Global Markets Weekly - 10 March 2008

• The recent rally in equities is now over...
  Back in late January, we highlighted that investor sentiment was pointing to a rally for equities. Our aggregate indicator of sentiment had fallen to 1.5 standard deviations below its long-term average – so low that, regardless of our medium-term view, equities looked oversold and it was therefore reasonable to expect a rally in the near term. Markets did rally over February. However, on 6th March, the S&P 500 eventually slipped back below its late-January lows, so this rally – such as it was – has now come to an end. 
• …as investor sentiment is declining once more.
  Confirming this, the Coutts Aggregate Investor Risk Appetite appears to have peaked and is heading down. At -1.1, however, it still has further to fall before reaching the levels of pessimism we saw at the end of January. Against a worsening economic backdrop, investor sentiment troughed at a lower level in January than in November, and that pattern may be repeated in March.
• Technical analysis seems to confirm this view.
  Technical analysis also supports the view that the weak rally of the past six weeks is probably over. The previous two times the S&P 500 broke through its near-term lows led to a period of further falls.
• US housing woes suggest that financials will continue to underperform.
  The recent declines have been led by financials, and this month marks one year since the start of the sector’s underperformance (see chart on page 2). Over the past week, the data releases have continued to show large rises in residential mortgage delinquency and foreclosure rates in the US. As this is a fundamental driver of banking sector write-downs, it points to the potential for further underperformance in the coming weeks.
• Investment-grade bonds are pricing in a very severe recession...
  One asset class that didn’t rally during February was investment-grade credit. The 5-year iTraxx investment-grade index is currently pricing in a cumulative default rate of over 10%. Using data going back to the 1970s, the worst ever comparable default rate was 5.3%. So investment-grade credit appears to be pricing in easily the worst recession of the past 40 years.
• …but that appears to be the result of forced selling.
  We think this is an over-reaction, driven in large part by the forced unwinding of high volumes of leveraged credit structures that used predominantly investment-grade credit derivatives and default protection.
• The latest economic data suggested a recession is likely but still by no means certain.
  Last week's economic numbers were mixed, continuing to point to the likelihood of a US recession, but not conclusively so. The widely watched manufacturing ISM purchasing managers' survey declined to 48.3, below the crucial 50 level which separates expansion from contraction but still above the low-40s levels that have been consistent with previous economy-wide recessions. The payroll numbers were more negative, with 63,000 US jobs lost in February. The trend in labour market data is downward. However, as this is a lagging indicator of a previously observed slowdown in growth, it isn't telling investors much they don't already know.
• We still expect a sustainable equity rally later in the year.
  Despite the outlook for near-term declines, we still expect equity markets to stage a fundamentally-driven rally later on, probably starting around the middle of the year. On some measures, equity valuations are down to their best levels since the early 1990s, and they also look cheap relative to bonds. As a result, we would expect that, once the economic backdrop improves, the equity rally should prove strong and sustainable.

Indices, Interest rates and Inflation

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