2 - Market developments in 2006

2.1 Macroeconomic developments

Global economic growth remained high in 2006, although towards the end of the year there were signs that the expansion of the past three years was slowing. The rate of growth in the US economy declined, while the activity level in Japan, and particularly in the euro area, gathered pace. Thus, growth disparities across major regions were reduced. The current expansion has been the strongest for several decades, with increasing output and falling unemployment in most industrialised countries. Capacity utilisation has increased, which normally tends to push up prices and wages. Most industrialised countries operate various inflation targeting regimes in the conduct of monetary policy. The central banks of the largest economies raised their policy rates in 2006. The US, which has been a primary engine behind the cyclical upturn, ended the monetary policy tightening cycle in mid-2006, while other major countries continued tightening through the year. There are many indications that short-term interest rates are peaking at a lower level than in previous cyclical upturns.

A special feature of this expansion is that inflation has remained relatively low. This may be partly attributable to a high degree of confidence in central bank policy and low inflation expectations, but increasing globalisation has also been of importance. Increased imports from low-cost countries have contributed to curbing domestic inflation, and wage growth has been restrained by the risk that jobs may be outsourced to countries with lower cost levels. These factors have contributed to curbing wage growth. However, prices have risen substantially in some sectors of the economy, particular sectors relating to commodities, property and transport services.

Following several years of strong economic expansion, there were signals of slowing growth in the US in 2006. Slower growth particularly reflected the slowdown in the housing market after the upswing of recent years. Housing starts and turnover fell markedly and the rise in prices levelled off.

The decline in the housing market has been partly offset by increased investment and higher employment in the business sector. Rising share prices and lower energy prices towards the end of the year led to an increase in household wealth and real disposable income. Private consumption, which has been the most important growth factor in the US economy in recent years, has been stimulated by lower oil prices and a decline in long-term interest rates. The lower interest rate level has enabled households to withdraw mortgage equity by refinancing housing loans.

After raising its policy rate in 17 increments since June 2004, the Federal Reserve Bank has kept its policy rate unchanged at 5.25 per cent since June 2006. In the reasoning behind its monetary policy decisions, the Federal Reserve has gradually signalled that growth is beginning to slow, with an easing of inflation pressures.

Economic growth in the euro area gathered pace in 2006, and the expansion was the strongest since 2000. Exports of goods and services have been the most important driving force, but private investment and private consumption have also contributed. In Germany, VAT was raised from 16 per cent to 19 per cent on 1 January 2007, which may have contributed to the growth in consumption towards the end of 2006. Solid corporate profitability and low interest rates were conducive to investment growth. Employment has increased and unemployment has fallen to the lowest level recorded since 2001. Wage growth has been moderate, and with falling energy prices inflation fell to below 2 per cent towards the end of the year. The ECB raised its key rate on five occasions in the course of the year, to 3.50 per cent at end-2006.

Growth in industrial production remained buoyant in the UK, while there were signs of somewhat weaker growth in retail trade in the past few months of the year. House prices continued to rise, while turnover in the housing market levelled off somewhat. There has been considerable inward labour migration to the UK from the new EU countries, which has helped to curb wage growth. The inflation rate has hovered at just over 2 per cent, and the Bank of England raised the key rate to 5 per cent in the course of the year.

The Japanese economy showed favourable developments in 2006. GDP growth was solid, and unemployment was falling. The economy began to show signs of pressures. There was a greater shortage of qualified labour, and scattered signs of wage and price inflation. House prices started to rise again, after falling for more than ten years. After a long period of close to zero interest rates, the Bank of Japan raised its policy rate to 0.25 per cent in July.

The most important force driving economic growth in Japan has traditionally been exports, primarily to neighbouring Asian countries. China, for example, accounts for 15 per cent of Japan's exports, twice the level 5 years ago. Many firms in Japan are operating at close to full capacity.

China's global economic importance is rising steadily each year, and in 2006 GDP growth was over 10 per cent. The most important factors behind the upturn are a continued rise in investment and an increase in net exports. The most important force driving China's growth in recent years has nevertheless been its entry into the global economy, which has laid the foundation for the country's further industrialisation. In order to curb the risk of overheating, the authorities tightened policy in a number of areas. Restrictions have been placed on access to land in some areas, the equity required for investment projects has increased, and the policy rate and primary reserve requirements have been raised.

