Global Markets Weekly - 14th January 2008

• The Fed turns more dovish, signalling further rate cuts…
  Last week saw a noticeable softening in tone from Ben Bernanke, chairman of the Federal Reserve (Fed). In a speech on 10th January, he outlined his view that the outlook for the US economy had worsened since the time of the Fed’s last official forecasting round in November 2007 and said that the Fed ‘stands ready to take substantive additional action as needed to support growth.’ The market has taken this – rightly, in our view – as a signal that the Fed intends to cut interest rates by 0.5% at their next meeting, on 30th January.
• …as the economic outlook takes a turn for the worse.
  We think two key data released this year have been instrumental in changing the Fed’s view: the surprisingly large decline in the purchasing managers’ index from the Institute for Supply Management (ISM); and the weak labour market numbers, particularly the 0.3% increase in the unemployment rate during December alone, which took the level to 5.0%. From its trough in the first quarter of 2007, unemployment has now increased 0.6% . Although the overall level is still low, unemployment is increasing faster than we had been expecting, raising the chances of a US recession in the first half of 2008 – the Key Risk Scenario outlined in our 2008 Outlook.
• Credit is becoming more expensive, despite central banks' actions.
  In addition, financial markets’ impact on the real economy has intensified over recent weeks. Although central banks managed to ease liquidity conditions in cash markets, rates payable on new borrowing by some businesses and households have kept rising. So credit affordability continues to worsen, even though a further 150 basis points (bps) of Fed rate cuts have been priced into the US yield curve – on top of the 100 bps of cuts so far.
• Equity weakness is likely to spread beyond the financials sector…
  In last week’s Global Markets Weekly, we discussed that net earnings downgrades for S&P 500 stocks remain limited to the financials and consumer discretionary sectors. That has been reflected in equity performance (see chart on next page). Excluding financials, the S&P 500 index is little changed from its 2007 peak, but financials have underperformed by around 30% over the past year. Unlike government and corporate bonds, non-financial equities appear to have priced in too small a probability of recession and so have room to fall if earnings downgrades spread to other sectors.
• …as markets price in a higher chance of recession.
  Regardless of whether the US or other regions have a recession, equities will probably use the coming months to play catch-up with credit and government bond markets, pricing in a higher probability of a recession, which is to say a downgrading of the current fast pace of earnings recovery assumed for the second half of 2008.
• Low valuations offer little protection against a sell-off caused by recession fears.
  As equity investors come to a greater appreciation of recession risks, valuation is not a significant variable when assessing the scale of any associated sell-off, according to our analysis of past recessions. However, valuation is a key determinant of the scale of the eventual recovery once the market has troughed during the recession. This makes intuitive sense: faced with a recession, equity markets experience panic-selling; yet the bottom-fishing once an end to the recession is in sight is essentially valuation-driven.
• The near-term outlook for equities has worsened.
  Increased recession risks coupled with the current ‘contained’ pattern of earnings downgrades and price performance have heightened our conviction that equity prices are likely to decline over the coming months.

Indices, Interest rates and Inflation

	Close 11-Jan-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,140	-2.6	-5.5	-9.1	-4.5
FTSE 100	6,202	-2.3	-5.1	-7.8	-4.0
S&P 500	1,401	-0.8	-5.2	-9.9	-4.6
Nasdaq Composite	2,440	-2.6	-8.0	-12.0	-8.0
DJ Stoxx (Europe)	394	-2.0	-6.7	-9.0	-5.1
Nikkei 225	14,111	-4.0	-12.1	-19.2	-7.8
Hang Seng	26,867	-2.4	-8.1	-7.8	-3.4

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Mar-08 Forecast	Jun-08  Forecast	Current	Next Date
US (Fed Funds)	4.25	3.50	3.25	4.3	30-Jan
UK (Base rate)	5.50	5.25	5.00	2.1	07-Feb
Euro-zone (Repo Rate)	4.00	4.00	3.75	3.1	07-Feb
Japan (Call rate)	0.50	0.50	0.50	0.3	22-Jan

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