Global Markets Weekly - 21st April 2008

• The credit crisis has driven bank shares down and credit spreads wider.
  Over the past six months, financial markets have been dominated by one big theme: the impact of sub-prime-related write-downs. As a result, bank shares have underperformed and credit spreads have widened as bank balance sheets – and lending conditions – have tightened.
• This phase of the crisis seems to be drawing to a close...
  Though a few more nasty surprises may emerge, this first stage of the credit crunch seems to be drawing to an end. Current estimates of final write-downs from residential mortgages, consumer loans and commercial property loans by banks of around $400 billion look much more credible than the initial estimates of $100 billion. And capital injections into banks since the crisis started now total around $150 billion and rising.
• …but the economic impact is expected to persist for some months.
  Yet the economic impact of the credit crisis is only just starting to be felt and will continue for months to come. So the credit crunch is morphing into a more ‘normal’ recession, and this will have an impact on relative asset price behaviour.
• Markets tend to anticipate the end of recessions by four months...
  As investors, however, we can’t afford to wait until the full macro-economic impact of credit restrictions becomes clear. Our analysis of the eight post-War US recessions suggests that markets consistently anticipate the end of recessions by around four months. That fact would be particularly useful if we knew exactly when the recession will end. Sadly, we can’t even tell when a recession started until long after it’s over. Based on existing data, we assume that this recession began around the turn of the year. History reveals, however, that the numbers are often revised to show an earlier start point. That is important for us as investors, because judging how far we are through a recession is critical to deciding when to start adding risk back into portfolios. Fortunately, we can use several indicators to make that judgement and to assess the potential upside for risk assets.
• …and the strength of any rally is largely determined by valuation.
  The key variable determining the strength of a post-recession recovery in equity markets is valuation. During the pre-recession sell-off - when investors sell first and ask questions later - valuation makes little difference. But, once the driving market sentiment switches from fear to greed, assets' relative cheapness is crucial – when you’re still in a recession and economic conditions look bleak, it makes greater sense to invest if the stock market looks more like Wal-Mart than Harrods. Hence, the correlation between valuation and 10-year forward performance is very strong.
• Current valuations suggest the long-term outlook for equities is positive...
  The current price-earnings ratio of global equities is historically consistent with annualised returns of 13% over the next ten years. Of course, such a spot forecast should be treated with caution. However, we can fit error bands around this model. This suggests that, given current valuations, the risk of losing money in global equities over the next five years is 2.5% - the same slim probability as for making over 200%. The ‘worst realistic’ case the model suggests is that returns from global equities resemble those from cash; its ‘best realistic’ case suggests a cumulative return of around 125%.
• …so longer-term investors should start carefully adding risk to portfolios.
  Of course, near-term downside risks persist, which is why we remain tactically cautious at present. However, for investors with genuinely long-term investment horizons who can accept the almost inevitable near-term volatility, this looks like a good time to start selectively building equity positions.

Indices, Interest rates and Inflation

	Close 18-Apr-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,090	2.7	7.7	2.9	-6.0
FTSE 100	6,057	2.7	8.0	2.6	-6.2
S&P 500	1,390	4.3	4.5	4.9	-5.3
Nasdaq Composite	2,403	4.9	5.9	2.7	-9.4
DJ Stoxx (Europe)	364	3.1	7.3	-2.5	-12.4
Nikkei 225	13,476	1.2	12.6	-2.8	-12.0
Hang Seng	24,198	-1.9	13.2	-4.0	-13.0

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Jun-08 Forecast	Sep-08  Forecast	Current	Next Date
US (Fed Funds)	2.25	1.50	1.50	4.0	30-Apr
UK (Base rate)	5.00	5.00	4.75	2.5	08-May
Euro-zone (Repo Rate)	4.00	3.75	3.50	3.6	08-May
Japan (Call rate)	0.50	0.50	0.50	1.0	30-Apr

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