Global Markets Weekly - 11th February 2008

• The slowdown is taking shape…
  Economic data, tightening credit conditions and the dislocation in some sectors of the credit market continue to point to a further slowing of US growth and the risk of a recession during the first half of the year. Worsening US growth expectations have been the driver of the recent sell-off in equity markets; the S&P 500 is down around 10% so far this year.
• …with signs that growth concerns are spreading beyond the US…
  Yet increased expectations of interest rate cuts elsewhere suggest that growth concerns may be spreading to other regions: the short end of the yen and euro curves are pricing in rate cuts. At his February press conference, European Central Bank (ECB) president Jean-Claude Trichet strongly hinted that the bank’s growth forecasts for the eurozone would be downgraded next month – a peg on which an ECB rate cut could be hung.
• …and even to Asia.
  A comparison of leading indicators from various regions shows that the US is far from alone in exhibiting signs of slowing growth. The annual change in the OECD leading indicator is now negative across all major regions of the developed world. Although forwardlooking growth indicators remain relatively high in Asia, they have shown a comparable degree of slowing.
• The dollar has stabilised against the euro…
  This diffusion of growth concerns has assisted the US dollar. Although the euro has strengthened against the dollar fairly consistently for the past two years, this trend appears to have stalled over the past three months, with the exchange rate remaining in a trading range of 1.44-1.48 since the start of November.
• …and US equities have started to outperform European stocks…
  The combination of slowing global growth and the Federal Reserve’s more aggressive rate cutting in order to support the economy has served to widen the expected real-return differential between the US and other markets. That has reversed the underperformance of US equities relative to European equities which has been evident since last September (see the chart on the next page).
• …which is the more usual response to slowing growth.
  In the past, dollar resilience and outperformance by safe haven equity markets have been the more usual response to slowing growth than the dollar weakness and US underperformance of the second half of 2007. This suggests that investors’ focus has now moved from the sector-specific effects of a structural dislocation in the credit creation mechanism to more general concerns about how this could affect global growth.
• Exports are helping the US manufacturing sector.
  Interestingly, however, US exports have increased by 14% over the past year, thanks to the dollar’s weakness and US exporters’ exposure to Asia, which continues to grow at a rapid, if somewhat reduced, pace. Manufacturing is the most export-exposed sector of the economy. That explains one of the anomalies in the recent US data: the widely watched manufacturing ISM survey has moved back above 50 (consistent with a moderate expansion) while the more domestically-oriented non-manufacturing ISM has fallen surprisingly far, to 44 – which is consistent with a recession.
• We expect defensive equity markets to outperform.
  Our aggregate indicator of risk appetite suggests that we are currently in the midst of a sentiment-led bounce. Regardless of the direction of equity markets over the coming months, however, we think we have entered a new phase of market reaction to the economic slowdown in which the traditionally more defensive regions should outperform their historically high-beta counterparts.

Indices, Interest rates and Inflation

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