Global Markets Weekly - 14th April 2008

• Equity markets fell slightly and investment-grade spreads widened...
  The rally in risk assets since ‘Bear Stearns Monday’ (17th March) showed some signs of running out of steam last week. Equity markets declined, and even investmentgrade credit spreads – which have tightened significantly over the past month – slightly rewidened, though they have not reached the levels seen in early March.
• .…as the data continued to point to a US recession...
  Economic data releases were thin on the ground, but a flurry of official releases highlighted the continued downside risk of a consumer-led recession in the US – an economic risk which is semi-detached from the liquidity problems the Federal Reserve and other central banks have done so much to address.
• …and the FOMC minutes cited concerns over the extent of the downturn..
  The minutes from the 18th March meeting of the Federal Open Market Committee (FOMC) showed that some members remain worried about the prospect for a ‘prolonged and severe slowdown’, as the recent turmoil in financial markets restricts the supply of credit and exacerbates the likely sharp reduction in demand for credit.
• Yet robust growth in emerging economies should prevent a global recession.
  The International Monetary Fund (IMF) cut its forecasts for global growth by 0.4% for 2008 and by 0.7% for 2009. This surprisingly large revision was concentrated in the advanced economies, with US growth now forecast at just 0.5% this year and 0.6% next – sharp downward revisions of 1.0% and 1.2%, respectively. Moreover, the IMF stressed the downside risks to these forecasts. Thanks to emerging market economies’ relative robustness, however, a global recession is still seen as highly unlikely.
• .Housing markets still look overvalued, and UK prices tumbled over the month.
  One major downside risk in developed economies is the potential unwinding of the unusually extended house price boom and, in particular, the response of household spending. After the recent price falls, the US is no longer near the top of the IMF’s overvaluation league table. Ireland, Holland and the UK are the three economies with the largest problem, all roughly 30% overvalued. The UK house price numbers for March were very disappointing, down 2.5% on the month – the worst fall since 1992. This confirmed the precarious level of house prices in the current low-liquidity environment and will have been a factor in the Bank of England’s decision to cut rates by a quarter point on 10th April.
• The IMF's estimate of creditrelated losses was widely misinterpreted.
  The most headline-grabbing financial news of the week was the IMF’s estimate of $945 billion of sub-prime and credit-related losses. Yet the number was frequently misinterpreted. As it was based on mark-to-market pricing and valuation techniques, it represented only potential, not realised, losses – and mortgage-backed and credit markets have rallied since the study was completed in March. Besides, the number was already priced in, as market data were used in its construction. So expressing surprise at the number is analogous to expressing surprise at the high implied default rates and low valuations in some credit and asset-backed security markets in March. We did just that at the time and, sure enough, investment-grade credit has since rallied.
• The US earnings season will set the tone for equity markets.
  The US earnings season will be key in setting the tone for equity markets over the coming months. Earnings expectations have declined slightly, but we think the probabilities are tilted towards the downside – at least relative to analysts’ expectations. Yet the rally in high-quality credit over the past month shows that, even with the threat of a US earnings recession, the strains of a low-liquidity environment can produce attractive investment opportunities for unleveraged, long-term investors – such as ourselves.

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