Growth is also high in India. This is primarily due to growth in the service sector, which accounts for just over 50 per cent of output. Developments in the agricultural sector, which employs more than half the labour force, have been far more moderate. There are signs of a tighter labour market for qualified labour in service production, which may dampen growth in the short term.

Chart 2-1: Developments in the most important fixed income markets in 2006. Yields on 10-year government securities. Annual percentage figures

2.2 Fixed income market development

In 2006, yields on 10-year government bonds rose by between 0.6 and 0.7 percentage point in the euro area and the UK, by 0.3 percentage point in the US and 0.2 percentage point in Japan. Chart 2-1 shows that the level of 10-year yields was rising in the first half of the year and falling in the second half of 2006. The decline in interest rates in the second half of the year was related to reduced inflation expectations and an end to the mone-tary policy tightening cycle in the US. As a result of lower 10-year yields in the US, the yield curve became steeper as the yield spread between short-term and long-term yields widened.

Chart 2-2 presents changes in the value of Lehman Global Aggregate g-overnment bond indices in 2006. In 2006, the total return was 3.1 per cent in the US, 0.3 per cent in Europe and 2.1 per cent in Asia.

Chart 2-2: Movements in Lehman Global Aggregate's government securities indices in the main markets in 2006 (31.12.05 = 100)

Chart 2-3: The difference between yields on corporate bonds* and Treasuries (credit spread) in the US in the past four years. Basis points

The yield spread between corporate bonds and government bonds did not change substantially in 2006 as a whole. The spread widened in connection with the equity market decline in May and June. In the second half of the year, the yield spread gradually narrowed to a level somewhat lower than at the beginning of the year. Over the past three years, the yield spread has varied between 80 and 100 basis points, which historically is very low (see Chart 2-3).

Chart 2-4 shows returns in fixed income markets each year since 1980. During this period, the average annual return was 8.5 per cent. The return in 2006 was 1.7 per cent and it has only been lower in 1994 and 1999.

In the early 1980s, inflation rates and interest rates were unusually high. Both inflation and interest rates have been low in recent years, which explains why nominal returns on fixed income instruments have been lower in recent years than they were early in the period.

Chart 2-4: Return in fixed income markets 1980-2006 measured in terms of an international currency basket. Per cent and annual figures

2.3 Equity market developments

The rise in global equity markets, which began in the spring of 2003, continued through 2006. The return on an equity portfolio with the same composition as the benchmark portfolio of the Government Pension Fund – Global was 17.1 per cent in 2006, compared with 20.3 per cent in 2005. The rise was particularly strong in Europe and the US, where prices rose by 20.5 and 15.7 per cent, respectively. The price rise in Japan was 6.6 per cent. An index consisting of 24 emerging equity markets rose by 29.9 per cent in 2006. Price developments were particularly strong in the second half of the year in most markets, following the fall in May/June (see Chart 2-5).

Table 2-1: Performance of the FTSE All-World Equity Index in 2006, measured in USD, NOK and in terms of an international currency basket. Per cent

Table 2-1 shows that developments were positive in all main sectors in 2006. Gains were strongest in utilities, telecommunications and commodities, and weaker in health services and IT.

Chart 2-5: Movements in the FTSE equity indices in the main markets in 2006 (31.12.2005=100)

Chart 2-6: The FTSE All-World Equity Index 1998-2006: Total and for the technology, media and telecommunications (TMT) sector (31.12.1998 = 100)

Chart 2-6 illustrates the significance of the technology, media and telecommunications (TMT) sectors for the equity indices over the past seven years. Equity prices in the TMT sectors rose sharply from 1999 up to the early summer of 2000 and then fell more sharply. Developments in equity prices in the TMT sectors have been somewhat weaker than in the other sectors in the FTSE All-World Equity Index in the past three years.

Chart 2-7 shows annual returns in the equity market since 1980. During this period, the average annual return was 14.6 per cent. The return in 2006, 17.1 per cent, was thus above average.

Chart 2-7: The return on the Fund's equity benchmark, 1980-2006. Measured in terms of an international currency basket.* Per cent