Market Overview
The following review is for the period 1 July to 31 December 2007 and does not reflect changes in market conditions since this date.
Overview
In an increasingly volatile environment, global equity markets fell back in the second half of the year, reversing some of the strong gains made in the first half. Global economic growth remained good. However, earlier financial policy tightening, continued US mortgage defaults and rising corporate debt exposure led to significant strains in the markets. As banks tightened lending requirements, the US Federal Reserve responded by cutting interest rates despite ongoing inflation pressures.
UK
UK economic growth moderated to a slower pace in the second half of 2007. The stock market, as represented by the FTSE All-Share Index, was volatile, reversing some of the gains recorded in the first half of the year.
The Bank of England increased interest rates by 0.25% to 5.75% in July and kept them at this level until December when it cut interest rates by 0.25%. Interest rates on lending between banks rose by more than the Bank of England base rate as uncertainty about rising US mortgage defaults led to banks hoarding cash. Short-term financing problems led to a well-documented withdrawal of deposits from Northern Rock during September.
Inflation fell to around the Bank of England’s 2% target in the second half of 2007 after breaking through the 3% upper limit at the start of the year. Consumers continued to expect inflation to rise, which meant that the Bank of England continued to stress inflation concerns when it responded to financial market strains by cutting interest rates in December.
Europe
As in the UK, European economic growth was curbed in the second half of 2007. Despite solid economic conditions, equity markets were volatile, reversing some of the gains made in the first half of the year.
The European Central Bank kept interest rates unchanged at 4% during the second half of the year. Despite global financial weakness, some members of the ECB wanted to raise interest rates as higher food and energy prices pushed inflation above its 2% target.
The euro continued to strengthen against the dollar and, to a lesser extent, the pound. Growth in emerging markets broadly offset this loss of competitiveness, so industrial confidence stabilised at the end of the year.
US
US economic growth has been volatile over the past year, mainly reflecting the impact of swings in energy prices on consumer spending. The underlying picture has been deteriorating. Continued sub-prime mortgage defaults have led to a broad-based tightening of lending requirements, increasing the risk of a recession in 2008.
In response to this the Federal Reserve cut interest rates pre-emptively. However, the initial rise in equity markets tailed off as the Federal Reserve stressed that it was only cutting interest rates reluctantly because of ongoing inflation concerns. In particular, the dollar continued to weaken, causing the price of imports to rise.
Japan
The Japanese market, as represented by the FTSE World Japan Index, fell sharply in the second half of the year. For UK investors a strengthening of the yen partly offset this. A deteriorating financial environment discouraged investors from borrowing in yen to finance economic activity in other currencies.
Asia
In contrast to other financial markets Asia, as represented by the FTSE World Asia Pacific ex Japan Index, continued to make gains in the second half of 2007. The region benefited greatly from the first Federal Reserve interest rate cut. It then wobbled as investors realised that the Federal Reserve was still worried about inflation and domestic policy makers continued to tighten monetary policy.
Fixed Interest
Reflecting the weakness in equity markets, the difference in yields between corporate and government bonds increased in the second half of 2007. However, a strong rally in government bonds as the Federal Reserve cut interest rates, limited the overall rise in yields.
High Yield
The high yield bond market deteriorated in the second half of the year after experiencing a strong first half year. The increased risk of a US recession, combined with rising corporate debt levels, reduced demand for high yield bonds.
Property
After several years of strong returns, the UK commercial property market came under pressure in the second half of 2007. The credit squeeze has led to banks tightening their lending requirements, meaning there is less money in the market to buy assets. As a result, prices have fallen back to more sustainable levels than those witnessed at the start of the year.
The views expressed above are those of Legal & General Investment Management, who may or may not have acted upon them. The above should not be taken as an invitation to deal in Legal & General investments, or any of the stated stock markets. Remember, the value of investments, and any income taken, may fall as well as rise, is not guaranteed and you may not get back the full amount of your original investment. Past performance is not a guide to future performance. Exchange rate changes may cause the value of any overseas investments to rise or fall.
