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Global Bonds Emerging Market Bonds Factors Shaping Markets Next Week

	FRIDAY* LAST WEEK DEC.31 2007 1 YR AGO Dow Jones Ind. Avg. 11,289 11,453 13,265 13,577 S&P 500 1,263 1,283 1,468 1,525 Nasdaq 100 2,245 2,321 2,652 2,645 The Russell 2000 666 698 766 848 DJ STOXX Europe 283 288 365 398 Nikkei Index 13,265 13,822 15,308 18,169 Fed Funds Target 2.00% 2.00% 4.25% 5.25% 2-Year U.S. Treasury    Yield 2.54% 2.66% 3.05% 4.88% 10-Year U.S. Treasury    Yield 3.98% 4.04% 4.03% 5.04% U.S.$/Euro 1.57 1.58 1.46 1.36 U.S.$/British Pound 1.98 1.99 1.98 2.02 Yen/U.S.$ 106.69 106.82 111.71 122.69 Gold (London) $934.38 $917.30 $833.92 $654.20 Oil $144.00 $139.64 $95.98 $71.41

  *Levels as of 10:45 a.m. PST

	Year to Date (1/1/08 - 7/3/08)   Dow Jones Industrial Avg -14.90% S&P 500 -13.99% NASDAQ -15.34% Russell 2000 -13.09% MSCI World Index -13.43% DJ STOXX Europe 600 (euro) -22.36% Year to Date (1/1/08 -7/2/08)   90 Day T-Bill 1.30% 2-Year Treasury 2.17% 10-Year Treasury 2.03% ML High Yield Index -1.71% JP Morgan EMBI Global Diversified -0.54% JP Morgan Global Hedged 0.19%

ECONOMIC RELEASES
July 1 Construction Spending (May) -- Construction expenditures fell 0.4% in May. Private residential spending dropped 1.6% as single-family home expenditures fell 3.4%. Expenditures on multi-family units actually rose 0.1%. Private nonresidential expenditures edged up 0.2% in May, its weakest performance in about five months as spending on commercial space declined.

ISM Survey -- The June ISM was better than the market expected, rising to 50.2 from 49.6 previously. This was also the first reading 50+ reading since January. A reading above 50 denotes an expansion in the sector. Nonetheless, both new orders and employment remain soft.

Vehicle Sales – June vehicle sales are estimated at 13.5 million units at a seasonally-adjusted annualized rate (from 14.3 million previously), which represents a 5% drop from May. Auto sales at this level also market the weakest monthly sales rate since August 1993.

July 2 Factory Orders -- Factory orders rose 0.6% in May, while shipments inched up 0.1%. Inventories also increased, moving up 0.5%. The inventory/sales ratio rose to 1.23 from 1.22.

July 3 Employment Situation – The US economy shed 62,000 jobs in June and the unemployment rate held steady at 5.5%. The June payroll decline marks the sixth consecutive months of decline on overall nonfarm payrolls and the seventh consecutive month.

ISM Non-Manufacturing Survey -- The June services-sector ISM was much weaker than the market expected, dropping to 48.2 from 51.7 previously. New orders and employment were also much weaker this month compared to last.

COMMENTARY
Overview

• The US economy shed 62,000 jobs in June while the unemployment rate remained at 5.5% (its cyclical high), the Labor Department Reported on Thursday. Downward revisions to previous months’ data totaled 52,000. Employment continued to fall across employment categories, with job losses in construction, manufacturing, and employment services. Meanwhile, health care and mining contributed to jobs gained. June’s payroll declines market the sixth consecutive month of net job losses and the seventh consecutive month of private payroll losses. Also in the details of the report, given our concerns about inflation, we carefully watch the average hourly earnings gauge. Absent a sustained increase in hourly earnings, it is unlikely we will revisit the 1970s wage-push inflation. In fact, average hourly earnings rose 0.3% for second straight month, but they edged down to 3.4% year-over-year from 3.5% previously and a peak of 4.3% in 2006. Perhaps more importantly, when adjusted for inflation, earnings growth is negative. This deterioration in “purchasing power” for the average American will not provide any momentum for consumer spending heading into the second half of the year.
• The financial markets remain under significant uncertainty with regard to the path of the economy and Fed policy. However, given the sustained, broad-based labor market weakness, the Fed is probably sidelined through at least year end. If anything, the situation could deteriorate further. One key area to watch: state and local government employment. This employment category added 25,000 jobs in June and 233,000 jobs over the last year. But, with many state and local governments facing budget constraints in the wake of the housing downturn, the pace of hiring will likely slow or come to a halt altogether in the next year, sapping the few remaining glimmers of strength from the job market.

