63.6 percent from 63.1 percent in October.

Endnote…
It was a light week for Asian and European economic data and so the markets paid even more attention than usual to U.S. data. By doing this, they acknowledged the important impact of U.S. economic events on their own economies. As the old saying goes — when the U.S. economy sneezes, Europe (and Asia) could catch a cold.

Looking ahead…