Global Markets Weekly - 31st March 2008

• We saw broadly positive developments on several fronts last week.
  Last week’s market moves, data releases and policy-related news were, on balance, positive. While avoiding some of the extreme – and ultimately unsustainable – intra-day leaps of recent months, developed market equities drifted broadly upwards, with the S&P 500 2.5% up on a week ago.
• The IFO s urvey underlined the German economy's resilience...
  The economic numbers, though certainly not in positive territory, have mainly surprised to the upside. In particular, the IFO measure of business sentiment was stronger than expected, suggesting that the German economy has remained resilient despite slowing export growth and an ever-strengthening euro. So far this year, the euro has strengthened only just over 3% in trade-weighted terms, versus a rise of 8% against the dollar. Even so, the trade-weighted measure is the highest since the euro's launch in 1999.
• …though the strong euro is likely to prove a headwind over the rest of this year.
  Like interest rates, exchange rates represent the monetary conditions faced by an economy and affect the real economy with lags – usually far longer than investors expect. We think slower global growth and a higher exchange rate will start to hit the European economy, but that evidence of this will build only gradually over the course of the year.
• The US housing market is showing encouraging signs of levelling out...
  Perhaps more significantly, the US housing market has shown signs of at least starting to level out. House sales increased in February after being broadly unchanged in January. Admittedly, home sales showed a similar increase at the start of 2007 but then declined further. However, the current level of sales is some 20% lower than 12 months ago, increasing the chances that this represents the cyclical trough.
• ...which is crucial to resolving the problems in the credit markets.
  Increasing home sales are critical to clearing the very large inventory overhang in the US housing market, so this rise in sales indicates that house prices have declined enough to start the process. Falling house prices – and the depreciation of underlying collateral which they imply – have been the key driver of the instability in the credit market and all the associated problems. So increased house sales would be the first indication that this negative dynamic was finally losing steam. For that reason, further increases in house sales over the coming months would be especially welcome.
• Talk of central banks buying mortgage-backed bonds brought down spreads.
  Meanwhile, US and UK policy-makers have begun to talk more explicitly about possible outright purchases of high-quality mortgage-related bonds in order to return liquidity to this strained market. As a result, investment-grade credit spreads fell dramatically last week, albeit from stretched levels. The success of this verbal intervention indicates how potent an announcement of real policy action would be.

• Despite this positive news, we still think it's too early to add risk to portfolios.
  But let us keep our feet firmly on the ground. For all this better-than-expected news, significant risks remain in the real economy. Falling house prices will affect US consumer spending with a considerably longer lag than they did credit spreads. As US consumers are the source of final demand for imports from Asia and Europe, the decoupling theory won’t be properly tested until later this year. And earnings estimates outside the financials sector still don’t reflect the high likelihood of a US recession, which has indeed probably already started. So the strategic case for adding more risk to portfolios is building. But, with real economy risks still not fully discounted, we think the case is not yet compelling.

Interest rates and Inflation

	Close 28-Mar-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	2,920	-3.8	-4.4	-11.4	-11.1
FTSE 100	5,693	-3.6	-4.6	-12.1	-11.8
S&P 500	1,315	-1.1	-3.8	-11.0	-10.4
Nasdaq Composite	2,261	-0.1	-3.0	-15.5	-14.8
DJ Stoxx (Europe)	348	-4.0	-3.9	-16.2	-16.2
Nikkei 225	12,280	-2.7	-7.9	-16.3	-16.3
Hang Seng	23,286	-10.3	-5.3	-14.9	-16.3

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Jun-08 Forecast	Sep-08  Forecast	Current	Next Date
US (Fed Funds)	2.25	1.50	1.50	4.3	30-Apr
UK (Base rate)	5.25	5.00	4.75	2.1	10-Apr
Euro-zone (Repo Rate)	4.00	3.75	3.50	3.1	03-Apr
Japan (Call rate)	0.50	0.50	0.50	0.3	08-Apr

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