Employment and interest rates concentrate minds

An insider's guide to the market: Employment growth (or the lack of it) and trends in interest rates are back at the forefront of issues affecting financial markets.

Although we can now see that the US economy started to grow as far back as the final quarter of 2001, the US labour market has yet to show clear signs of a sustained expansion in employment.

Over the past 12 months none-farm payrolls have only grown by 122,000 compared with average annual growth of 2.7 million jobs a year from 1992 to 2000.

The US monthly employment report is now one of the most keenly awaited economic news releases and has the potential to move bond and equity markets on its release.

While the trends in employment have moved centre stage in America, interest rates are the current focus of attention in Europe.

In the UK expectations are for a gradual upward trend in short-term interest rates for the rest of the year as the monetary policy committee (MPC) seeks to control strong consumer spending and a booming housing market.

In contrast euro-zone interest rates could decline this year given the stubborn reluctance of consumers in the big three economies of Germany, Italy and France to increase spending.

Turning first to the UK, recent figures released by the Bank of England showed that mortgage lending was growing at the fastest rate for a decade.

A survey conducted by the Nationwide building society indicates that the annual rate of UK house price inflation has remained stubbornly high at 17 per cent over the first two months of the year.

Up to recently most economists were forecasting a decline in the rate of UK house price inflation into a 5-10 per cent range. The current strength now points to another double-digit percentage point rise in UK house prices in 2004.

With the overall UK economy also strong the stage is set for a sustained phase of rising interest rates as the MPC seeks to ensure that inflationary pressures do not emerge.

In Europe there are some hotspots of house price inflation such as Ireland and Spain.

However, the state of the overall European housing market is not a major concern of the ECB in contrast to their UK counterparts. Weakness in consumer demand is now the prime concern in Europe although the European Commission's most recent quarterly report states that the European economy is doing reasonably well despite sluggish consumer spending.

Euro-zone exports remain healthy despite the appreciation of the euro.

The Commission's report makes the point that euro-zone exports are more sensitive to fluctuations in world demand.

Therefore, the strength in world demand over the past 12 months has largely offset the negative impact of lost price competitiveness due to currency appreciation. In fact euro appreciation should have a positive impact on consumer spending as lower consumer price inflation improves real household disposable income.

As yet there is no evidence of this occurring and a series of recent statements from council members of the European Central Bank (ECB) members indicate that the bank is concerned about this lack of buoyancy in consumption patterns.

Without some significant improvement in consumer spending in the second half of this year, official forecasts of euro-zone economic growth of 1.8 per cent for 2004 may not be met. With inflation now falling to below the ECB's target of 2 per cent there is now virtually no prospect of a rise in euro interest rates this year and a modest decline is a real possibility.

Back in the US the fabled American consumer continues to spend.

Tax cuts and short-term interest rates of 1 per cent have clearly helped, but there is an underlying strength to US consumer confidence that is sadly lacking in Europe.

However, if the US jobs market does not improve soon, economists will become fearful about growth prospects for the second half of the year.

Another negative influence on US real incomes and consumption is stubbornly high oil prices, which have risen by over 15 per cent in recent months in dollar terms.

The strong euro means that European consumers have been largely immune to the higher oil price. With so much worry and uncertainty regarding employment growth in America, lacklustre consumer spending in Europe, and rising interest rates in the UK, it is not too surprising to find that equity markets have slipped back in recent weeks.

It is often said that equity markets climb a "wall of worry" and the key issue for investors is whether what we are now witnessing is merely a correction in the context of a continuing upward trend in share prices.

Given the apparent resilience of the global economy to recover from the recession and geopolitical shocks in recent years, the odds still favour a continuation of global economic growth and consequent favourable conditions in financial markets.