Global Markets Weekly - 7th January 2008

• The numbers point to a further slowing of US growth...
  That the first half of 2008 would be testing for equities was a key theme of our 2008 Outlook. Sure enough, the year began with a weak US manufacturing survey from the Institute for Supply Management (ISM), driving the S&P 500 down 1.4% on Wednesday – its worst first day of trading since 1983. Meanwhile, inflation worries persist, not helped by oil touching $100 a barrel. This has raised concerns that high headline inflation readings later in the year could limit central banks’ scope to support growth by cutting interest rates.
• …but are still consistent with our GDP growth forecast.
  At 47.7, the manufacturing ISM signifies industrial sector contraction, but it still doesn’t herald an economy-wide recession in the near future. Previous US recessions have usually been signalled by ISM readings in the low 40s. Worryingly, new orders, the most important forward-looking component of the ISM, drove much of the decline in the headline number. Currently, however, the numbers remain consistent with our forecast for growth of around 1% during the first half of 2008.
• More downgrades to come? The ISM suggests so...
  While the focus remains on the chances of a US recession, of equal concern to investors is how this will affect earnings per share (EPS) growth and how much of an EPS slowdown is already priced in. The current expectation is for a short, sharp shock to earnings, mainly for the second half of 2007 (released in 2008). So far, earnings downgrades have been concentrated in three sectors of the S&P 500 – financials, consumer discretionary and materials. So analysts expect most of the industrial sector to be immune from the slowdown in growth. Yet the new orders component of the ISM suggests otherwise. That contradiction will be resolved at some point, probably through further earnings downgrades.
• …while analysts’ expectations seem unduly optimistic.
  As expectations for EPS growth for the second half of 2007 were revised down, forecasts for later in 2008 were revised up. Typically, corporate profits do recover quickly, as companies switch from job-hoarding to job-shedding, driving down unit labour costs. Even so, the expected pace of EPS recovery seems too optimistic. If further downgrades occur, industrials and technology seem to be the next sectors in the firing line.
• Risk appetite appears to be declining again…
  The continuing credit crisis and worries over growth appear to have choked off the nascent recovery in investor sentiment. On 26th November, our aggregate measure of risk appetite hit its recent low of -1.0 (the neutral mark is zero). On the occasions over the past five years when it has reached similarly low levels, it has rebounded significantly, to at least +0.5. This time, however, it appears to have stalled earlier than usual.
• …which could spell trouble for equity markets in the short term.
  One indicator is particularly negative: individual investor sentiment. Of the US individual investors surveyed, 55.3% were bearish (and only 25.6% bullish). We’ve seen that level of pessimism only three times since 2000: in February 2003, July 2006 and November 2007. On the first two occasions, the S&P 500 rebounded by around 10% over the following three months. By contrast, the recent rally quickly petered out. Furthermore, the previous three times, overall risk appetite was far more bearish at -1.0 on average, versus -0.4 now. Hence, the other indicators could well worsen further before we see an equity rebound..

• Yet the medium term looks brighter for equities.
  Clearly, difficult times lie ahead for equity markets in the short term. But, as valuations are moderate, balance sheets healthy and growth concerns probably overdone, we have greater confidence in the medium-term outlook for equities.

Indices, Interest rates and Inflation

	Close 4-Jan-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,223	-2.2	0.5	-4.2	2.0
FTSE 100	6,349	-2.0	0.5	-3.1	3.8
S&P 500	1,412	-4.5	-3.5	-8.5	3.5
Nasdaq Composite	2,505	-6.4	-4.4	-8.4	9.8
DJ Stoxx (Europe)	402	-3.2	-2.2	-5.6	4.9
Nikkei 225	14,691	-4.0	-5.1	-14.1	-11.1
Hang Seng	27,520	0.5	-4.7	2.0	39.3

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Mar-08 Forecast	Jun-08  Forecast	Current	Next Date
US (Fed Funds)	4.25	4.25	4.25	4.25	30-Jan
UK (Base rate)	5.50	5.25	5.00	5.0	10-Jan
Euro-zone (Repo Rate)	4.00	4.00	3.75	3.75	10-Jan
Japan (Call rate)	0.50	0.50	0.50	0.50	22-Jan

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