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Global Markets Weekly - 29 June 2009

• Riskier assets continued their consolidation last week and bonds benefited...
  Equity markets trod water last week, after falling 3% the week before, and have consequently given back a little of the almost 40% rally from March’s lows. This pattern was reflected in the performance of other riskier assets, such as commodities and credit spreads. The US dollar and government bonds have benefited from a flight to safety, with US ten year yields down from a recent high of almost 4.0% to 3.7% and the trade-weighted dollar up 2% in June. This slight reversal in market risk appetite coincided with the pace of upside economic surprises losing momentum.
• ...as investor sentiment has turned back down to a neutral level.
  Our proprietary sentiment indicator has been suggesting for some weeks that equity markets and other riskier assets were due a correction. It recovered from extremely depressed levels in early March to more optimistic sentiment over the past six weeks, implying a possible consolidation in the short term. However, surveys indicate that fund managers are rebuilding their equity positions and that any correction in riskier assets would be used to add further risk back into portfolios, not to pare it back.
• The Fed eased concerns of an imminent end to its ultra-loose monetary policy.
  This pull-back in riskier assets in the weeks running up to last Wednesday’s meeting of the interest-rate-setting committee of the US Federal Reserve (Fed) was the market’s way of signalling that it is far too soon to discuss the removal of monetary policy stimulus. The Fed normally doesn't start tightening until the unemployment rate decisively stops rising – which we don’t expect to happen until the middle of next year at the earliest. But investors have started to worry that policy-makers will have to begin the process earlier in this cycle, because of the unprecedented explosion of the Fed’s balance sheet and the massive fiscal stimulus. So the Fed used its post-meeting statement to signal to investors that it is in no rush to start exiting from ultra-low interest rates and quantitative easing. In response, futures markets lowered their expectations for the pace of Fed rate rises next year, with rates now expected to hit 0.5% rather than 0.75% by the end of the first quarter.
• The improving economic backdrop should be positive for riskier assets...
  With June’s Fed meeting now behind them, investors should breathe a sigh of relief and focus once again on where value lies in financial markets. As the economic backdrop is gradually improving, we believe that riskier assets – such as equities, corporate bonds and commodities – offer better potential returns over the year ahead than government bonds. Within bond markets, the best opportunities are in credit markets, both investment-grade and high-yield, where spreads appear to have further to fall and attractive yield pick-ups remain.
• ...while index-linked bonds could benefit from medium-term inflation concerns.
  Mounting medium-term inflation concerns, relating to quantitative easing ‘working too well’, mean that the outlook is better for inflation-linked government bonds than for conventional bonds. Excess capacity is temporarily suppressing global prices. But inflation is the greater medium-term risk - if political pressures prevent central banks from reining in their inflated balance sheets in a timely manner. Inflation is a special concern over the next decade, given the mountain of new government debt that will have to be absorbed by financial markets. The need to finance massive fiscal deficits during the coming years could lead to political pressure on central banks to print money to buy much of the newly issued debt. Concerns about an eventual significant pick-up in inflation may soon begin to be factored into government bond yields. Should long-dated real interest rates become chronically elevated, that would limit the upside for equity markets.

Indices, Interest rates and Inflation

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