Global Markets Weekly - 25th February 2008

• The current equity rally has lasted a month...
  The S&P 500 has now rallied over 4% since its low point on January 22nd. Over the same period, traditionally high-beta markets such as Europe and emerging Asia have outperformed, gaining 6% and 8%, respectively.
• ...but will it prove sustainable? We think not.
  Both the size of the rally and investors’ apparent preference for more cyclical markets poses the legitimate question of whether equities have bottomed out and are now set for a sustainable rally. We think not; rather, the balance of probabilities favours further equity declines. Here, we outline the three key factors behind this judgement.
• Investor sentiment is still negative, so the bounce could have a little further to go.
  First, the mildly positive news: sentiment has been pointing to a temporary bounce - and still does. On January 22nd, the Coutts Aggregate Risk Appetite Indicator (CARAI) reached 1.5 standard deviations below its long-term average. As we noted at the time, this was a good indicator that equities were oversold and a sentiment-led rally was due. As a model for this rally, we looked at the previous trough in CARAI last November. That rally consisted of a 7.5% trough-to-peak move in the S&P 500, which lasted two weeks. By comparison, this rally has been longer and shallower. With risk appetite still negative, we think equities should be able to maintain this weak positive momentum for some time yet.
• But credit markets' problems persist, suggesting that equities could sell off.
  Second, and more worrying, credit market strains are worsening. While equity markets are benefiting from improving sentiment, credit markets are sinking further into the doldrums. Credit spreads have widened relentlessly over the past month - even as some equity investors have come to think they may be seeing light at the end of the tunnel. Previous periods of dislocation between equity and credit markets over recent months have been brief and have been resolved by equity markets selling off, rather than credit rallying. This episode will probably resolve itself in a similar fashion. The dislocation now appears to be at its most extreme since the current credit crisis began, so this could well lead to a period of combined equity weakness and credit strength. The medium-term message for economic growth from fixed income markets is less ambiguous: credit conditions are set to tighten in most developed economies, which will reduce potential growth.
• Equities have not fallen as much as usual in a US recession...
  Third, a recession is not priced in. On average, post-war US recessions have resulted in a peak to trough move of 25%. The S&P 500 is currently 13% off its September peak, suggesting that equities are currently pricing in half a recession. Yet leading indicators of recession have intensified over the past month, and we think equity markets will price one in more fully during the first half of the year.
• …and earnings forecasts look too optimistic, increasing our concerns.
  One factor currently supporting equity valuations is that consensus earnings expectations point to slower, but still positive, earnings growth in 2008 and 2009. However, the three previous US recessions have all led to earnings recessions, when corporate earnings suffer outright declines. That increases our concerns that the equity market is vulnerable to any perceived rise in recession risks, once the current sentiment-led bounce has played out.
• Though wary on equities in the short term, we expect a lasting rally later this year.
  For equities, the downside risks still outweigh any upside potential. So, with little to play for, we are happy to keep overweight positions in cash and government bonds for the time being. However, we see scope for a fundamental recovery in equities around mid-year and hence, though cautious, remain watchful.

Indices, Interest rates and Inflation

	Close 22-Feb-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,013	1.7	2.9	-4.2	-8.3
FTSE 100	5,888	1.7	2.6	-4.3	-8.8
S&P 500	1,353	0.2	3.3	-4.5	-7.8
Nasdaq Composite	2,303	-0.8	0.5	-10.1	-13.2
DJ Stoxx (Europe)	358	0.6	1.1	-10.0	-13.7
Nikkei 225	13,500	-0.9	7.4	-9.3	-11.8
Hang Seng	23,305	-3.5	7.1	-10.4	-16.2

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Mar-08 Forecast	Jun-08  Forecast	Current	Next Date
US (Fed Funds)	3.00	2.50	1.75	4.1	18-Mar
UK (Base rate)	5.25	5.25	5.00	2.2	06-Mar
Euro-zone (Repo Rate)	4.00	4.00	3.75	3.2	06-Mar
Japan (Call rate)	0.50	0.50	0.50	0.7	07-Mar

Disclaimer

Issued by Coutts & Co, which is authorised and regulated by the Financial Services Authority. The value of investments, and the income from them, can go down as well asup, and you may not recover the amount of your original investment. Past performance should not be taken as a guide to future performance. Where an investment involves exposure to a foreign currency, changes in rates of exchange may cause the value of the investment, and the income from it, to go up or down.

The information in this document is not intended as an offer or solicitation to buy or sell securities or any other investment or banking product, nor does it constitute a personal recommendation. The information shown is believed to be correct but cannot be guaranteed. Any opinion or forecast constitutes our judgement as at the date of issue and is subject to change without notice. Any Coutts company, or a connected company, its clients and officers may have a position or engage in transactions in any of the securities mentioned.

The analysis in this document has been procured, and may have been acted upon, by Coutts & Co and connected companies for their own purposes, and the results are being made available to you on this understanding. To the extent permitted by law ad without being inconsistent with any applicable regulation, neither Coutts & Co nor any connected company accepts responsibility for any direct or indirect or consequential loss suffered by you or any other person as a result of your acting, or deciding not to act, in reliance upon such analysis.

Not all products and services offered by the individual Coutts companies are available in all jurisdictions, and some products and services may be available only through particular Coutts companies. Certain aspects of the service may be performed through, or with the support of, different members of The Royal Bank of Scotland Group, of which Coutts & Co is a member.

None of the overseas Coutts companies or offices is an Authorised Person subject to the rules and regulations made under the Financial Services and Markets Act 2000 for the protection of investors and depositors, and compensation under the Financial Services Compensation Scheme will not be available in respect of business transacted with them.

Coutts (Cayman) Limited. Registered Office: Coutts House, 1446 West Bay Road, PO Box 707, Grand Cayman KY1-1107, Cayman Islands. Licensed under the Banks and Trust Companies Law (2007 Revision). Coutts (Cayman) Limited is not regulated by the Cayman Islands Monetary Authority in its conduct of securities investment business.

Coutts Offshore Europe Limited. Registered office: 23-25 Broad Street, St Helier, Jersey JE4 8ND. Regulated by the Jersey Financial Services Commission for carrying on investment and trust company business. Regulated by the Guernsey Financial Services Commission for carrying on investment business. Trading in Jersey as Coutts Channel Islands. Business address in Isle of Man: PO Box 59, Royal Bank House, 2 Victoria Street, Douglas, Isle of Man, IM99 1DU. Licensed by the Isle of Man Financial Supervision Commission for Investment and Corporate Service Provider business. Trading the in Isle of Man as Coutts Isle of Man.