US MARKETS
Treasury Bonds

• Treasuries rallied powerfully this week as rate hike expectations dissipated and investor focus turned to the sour outlook for the economy. With interest rates regaining their positive correlation with equity price action and equities swooning meaningfully, rates followed suit led by the front end of the yield curve. Yields on the two-year Treasury note rallied 30 basis points while yields on the 10-year Treasury note rallied 14. Economic data, including nonfarm payrolls, was largely in line with expectations, but fears related to escalating oil prices, depreciating asset prices and heightened inflation expectations weighed on sentiment. To that end, agency spreads widened about five basis points as investors shied away from spread product.

Large-Cap Equities

• Equity markets fell this week as oil prices continued to hit all time highs. Employers in the US cut jobs for the sixth month in a row, signaling a deepening economic slowdown. The S&P 500 and Russell 1000 indexes finished down 1.5%. Small-cap stocks underperformed large-cap stocks, finishing the week down more than 4.5%. In terms of style, large-cap growth stocks underperformed large-cap value stocks. The best performing sector was health care and the worst performing sector was materials. Oil prices hit $144 per barrel this week as Middle East turmoil concerned investors. Shares of NVIDIA Corp. (NVDA) dropped 30% after the company cut its second quarter sales forecast. A combination of price cutting and increased competition from Advanced Micro Devices (AMD) and Intel (INTC) were the catalysts for the sales slump. General Motors Corp. (GM) shares fell to their lowest levels in over 50 years after a Merrill Lynch analyst reported that bankruptcy was a possibility. GM is facing a large drop off in US auto sales as June sales slid 18%.

Corporate Bonds

• Investment grade primary activity (new issuance) was non-existent this week as issuers and investors took a well-deserved break from the new issue market. This week was somewhat unusual as it started with month/quarter-end rebalancing and ended one day short of the norm (with the market closed for the Friday Holiday). It feels as if investors are uneasy with little to no conviction to add risk in this environment. The new issuance market has been the conduit for investors to add to their portfolio at a slight discount to existing secondary paper and increase liquidity at the same time. New issuance is expected to be fairly subdued as many issuers have entered their earnings blackout period.
• Investment grade corporate spreads widened as investors shied away from adding spread product and adopted a more defensive position going into the summer doldrums. Many investors are looking for a catalyst that will cause the market to rally, but as we enter into the heart of the summer, it is difficult to think of any one thing that could cause the market to reverse course. The Lehman Credit Index Option-Adjusted Spread (OAS) finished the week at +241, 12 basis points wider. Telecom/cable/media widened by 15; utilities widened by nine; industrials widened by 12; and financials widened by 20.

• Mortgage woes are back as credit fears mount and economic malaise settles in. Thirty-year agency mortgage spreads widened 10 basis points, consistent with the behavior of other spread products. The pickup in volatility and poor supply technicals has kept traditional mortgage investors (money managers, banks, and hedge funds) on the sidelines. The agency mortgage market has also been negatively impacted by the reversal of fortunes in the non-agency prime mortgage market. Non-agency mortgage pricing has deteriorated back to the March lows as ratings downgrade risk grows. For the week, the 30-year current coupon versus 10-year Treasury note yield closed at 194 basis points.

