Buoyancy to push rates higher

Investor/An insider's guide to the market: Investors in the bond and equity markets have had to cope with a lot of noise over the summer months with the latest being the police operation in Britain aimed at preventing an alleged imminent terror attack on British airports.

Not surprisingly, airline stocks initially fell but have since recovered some of the lost ground as airline travel in Britain gets back to normal. There may well be some long-term changes to security at British airports, which may have adverse consequences for Ryanair and Easyjet. For example, Ryanair's plans to encourage as many passengers as possible to just carry on hand luggage may well have to be scrapped for flights emanating out of Britain.

However, the low-cost carriers have proved themselves to be adept at adjusting to adverse developments and Investor does not expect the heightened security arrangements at British airports to alter radically the medium-term growth prospects of the low cost carriers.

On the positive side, the overdue ceasefire between Israel and Lebanon seems to be holding and thus enables investors to refocus on underlying economic developments. In this regard there have been some very significant developments over the past week.

Economic data coming out of Europe provides the firmest evidence yet that the recovery in the European economy is becoming self-sustaining. Up to recently, optimistic forecasts of euro-zone growth had to rely on the positive results coming from various surveys of consumer and industrial sentiment.

This week the latest official European Union data confirmed what the surveys had been saying - the euro zone is now growing at its fastest pace in over six years. The data shows that the 12-nation euro zone saw its growth reach 0.9 per cent in the second quarter, the strongest rate since the second quarter of 2000, the European Union's Eurostat data agency said in a first estimate. The figure, which compared with 0.6 per cent in the first quarter, also beat forecasts from private economists for growth of 0.7 per cent and a European Commission prediction of 0.4-0.8 per cent.

Usually the laggard among major economies, the euro zone performed better than both the US and Japan, which saw growth in the second quarter of 0.6 per cent and 0.2 per cent respectively.

This translates into annual growth within the euro zone of 2.4 per cent, the strongest rate since the first quarter of 2001 and up from 2 per cent in the first quarter. The economy of the 25-nation EU also expanded 0.9 per cent in the second quarter and 2.6 per cent over one year.

Germany, the biggest economy in the euro zone, underpinned the region's second-quarter performance with growth of 0.9 per cent over one quarter, the fastest rate since the first three months of 2001.

In an interview with Handelsblatt, the head of the German government's council of independent economic advisers, Bert Rürup, said "if there are no major surprises in the third and fourth quarters, economic growth of around 2 per cent for the full year 2006 is realistic".

While Germany is now doing well, growth was even stronger in France, which saw quarterly growth of 1.2 per cent. Europe's smaller economies also saw firm growth with the Netherlands reporting a quarterly expansion of 1 per cent and Spain reporting 0.9 per cent. However, Italy, the third-biggest economy in the euro zone , was a weak spot with quarterly growth of only 0.5 per cent.

Outside the euro zone the economic outlook for Britain is solid if somewhat unspectacular. Given the importance of the housing market to British consumer demand, the most recent RICS survey is significant. It showed that house prices in July are growing at their fastest pace since May 2004 and is the fourth consecutive month of improvement. Strength in the British housing market is one of the key reasons that led to the decision by the monetary policy committee to raise British base rates to 4.75 per cent.

While there are some risks to Europe's medium-term growth prospects such as the potential for a much stronger euro, and the planned increase in the German VAT rate from 16 per cent to 19 per cent in 2007, Investor takes the view that European economic growth will be at or above its long-term annual trend of 2 per cent over the next 12-18 months.

This is clearly good news for equity markets as it should enable corporate profits to continue to grow strongly. It is not such good news for bond markets since short-term interest rates will continue to rise.

Investor expects the ECB to add another 50 basis points to its repo rate before year-end and a rate of 4 per cent by this time next year is on the cards. Investor would not rule out euro interest rates peaking at higher than 4 per cent in this cycle.

For Britain a further rise to 5 per cent is likely by year-end as the Bank of England does not want to take any risks with inflation. Even in the US, where the Fed has paused at 5.25 per cent, a resumption of monetary tightening would occur if inflation indicators deteriorated.

Recent economic data, therefore, reinforces Investor's view that the macroeconomic environment is going to remain one of robust growth, strong profitability and gently rising interest rates for quite some time. This is an equity-friendly environment but medium and long-dated bonds will stay under pressure.