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Global Markets Weekly - 18 May 2009

• Despite rising economic confidence, the market rally lost momentum...
  Last week saw a stalling, but not yet a reversal, of the recent rally in equities and other riskier assets. Surveys of economic confidence continued to improve from the first quarter lows, with OECD lead indicators showing a stabilisation or recovery in almost all regions of the world. The improvement was welcome, if not especially surprising to investors, as business confidence surveys had already improved – and one of the variables in the OECD lead indicators is equity prices anyway.
• ...as data of actual activity - such as US jobless claims - disappointed.
  So, while business confidence may be rebounding from its post-Lehman funk, data releases for actual economic activity haven’t yet shown a similar V shape. One potentially positive development in the US over recent weeks has been a slowing rate of job losses, as measured by initial jobless claims. However, this number rebounded last week, and its four-week moving average, often used as an indicator of changes in total payrolls, is rising again. The 0.5% fall in US retail sales during April was also worse than expected, with retail sales now more than 10% down on a year ago.
• Weak retail demand is putting downward pressure on US prices.
  The price of imports into the US has declined 16.5% in dollar terms over the past year. While the dollar has strengthened 9% on a trade-weighted basis over that period, weak final retail demand has become a driver of import price deflation. Indeed, underlying deflationary pressures in all developed economies help to explain why, despite some commentators’ alarm about the inflationary impact of quantitative easing, inflationary expectations have barely moved during the recent equity rally.
• The Bank of England issued a warning on UK growth. 
  In its quarterly Inflation Report, the Bank of England moderately raised its inflation forecast, but not to troubling levels. Investors instead preferred to concentrate on the downbeat growth assessment from the Bank’s governor, Mervyn King. His warning that any recovery in the UK would be ‘slow and protracted’ helped to drive 2-year gilt yields to a new low. So, although investors may be questioning the likelihood of a V-shaped recovery for the global economy, such an outcome is not even being entertained for the UK.
• The German economy contracted very sharply, despite a pick-up in lead indicators.
  During the first quarter of the year, economic activity in Germany contracted by an alarming 3.8% quarter on quarter. The annual pace of decline is just short of 7%, the fastest since at least 1970, and the 16% annualised pace of decline in the first quarter was worse than the steepest annual fall in German GDP during the Great Depression (-14% in 1931). As in other regions, however, lead indicators of German growth have improved since the first quarter, with factory orders also showing signs of rebounding.
• Markets had become over-pessimistic in the first quarter...
  The extreme case of Germany illustrates a wider point about the improvement in economic data and associated rally in risk assets during the second quarter: the nosedive pace of economic decline since Lehman’s failure had no historical precedent and was never likely to continue. Nevertheless, during the quarter, some asset prices came to reflect this ultra-pessimistic view.
• ...but now look too upbeat, so they may need further fuel if the rally is to continue.
  So the evidence over recent months that the pace of economic decline has a limit and is probably slowing has had a powerful impact on valuations of equities and other financial assets. Yet, while surveys show a sharp rebound of confidence, expectations of a similarly fast return to actual economic expansion are faltering. Instead, the more prosaic reality is to be found between the L-shaped pessimism of February and the V-shaped optimism of May. The evidence required to support a continued equity rally from these levels will now prove increasingly difficult to find.

Indices, Interest rates and Inflation

View the full Global Markets Weekly report (pdf).

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