• The municipal market rallied 8 to 12 basis points. Two-year bonds yielded 2.55% by Thursday’s session, and 10-year bonds yielded 3.80%. Attractive valuations relative to US Treasury bonds, limited new issuance and healthy demand fueled by July 1 coupon and maturity payments all supported high quality bonds. Lower quality securities continue to suffer from illiquidity although the overall market tone has improved. The primary market was relatively inactive due to the holiday. All three rating agencies upgraded the Louisiana’s state general obligation debt rating one notch to the A+/A1 level. The state benefitted from high oil and gas revenues as well as Hurricane Katrina recovery-related revenues.

• The high yield market began July in a dispiriting manner. The sell-off, which began in mid-June, has continued into July, as renewed worries about the state of the global economy and the condition of the financial system have led to new concerns. The continuing rise in the price of crude oil is fueling inflationary concerns across the globe. The high yield market is not immune to the global capital market worries, and as a result, spreads for the broad market have widened approximately 100 basis points since early June 2008 to a current spread level of +730 basis points and a yield of 10.7% for the Merrill Lynch High Yield broad constrained index. Clearly, the equity markets and the price of crude oil will be the biggest near-term drivers of the capital markets. However, second-quarter earnings season will begin in two weeks and will provide more clarity and transparency as to the financial state of individual companies and the condition of the global economy.

• Stocks in Western Europe lost ground during the past week. The worst performing sectors were Basic Resources (-6%) and Retail (-7.7%). German Salzgitter AG (-16.7%), one of Europe’s leading steel and technology corporations, declined strongly after analysts predicted that the company will not be able to raise their output prices as input prices increase. British retailer Marks & Spencer fell (-30%) after analysts cut the company’s profit forecast.
• Among the sectors that did well were Telecom (+5.8%) and Health Care (+3.9%). In the telecom sector, Etisalat and France Telecom (+12.5%) announced their plans to collaborate in a number of strategically important telecommunications areas including home services, contents, and international networking. International pharmaceutical company AstraZeneca (+7.1%) won a major court decision warding off generic US versions of its popular antipsychotic drug, Seroquel, until its patent expires in 2011. Among the more notable euro zone macroeconomic news was the rise of interest rates to 4.25% from 4% by the European Central Bank. Euro zone PMI Services and PMI Manufacturing stats, 49.1 and 49.2 respectively, were weak in comparison to German statistics of over 50.

Eastern European Equities

• The CECE index of equities traded in Central Europe (Czech Republic, Hungary, and Poland) lost 1.4% this week, while the Russian stock index RTS finished the week down by 4.6%.In Central Europe, Czech coal producer NWR lost the most ground (-13.7%), followed by Polish bank Getin Holding (-13.7%) and Polish biotech company Bioton (-12.3%). NWR posted a record decline after the biggest drop in coal prices in three years. The slump followed speculation that a four-week long rally was overdone. Getin Holding also sold off after it was reported that the owner, Leszek Czarnecki, cooperated with the communist-era secret police in the 1980s. The shares dropped to the lowest level in more than two years. Bioton went down after the Polish news agency PAP announced that the company’s expected revenue for this year is below 500 million zloty ($235.8 million) due to a stronger zloty. Among the stocks that fared well, Polish media company TVN led the way (+5.9%) followed by Czech utility company CEZ (+5.6%) and Telekomunikacja Polska (+3.4%). TVN received a boost after the company completed their 500 million zloty bond issue which is said to be the largest bond issue in the Polish market to date this year. CEZ stocks went up after the company won a tender for a state-run power grid in northwest Turkey. Telekomunikacja Polska rallied after a Warsaw province court ruled that the company may receive a 140 million zloty subsidy for the public phone service it delivered in 2006.
• In Russia, Uralkali sold off the most (-8.3%), followed by Lukoil (-8.1%) and Sberbank (-7.7%). Shares of oil refinery Lukoil suffered from an increase of the oil export duty as well as the overall decline in oil output in the country. The shares of financial institution Sberbank went down even after the company denied plans to sell shares in Hong Kong. Among the leaders of the week were VTB Bank (+1.7%), Rostelecom (+0.1%) and fertilizer manufacturer Akron (+0.1%). VTB’s shares went up after its subsidiary, VTB-Leasing, announced plans to sell 10 billion rubles of bonds to finance its business. Rostelecom, Russia’s largest long-distance phone company announced that its profits almost doubled in 2007, largely due to offering new products such as internet access. Akron publicized that it will sell as much as a 10% stake in a public sale of shares in London to fund the expansion of one of its entities.

