The Big Picture

Turbulence in global markets has returned, initially prompted by a rout in Chinese stocks on fears of authorities intervening due to concern over the pace of gains in the local A-share market. In addition to this trigger point, there was a very weak data on US durable goods orders for January, increasing concern for lending, and ex Federal Reserve Chairman, Alan Greenspan, commented that the US could face recession later this year. But the key to equity and other asset prices in the medium term is the yen carry trade – can those investors who have borrowed yen (and to some extent Swiss francs) at near zero rates and who have been providing the liquidity to support other asset classes hold their nerve?

The currency risk remains high

The further drop in global equity markets yesterday took place at pretty much exactly the same time as the renewed rise in the yen, suggesting that the unwinding of the yen carry trades remains a key concern for markets (since these carry trades will have helped fund the purchase of higher yielding assets). Data collected by US futures exchanges show speculative short yen positions were reduced last week, but there is a strong possibility that this week’s data (released at 20.30 GMT tonight) may actually show an increase in short positions - some would find this alarming!

Carry trades have been pretty much the only strategy to have made money in the currency markets over the past two years, but this week’s events should serve as confirmation that these are high risk positions. The jump in the yen on Tuesday alone (by just over 2%) was of a scale that was by no means unprecedented, yet it was enough to wipe out half of the annual carry between US and Japanese interest rates. If these trades really have been anywhere near as popular as the futures market data (and anecdotal evidence) suggests, and participants are only now coming to terms with the huge risks involved, then we have every reason to fear further yen strength and equity weakness. 

However, all is not lost. Continued earnings growth, albeit at a slower pace, argues against a bear market developing.

Global financial markets are shaky, but economic fundamentals remain healthy

Equity markets continue to unwind overbought conditions built up in recent months, as investors are on edge about the economic and profit outlook. Analysts are cutting earnings estimates and profit growth is set to slow quite markedly in the coming months. However, BCA’s Global Leading Economic Indicator suggests an outright contraction in profits is unlikely. Continued earnings growth, decent valuations and low bond yields should provide support to global stock markets.

Global equity markets and high-yielding corporate credit will remain vulnerable in the near term given the sharp run-up in prices in recent months. But a healthy global economy provides a firm foundation under asset prices: economic growth is broad based, corporate balance sheets are robust and inflation and interest rates are low. Moreover, the rally in bond prices is reassuring, as lower yields will help stabilise the global economy and the U.S. housing sector. Concerns about U.S. growth and the mortgage loan market will linger in the near run, but the odds of a hard-landing in the U.S. are slim. Bottom line: while near-term turbulence could persist, global equity prices should end the year higher and the rise in high yield credit spreads will be moderate.

If we assume there will be a sharp US slowdown, who will be hit hardest in the UK? 

The sectors of the UK economy most at threat from a major economic slowdown in the US include manufacturing, the City of London, tourism and the London housing market. But a US slowdown could be bad news for everyone if it further unbalances the UK economy. The manufacturing sector will be the hardest hit by the direct trade effects of a US slowdown. It exports nearly half of its output and is particularly vulnerable to fluctuations in the US economy. A US slowdown could reduce manufacturing output by around 2%. 

The impact on the UK’s tourism sector will probably be even larger. During the last US slowdown in 2000/01, Americans visitors to the UK dropped by half a million. If a similar number of US tourists stay away this time, the output of the tourism sector could fall by around 4%. 

But the sector that will probably suffer most from a US slowdown is the wholesale financial services sector. The close links between London and New York go beyond simple trade effects. A US slowdown could reduce the output of the City of London by 5%. 

The US slowdown could also have a dampening impact on the London housing market, given the influence of US investors. Along with the negative effect on the City and tourism, this suggests that London will be the hardest hit region. 

Not every sector of the economy will suffer directly. Indeed, if the US slowdown results in interest rates being kept lower than otherwise, this might even support the housing market outside London. And a further fall in the dollar could reduce costs for UK companies that import commodities. 

But a bigger concern than the fate of particular companies or sectors is the danger that a US slowdown further unbalances the UK economy. A bigger drag from net trade could force the policymakers to shore up the domestic economy again, further raising the levels of household debt and house prices and increasing the dangers of an abrupt downturn at some point in the future. 

Technically ……………… 

FTSE-100 (6116) is now showing a 100 point loss for 2007 although, from a technical perspective, it is of far greater significance that it has broken down (for the first time) through the uptrend that started last summer. At the very least this means that the bullish sentiment which has been so prevalent up to now has been dented as investors reassess their appetite for risk, although the fact that there has not been a significant break down through the 4-year uptrend could mean

that there will be some measure of support at current levels - not least because the FTSE has become relatively oversold. Nevertheless, it seems premature to suggest that this corrective phase is already over.

 Bottom bottom line:

The equity sell off is unwarranted on fundamental grounds, but watch the yen!

 And finally……………..

What would happen if the US lost the war? (Click here)

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.