Global Markets Weekly - 28th January 2008

• Markets have moved fast this year. Here, we review recent developments.
  In our 2008 Outlook, we forecast that a tough environment for risk assets – such as equities, corporate bonds and property – in the first half of the year would then brighten as inflation concerns eased and central banks focused on boosting growth. January’s steep market falls were a reminder that, however good our macro-economic logic may be, markets generally respond faster than expected, while economic variables tend to respond more slowly. Given the large adjustment already seen in markets, we here review the six indicators we said could mark a shift to a better environment for risk assets. 
• Headline inflation remains high but may have peaked.
  US headline inflation turns down: this would be the clearest indication of a shift from the deceleration phase of the economic cycle (which is negative for risk assets) to the slowdown phase (which is moderately positive). There is no sign of a weaker dollar being passed on to consumers, and wage growth remains subdued. Headline inflation, though high, may now have peaked. We view this as a neutral development.
  
• The Fed has cut rates, and markets expect easing in Europe and Japan
  G7-wide interest rate cuts: the Federal Reserve (Fed) has turned decidedly dovish in word and deed. However, the reason for the change in tone is a worsening growth outlook rather than improving inflationary expectations. Even so, because of the scale of US rate cuts and the fact that short-dated European and Japanese bonds are now pricing in some chance of rate cuts from their central banks, we see this as positive.
  
• Monetary policy is still clearly loose in the US.
  Loose monetary policy levels maintained: after the 75 basis point cut, the real Fed funds rate (Fed funds minus inflation) is now -0.6%, and more cuts are priced in. By contrast, leading indicators point to US growth around 0% in coming quarters. We see negative real rates as positive.
• Banks have received fresh capital, but credit concerns are spreading to the consumer.
  Bank recapitalisation: the sub-prime-related write-downs announced by banks in January have broadly matched analysts’ expectations. The flow of capital from Asia and the Middle East has also been encouraging. Worryingly, however, several banks’ results showed credit quality concerns spreading to consumer credit. Some banks have also announced writedowns on their exposure to bond insurance companies which have been downgraded. Both factors could lead to further downgrades. Concerns over banks’ balance sheets have intensified this month, which we consider negative.
• The oil price has fallen and looks set for further declines.
  Oil price declines: this is critical for inflation. Oil prices have declined 6% this year, and several factors – notably slowing economic growth and reduced speculative interest – suggest further declines. We see this as positive.
• China is extending its QDII programme and providing capital for western banks.
  Opening of the Chinese capital account: progress here is a political issue and so will be slower than market adjustments. That said, China's sovereign wealth fund has been a key player in the recapitalisation process for banks. In addition, the Qualified Domestic Institutional Investors (QDII) legislation that allows local Chinese banks to invest in some overseas markets has been extended to Singapore and will soon include the US, Germany and Japan. We view this as moderately positive.
• We expect some further volatility, but the mediumterm outlook is improving.
  In summary, there is further downside risk to equities over the coming months, because of concerns over a US recession. Yet we see several encouraging developments for the medium term. We think the foundations are being laid for a sustainable recovery.

Indices, Interest rates and Inflation

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