Global Markets Weekly - 21st January 2008

• The chance of a US recession rose, amid worsening data.
  In recent weeks, economic releases have increased the probability of a US recession during 2008. The unemployment rate rose sharply, while the Institute of Supply Management (ISM) purchasing managers' index fell further than expected.
• Investor sentiment fell, partly on concerns over consumer credit.
  By contrast, the sub-prime-related write-downs announced by US banks over recent weeks have been broadly in line with market expectations. So far, however, the write-downs aren’t having a cathartic effect on investor sentiment. The rise in unemployment – a critical influence on consumer default rates – is feeding concerns that credit problems are no longer wholly contained within the sub-prime mortgage sector. For example, Citigroup’s results included a $4 billion cost for consumer lending (auto loans, credit cards etc., rather than mortgage debt).
• Risk assets are set to decline before picking up later in the year.
  In our 2008 Outlook, we warned that the first half of the year would be a tough environment for risk assets – such as equities and high-yield corporate bonds – but more supportive for commodities and government bonds. Later in the year, that pattern is likely to reverse, with risk assets outperforming. We maintain this view, but the recent price declines have been quicker than we expected a month ago, principally because of the disappointing economic and consumer credit data.
  As equity markets move to price in a greater probability of a recession, we have looked at previous recessionary periods in the US in order to gauge roughly how much recession risk is currently priced into equities.
• Equity markets still haven’t fully priced in a recession.
  Our analysis shows that US recessions last an average of ten months. From the preceding peak to the start of the recession, equity prices have declined by 9% on average, followed by a further 15% during the recession itself – a total decline of 24% from the peak. The S&P 500 is now 15% below its September 2007 peak, suggesting that around 60% of an ‘average’ recession has currently been discounted by equity markets. On this analysis, bond markets are closer to fully pricing in a recession, so the recent equity declines could be seen as equity investors simply catching up with their more bearish bond counterparts.
• Central banks seem more inclined to support growth...
  On a more positive note, the reduction in growth expectations is now clearly affecting the importance central bankers are attaching to supporting growth relative to containing inflation. In a recent speech, Ben Bernanke, the Chairman of the Federal Reserve, said he would be prepared to undertake ‘substantive additional action as needed to support growth and to provide adequate insurance against downside risks’ – a clear sign that the Fed intends to increase the pace of rate cuts. And policy-makers from the European Central Bank have also begun to talk about the downside risks to growth – offering a more balanced assessment of the outlook for the eurozone than their usual upbeat assessment and warnings about inflation risks. Meanwhile, in Japan, the short end of the yen curve is now completely pricing out any further rate rises.
• ...which is key to any pick-up in investor sentiment.
  Central banks’ focus on supporting growth, rather than containing inflation, was highlighted in our 2008 Outlook as a key factor that would eventually lead to an improvement in equity market sentiment. So, although the headline news for equity markets has clearly been bad over the past week and we could still see further declines in the near term, we appear to have surmounted a key obstacle to a sustainable equity rally later in the year.

Indices, Interest rates and Inflation

	Close 18-Jan-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,004	-4.3	-5.8	-11.5	-8.6
FTSE 100	5,902	-4.8	-6.0	-10.7	-8.6
S&P 500	1,325	-5.4	-8.9	-14.0	-9.8
Nasdaq Composite	2,340	-4.1	-9.9	-16.4	-11.8
DJ Stoxx (Europe)	373	-5.2	-8.5	-12.5	-10.1
Nikkei 225	13,861	-1.8	-8.9	-19.0	-9.5
Hang Seng	25,202	-6.2	-5.7	-14.5	-9.4

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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