Global Markets Weekly - 17th March 2008

• Equities rallied briefly midweek, as central banks injected liquidity.
  Last week saw an intensification of investors’ concerns about the health of the financial sector. Action by the Federal Reserve (Fed) to extend its emergency liquidity provision to one-month maturities and accept high-grade mortgage bonds as collateral produced an initially euphoric response from the equity market, the S&P 500 rallying 4% on 11th March. Banks are the main beneficiary of the Fed action, and their shares responded even more aggressively, up 10% on the day. However, the rally proved short-lived, as markets came under renewed pressure.
• But we think risk appetite has further to fall.
  One factor behind this powerful initial rally was the fact that risk appetite was at a very low level. The Coutts Aggregate Risk Appetite Indicator (CARAI) is 1.6 standard deviations below its long-term average. This is lower than the -1.5 level in late January that helped equities to stabilise during February. We think risk appetite may have further to decline. Because of the worsening macro-economic backdrop, a lower level of sentiment has been required to propel the previous two equity market rallies. We saw a similar pattern of progressively lower troughs in investor sentiment in the previous bear market. So the market may be laying itself up for a short-term sentiment-led bounce – though probably not quite yet.
• Rising petrol prices are putting pressure on US consumers.
  Risk aversion is also affecting other asset markets. Gold reached $1,000 an ounce during the week, as safe haven flows combined with inflation concerns. Higher oil prices – now around $110 a barrel – are also weighing on economic growth expectations. Because of the low level of taxation on petrol in the US, rising oil prices are passed on to retail fuel prices more than in any other major economy. Such increases will therefore act as a tax on US consumers just when retail sales growth has already slowed to a stand still.
• The weakening dollar raises the chances of ECB rate cuts.
  On a trade-weighted basis, the US dollar reached all-time lows last week. This weakness has come mainly against the euro and the yen. Officials from the European Central Bank (ECB) have become increasingly vocal about the euro’s strength in recent weeks. The exchange rate is a highly visible link between the European and US economies, and these moves add weight to our argument that the ECB will ultimately have to follow the Fed and cut interest rates.
• Inflation concerns look exaggerated - witness February’s data.
  US inflation for February was flat on the month, using both the headline and the core (excluding food and energy) measure. This was very encouraging. The low level of growth in unit labour costs leads us to believe that inflation concerns in the US are currently overstated. As inflation lags economic activity, we think the current phase of weaker growth that started around mid-2007 will increasingly drive down inflation during 2008.
• We expect some further volatility before the outlook brightens.
  With a US recession starting to crystallise and a forced de-leveraging evident in some sectors of financial markets, we remain cautious on the near-term outlook for equities. That is not to say that our economic and market outlooks have worsened in recent weeks. Rather, we are progressing through the bearish scenario we have previously outlined. Of course, we need to bear in mind that, so far as financial markets are concerned, the darkest hour is just before the dawn. But we think it will get a little darker yet before the sun rises.

Indices, Interest rates and Inflation

	Close 14-Mar-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	2,866	-1.3	-4.1	-11.2	-12.2
FTSE 100	5,632	-1.2	-4.2	-12.0	-12.8
S&P 500	1,288	-0.4	-4.5	-12.2	-12.3
Nasdaq Composite	2,212	-0.0	-5.2	-16.1	-16.6
DJ Stoxx (Europe)	341	-0.8	-5.9	-17.8	-17.8
Nikkei 225	12,242	-4.2	-10.2	-20.0	-20.0
Hang Seng	22,237	-1.2	-7.4	-20.1	-20.1

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Mar-08 Forecast	Jun-08  Forecast	Current	Next Date
US (Fed Funds)	3.00	2.25	1.50	4.0	18-Mar
UK (Base rate)	5.25	5.25	5.00	2.2	10-Apr
Euro-zone (Repo Rate)	4.00	4.00	3.75	3.3	03-Apr
Japan (Call rate)	0.50	0.50	0.50	0.7	08-Apr

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