Investor Watch: Henderson Global Investors: Economic & Market Update

Henderson Global Investors: Economic & Market Update

Highlights

There is little doubt the European Central Bank will act again to curb inflation after raising interest rates to 4.25%.

Employment in the United States contracted by 62,000 in June, while the unemployment rate was unchanged at 5.5%.

Mortgage applications in the United Kingdom slumped to just 42,000 in May.

The oil price rose to another record high, reaching $145 a barrel for the first time.

Views

Although the European Central Bank has said that last week's increase in interest rates was not the start of a series of moves, there is little doubt it will act again if inflation expectations appear to be rising.

Developments in the US labour market are consistent with little to no growth in the economy, though recent surveys suggest things may be getting a little worse.

Unwillingness on the part of potential sellers to accept bigger price cuts has caused transactions in the UK housing market to dry up.

Speculative positions in the oil market have increased, but it is unclear whether these are driving prices higher, or just taking advantage of an upward trend that reflects fundamental factors.

As expected, the European Central Bank (ECB) increased interest rates in the Euro-zone by 25bp last week, lifting them to 4.25%.
The ECB has made it clear that it is worried current high inflation rates will lead to a general rise in inflation expectations and wage settlements. If this occurs, there is a risk that inflation in the Euro-zone gets stuck at a permanently higher rate.
The ECB has gone out of its way to emphasise that it does not see this move as the start of a series of rate hikes, but there is little doubt that it would act again if it felt that inflation expectations had not been sufficiently damped.

Euro-zone inflation for June hit 4.0%, its highest level since the beginning of the monetary union and 2% above the ECB's target rate.
As with most of the world's inflation, the main contributors have been food and energy. Core inflation remains at a relatively subdued 1.7%.
But the ECB remains concerned with the potential for pass through into higher Euro-zone wages. Based on the lagged relationship between resource utilization and headline inflation, the latter is set to remain elevated around current levels until at least the end of 2008.

Bond yields in Europe have been rising since the middle of March.
Initially, this move reflected an improvement in risk tolerance - after the Federal Reserve organised the rescue of Bear Stearns by JP Morgan - and optimism that the credit squeeze would not prevent an economic recovery in the second half of the year.
More recently, yields have continued to move up on fears of higher inflation and higher interest rates. Comments from the ECB that there is no plan for a series of interest rate hikes have arrested the rise in yields, but so far have been insufficient to send it into reverse.

The US ISM composite PMI dipped below 50 in June, following two months above the key boom/bust level, dashing hopes of an imminent recovery in the US economy.
Non-manufacturing new orders fell sharply from 53.6 to 48.6 whilst inventories declined slightly. The export sector for both manufacturing and service industries remained the bright spot with 58.5 and 52.0 prints, respectively, though both were down slightly on the previous month.
The prices paid series remained at a high level indicating input price increases are prevalent in the economy. There remains little evidence of pass-through of price increases to end users.

The US economy shed jobs for the sixth month in a row and according to our model there are more losses to come. The monthly payrolls number could accelerate to an average of -140,000 between now and December
Non-farm payrolls fell by 62,000 with the construction, manufacturing and service sectors all registering declines.
The decline in temporary help service employment, usually a good leading indicator for the state of the overall labour market, has accelerated with -32,000 and -30,000 prints in May and June after a -19,000 print in April.

Mortgage applications in the UK dropped to just 42,000 in May.
House price series show prices have fallen 10% from their peak. It seems homeowners who are looking to sell are not prepared to accept a bigger drop in their asking prices. With buyers looking for bigger discounts as insurance against further falls in prices, the result has been a collapse in the volume of transactions.
Fortunately, the relationship between retail sales and housing transactions is not as strong as it was. Even so, it is hard to believe that retail sales can continue to grow at their current pace while the housing market is so weak.

The UK's composite PMI collapsed to 46.8 in June from 49.7 the previous month. In previous cycles, the bank rate might have been expected to have reached 4% in the following couple of months.
This time around, the Bank of England has had to struggle with an inflation rate which has been persistently higher than its 2% target.
Indeed, the PMI composite output prices measure increased from 60.0 to 61.2 last month. The output prices measure has not kept pace with input prices as companies have not been able to fully pass on all input price increases to end users.

The Tankan survey in Japan showed a drop in business confidence across manufacturing and non-manufacturing industries, though the decline was less than expected.
Details of the survey suggested that Japanese firms are responding to large increases in input costs by pushing up their prices.
In the short-term, this is unlikely to worry the Bank of Japan. After all, the economy has only just emerged from deflation. Indeed, if food and energy price inflation fades and core inflation rises to around 1%, then the Bank of Japan will be very happy. It will not, though, be prepared to leave interest rates as low as 0.5% in such a scenario and eventually they would be increased.

