Croesus/The Investor's View: Now that the mid-point of 2007 has arrived, it is timely to review those developments that have affected the financial markets during the first half of the year.

The performance of the Iseq overall index, which is barely changed from its end-2006 level, might suggest that it has been an uneventful first half. Nothing could be further from the truth as the market had to react to significant international and domestic developments.

The key external trend has been the deepening conviction among policy-makers and market participants that interest rates remain firmly on an upward trajectory. The majority of forecasters now expect the European Central Bank to push euro rates to 4.5 per cent by year-end. At the beginning of the year most pundits believed that 4 per cent would turn out to be the peak in the interest rate cycle.

The Bank of England has also been busy with the UK base rate at 5.5 per cent and many economists are predicting that it may soon reach 6 per cent.

Ongoing strength in global economic growth is the explanation for rising interest rates. Central bankers are concerned that tighter labour markets, and the apparent ease with which companies pass on price rises to consumers, will create significant upward pressure on inflation. The core stance of central bankers worldwide is to nip inflationary pressure in the bud and the only weapon that they possess to do this is higher interest rates.

Earlier in the year there were some fears that the recession in the US housing market would lead to a more general US economic slowdown. This has not happened and the predicted slowing in the US economy has been very mild so far. A more significant development, however, is that the rest of the world seems to have decoupled from the US economic cycle.

The European economy has been gradually gathering pace all year and most economists now believe that Europe can continue to grow even if the US economy slows sharply.

In Asia, there are now three powerful economies - Japan, China and India - and all three are enjoying robust economic growth.

Global equity markets have risen in the 4-8 per cent range over the first half of the year since stronger economic growth has boosted profits.

For much of the period, equity markets were helped by the surprising stability in bond yields despite rising short-term interest rates. However, in June this changed suddenly as bond participants took fright resulting in significantly higher bond yields. Ten-year euro bond yields had been trading around 4 per cent for most of the year but in June they rose sharply to 4.6 per cent. In the US 10-year yields spiked to over 5.3 per cent but have since eased back to 5.1 per cent.

On its own, this recent rise in yields is not sufficiently large to undermine equity valuations. However, it is seen by many analysts as a signal that conditions in the booming credit markets are going to steadily deteriorate.

The potential negative impact on equity markets will be felt through a reduction in mergers and acquisitions and the possibility that some highly leveraged companies might get into difficulty.

These international developments seem to have had little or no impact on the Irish market, with one important exception. Rising ECB-inspired interest rates have seriously damaged investor sentiment through the ongoing weakness in the Irish housing market.

The underperformance of the Iseq so far this year is attributable to investors' fears that the housing downturn marks the beginning of a much tougher period for the Irish economy. Financial stocks have borne the brunt of selling in recent months with all the large financial stocks in negative territory in the year to date.

Bank of Ireland and Irish Life and Permanent have been hardest hit reflecting their higher exposure to the Irish residential mortgage market compared to AIB. Anglo Irish Bank has again held up better, given its limited exposure to the residential market.

Several of the markets building and construction stocks such as McInerney and Grafton Group have also underperformed. An exception is CRH, which has risen by 15 per cent so far this year as investors have focused on its strongly performing European operations.

Croesus expects that interest rate and bond yield developments will continue to adversely affect investor sentiment during the second half of the year. However, equities are likely to continue to outperform bonds although volatility may well increase.

For Irish-quoted companies, there seems little prospect of an early reprieve from the current market torpor. Nevertheless, the downside in Irish share prices looks limited and Croesus expects the Irish market to make back some of its relative underperformance later in the year.