Global Bonds and Currencies

• Global bond markets remained under the influence of two opposing trends: rising inflationary fears due to higher food and energy prices, and mounting evidence that the impact of the credit crunch is widening beyond the financial sector to the broader economy. Central banks are talking tough in order to dampen inflationary expectations at a time when consumer confidence has fallen sharply and credit availability remains limited. Sharp drops in stock markets and growing fears about the economic outlook gave some support to bond markets, however, as risk aversion grew. The European Central Bank (ECB) raised interest rates by 0.25% to 4.25%, as had been widely expected. European bond yields had risen sharply in advance of the ECB meeting in anticipation of the rate hike, and the yield curve had flattened: two-year and five-year yields were 24 basis points higher, with 10-year yields up by 13 basis points. However, Mr Trichet’s subsequent comments in his press conference that he had no “bias” in terms of future interest rate movements led to a sharp recovery in European bond markets as a trend increase in interest rates was seen as being less likely. As a result, yields ended little changed on last Friday’s levels. UK Gilt yields were also lower following the ECB’s press conference. Yields beyond five years had been 5-8 basis points higher as sharply higher retail and manufacturing price inflation led to a steepening in the yield curve; they ended only two basis points higher on the week, while shorter-maturity yields ended 2-8 basis points lower. Japanese government bond yields out to 10 years were 5-10 basis points higher, as the latest Tankan business sentiment survey, while reflecting a slowdown in manufacturing among large firms, was not as weak as had been expected.
• Currency markets continued to be dominated by interest rate expectations; the euro initially gained support from expectations of an ECB rate hike and had risen by approximately 0.5% versus the US dollar prior to the rate hike. However, with European rates now possibly on hold, the euro weakened to end the period approximately 0.5% lower versus the dollar. With interest rates in Japan on hold at very low levels, the yen weakened further against the European currencies and the dollar. Sterling also softened as further signs of housing market weakness, a sharp fall in consumer confidence, and weakness in consumer spending raised fears about the economic outlook at a time when the Bank of England is constrained in its ability to lower rates by above-target inflation. The pound fell by 0.6% versus the dollar and by 0.1% versus the euro during the week.

• Emerging market dollar-pay debt spreads widened by this week, as risk markets continued their negative tone reflected through weaker equity markets. In Indonesia, the central bank raised its benchmark interest rate by 25 basis points to 8.75%, in line with expectations. This is the third month in a row Bank Indonesia has hiked as record oil and food prices continue to keep an upward pressure on inflation.
• In Turkey, inflation slowed for the month of June, printing at 10.6% (year-over-year), much lower than the 11.6% forecast. This brought some relief to the local rates market late during the week, stopping some of the weakness seen over previous weeks.

FACTORS SHAPING THE MARKET NEXT WEEK

• Next week the stream of data releases slows. To make up for it, Fed Chairman Ben Bernanke will have two opportunities to speak and the market will likely pay close attention. On Tuesday, Mr. Bernanke speaks before the FDIC on the subject of mortgage lending. On Thursday, Mr. Bernanke appears before a house panel to testify on the financial markets. Thursday’s testimony topic sounds like it will provide more market fodder.
• Next week’s calendar for Western Europe kicks off with the release of industrial production numbers for Great Britain and Germany. On Wednesday, the GDP for the Euro zone is scheduled to be announced. The UK’s Monetary Policy Committee meets on Thursday to discuss BoE interest rate policy.
• Eastern Europe’s week starts on Monday with information on the May net wages in Romania. On Tuesday, the Czech Republic will release consumer inflation (CPI) and unemployment numbers for June. Turkey will publish the country’s 2-week CPI forecast.

NEXT WEEK'S US ECONOMIC RELEASES

July 8 Pending Home Sales Index
July 11 University of Michigan Consumer Sentiment, International Trade