The price of crude oil has finished higher in 19 out of the last 27 weeks so far this year.
It is difficult to imagine that oil demand has increased relative to supply enough to justify the 42% increase in the price seen thus far this year. The cause may be the amount of investment flow into commodities.
There has been an explosion in the use of derivative contracts on oil, and commodities in general. Total futures open interest on oil has increased 284% since 2003 after having risen by a more subdued 70% from 1995 to 2003 – a period in which active investment in alternative assets such as commodities was less prevalent.

Local Returns

Sterling Returns

US Dollar Returns

29/06/08 to 06/07/08

Index

% Week

Year to
Date

% Week

Year to
Date

% Week

Year to
Date

FTSE All Share
FTSE 100

2736
5413

-2.7
-2.1

-16.8
-16.2

-2.7
-2.1

-16.8
-16.2

-3.2
-2.6

-17.1
-16.5

S&P 500 Composite
NASDAQ Composite
Toronto S.E 300 Composite

1263
2245
14010

-1.2
-3.0
-2.4

-14.0
-15.3
1.3

-0.8
-2.6
-2.5

-13.6
-15.0
-1.2

-1.2
-3.0
-3.0

-14.0
-15.3
-1.6

Dow Jones Euro Stoxx
Dax 30
SBF 250
Milan Comit General
Madrid S.E. General
Netherlands - CBS All Share
Swiss Market Index

311
6272
3016
1394
1267
486
6773

-3.0
-2.3
-3.3
-1.7
-2.8
0.0
-1.3

-25.0
-22.3
-23.8
-24.3
-22.9
0.0
-20.2

-2.9
-2.2
-3.2
-1.7
-2.7
0.1
-1.2

-19.2
-16.2
-17.8
-18.4
-16.9
7.8
-11.4

-3.4
-2.7
-3.6
-2.1
-3.2
-0.4
-1.7

-19.5
-16.6
-18.2
-18.7
-17.2
7.3
-11.7

Topix
FT/S&P World Pacific Basin ex Japan
ASX 200
Hang Seng
FTSE Singapore All Share
Kuala Lumpar Composite
Korea S.E. Composite
Taiwan S.E. Weighted Index
Bangkok S.E.T.

1298
312
5082
21424
727
1134
1578
7228
743

-1.7
-3.7
-3.0
-2.8
-2.9
-4.7
-6.3
-4.2
-4.2

-12.0
-19.3
-19.8
-23.0
-19.9
-21.5
-16.8
-15.0
-13.4

-1.8
-3.4
-2.3
-2.3
-2.4
-4.5
-6.7
-3.9
-3.7

-7.5
-17.0
-11.6
-22.7
-15.0
-20.3
-25.5
-9.0
-12.6

-2.3
-3.8
-2.7
-2.8
-2.8
-4.9
-7.1
-4.3
-4.1

-7.9
-17.4
-12.0
-23.0
-15.4
-20.6
-26.1
-9.3
-12.9

IFC Composite
Mexico IPC (Bolsa)
Brazil Bovespa
Argentinian Merval
IFC Russia

906
28338
59365
2006
3129

-
-3.3
-7.7
-4.1
-

-
-4.1
-7.1
-6.8
-

-3.8
-3.0
-7.5
-3.9
-6.0

-20.3
1.7
3.2
-2.7
-8.6

-4.2
-3.5
-7.9
-4.4
-6.4

-20.6
1.2
2.8
-3.1
-9.0

US Treas. Benchmark Bond - 30Yr
US Treas. Benchmark Bond 10 Yr
UK Benchmark Bond 10 Yr
Japan Benchmark Bond 10Yr
German Benchmark Bond - 10 Yr

4.53
3.97
4.97
1.64
4.50

0.2
0.2
0.6
-0.2
-0.1

1.1
2.5
-0.7
-0.4
0.9

0.7
0.6
0.6
-0.3
0.0

1.5
3.0
-0.7
4.7
8.8

0.2
0.2
0.1
-0.8
-0.4

1.1
2.5
-1.1
4.3
8.3

FTA British GVT IL 5% Infl. Over 5 Yrs
US Treas. Index Linked Bond > 5 Yrs

0.72
0.70

1.3
1.3

3.9
18.4

1.3
1.8

3.9
18.9

0.9
1.3

3.5
18.4

Lehman US Credit Agg A
Lehman US Credit Agg AA
Lehman US Credit Agg AAA
Lehman US Credit Agg BAA

6.30
5.66
4.28
6.65

-0.1
0.1
0.2
0.0

-0.9
-0.1
1.5
-1.0

-
-
-
-

-0.1
0.1
0.2
0.0

-0.9
-0.1
1.5
-1.0

Merrill Lynch UK All Stocks
Merrill Lynch UK Credit A
Merrill Lynch UK Credit AA
Merrill Lynch UK Credit AAA

7.37
7.79
7.06
6.25

0.0
0.0
0.0
0.3

-4.2
-4.8
-3.0
-3.5

0.0
0.0
0.0
0.3

-4.2
-4.8
-3.0
-3.5

-0.4
-0.4
-0.5
-0.2

-4.6
-5.2
-3.4
-3.9

Brent Oil ($/Barrel)
Gold Bullion $/ Troy Oz
Economist Commodity Index ($)

143.6
933
272.2

-
-
-

3.5
1.2
2.8

53.7
12.0
24.4

3.0
0.8
2.3

53.1
11.5
23.9

Currencies
¥
$
Euro
Aus $

vs $
106.7
-
1.569
0.96

vs £
211.6
1.98
0.792
2.06

-0.1
0.5
0.1
0.7

5.1
0.4
7.8
10.2

-0.5
-
-0.4
0.2

4.7
-
7.3
9.8

Economic Outlook

GDP growth (%)	2007	2008*	2009*
US Japan Euro-area UK G7 Asia ex Japan World	2.2 2.0 2.6 3.0 2.2 8.6 4.9	1.5 1.8 1.9 1.6 1.6 7.5 4.0	1.5 1.3 1.2 1.1 1.4 6.8 3.4

Global economic growth is likely to slow in 2008 and again in 2009, reflecting the lagged effects of higher interest rates, the credit squeeze and higher food and energy prices. There is a risk that, as the slowdown becomes synchronised, it deepens into a global recession. However, if this risk is avoided, growth should be recovering by the middle of 2009.

Inflation (%)	2007	2008*	2009*
US (core) Japan Euro-area UK G7 (headline) Asia ex Japan World	2.3 0.1 2.1 2.3 2.2 4.6 4.1	2.3 1.4 3.6 3.5 3.6 6.6 5.9	2.4 1.3 2.6 2.8 2.5 5.0 4.5

Higher food and energy prices are likely to lift headline inflation rates across the globe in 2008. Weakening economic growth should prevent core inflation rising in developed economies, allowing inflation to drop back in 2009. There is a risk, though, that somewhat higher inflation becomes more stablished in emerging economies.

Interest rates (%)	07 Jul 08	Jun 2009*
US Japan Euro-area UK	2.00 0.50 4.00 5.00	2.00 0.50 4.00 4.50

In the short-term, interest rates look set to rise in the Euro-zone. If inflation rates are moderating in the first half of 2009, any hikes are likely to be reversed and rates could also fall in the UK. In the US, interest rates are nlikely to rise before the second half of next year.

Currencies	07 Jul 08	Jun 2009*
Yen/$ $/euro £/euro $/£	107 1.57 0.79 1.98	100 1.45 0.82 1.77

The US dollar may weaken in the short-term, but over the next twelve months it is expected to start to recover against the Euro. Sterling remains vulnerable to negative sentiment on the UK economy. The yen is now close to fair value against the dollar.

* Henderson Global Investors' forecast

Financial Market Outlook

Govt 10-year bonds (%)	07 Jul 08	Jun 2009*
US Japan Euro-area UK	3.97 1.64 4.50 4.97	4.25 2.00 4.25 4.80

In the short-term bond markets are likely to be volatile, reflecting the confusing combination of lower growth and higher inflation. If interest rates are cut next year, yields could well fall in the UK and the Euro-zone. US yields may be rising in a year's time if the outlook for the second half of 2009 is better.

EPS growth (%)	2007	2008*	2009*
US Japan Euro-area UK Asia ex Japan	-3 7 15 8 45	2 5 -5 5 8	8 5 5 5 5

Weaker global growth and the effect of buoyant commodity prices on margins are likely to combine to produce disappointing earnings growth in 2008. Any recovery in earnings in 2009 will also be modest, in line with xpectations for output growth.

P/E ratios	2007	2008*	2009*
US Japan Euro-area UK	14.7 14.6 9.9 10.9	14.4 13.9 10.4 10.4	13.4 13.2 9.9 9.9

Equity markets appear cheap, in part because they are discounting weak earnings growth in 2008. Valuations should, therefore, offer some support if the economic downturn turns out to be moderate and inflation eases.

Equity markets	07 Jul 08	Jun 2009*
US (S&P 500) Japan (Topix) Euro-area (DJ Eurostoxx) UK (FT All Share) MSCI Asia x Jap US$ MS emerging markets US$	1263 1298 311 2736 465 1030	1475 1550 370 3250 550 1200

Equity markets are likely to remain volatile in the short-term and could fall on bad news from the financial sector, more inflation worries or signs that economic growth will be disappointing. By the middle of next year, assuming the outlook for 2009 is brighter, equities might be staging a more sustained recovery.

* Henderson Global Investors' forecast

This document has been produced based on Henderson Global Investors' research and analysis and represents our house view. The information is made available to clients only incidentally. Unless otherwise indicated, the source for all data is Henderson Global Investors. Any reference to individual companies is purely for the purpose of illustration and should not be construed as a recommendation to buy or sell or advice in relation to investment, legal or tax matters.

Please remember that past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise as a result of market and currency fluctuations and you may not get back the amount originally invested. Tax assumptions may change if the law changes, and the value of tax relief will depend upon individual circumstances.

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