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Global Markets Weekly - 5 May 2009

• Equities benefited as upside data surprises trumped concerns about swine flu.
  Last week, equities were assisted by a moderately better-than-expected earnings season in the US and by evidence that the pace of economic contraction is slowing in most regions of the world. This has allowed investors to overlook the near-term uncertainty associated with the outbreak of swine flu in Mexico and the results of the US government’s stress tests of the largest 19 US banks, due on 7th May.
• The stabilisation seems to be spreading to the household sector...
  Until recently, indications that the pace of economic contraction had slowed were limited to the manufacturing sector , suggesting that at least some of the improvement was related to a turn in the inventory cycle, rather than improving final demand. Early evidence of a slackening pace of US job losses and a corresponding rise in consumer confidence – also in the UK and Europe – suggest that this stabilisation is being felt in the household sector.
• ...but previous up-ticks in data during the credit crunch have soon faded.
  At the highest aggregate level, an index of the outturn of economic releases relative to expectations in the world’s ten largest economies is broadly neutral . Investors spent most of 2008 being disappointed by economic data. The index has not been positive for more than a month ever since the credit crisis began in summer 2007: what little good news there has been has always been short-lived. The improvement in the economic surprise indicator shows that the current stabilisation has an increasingly broad base, but it also poses a risk. With investors now expecting to see signs of economic improvement, the hurdle for risk assets has moved higher, altering the balance of risks in favour of data not being positive enough.
• The increase in bond yields has been down to rising inflation expectations...
  Indeed, by some measures, investors appear relatively unconvinced that the current improvement in economic indicators will translate to higher rates of growth . In particular, although government bond yields have risen during the rally in risk assets, they remain below the levels seen immediately before Lehman’s failure. This could be due to the downward pressure on yields from official purchases by, among others, the US, Japanese and UK central banks. Perhaps more pertinent is that the year-to-date increase in yields is entirely the result of a rise in inflation expectations, rather than real yields. Even though index-linked bonds have not been included in any central bank purchases, they have outperformed conventional bonds.
• ...suggesting that investors remain downbeat on growth prospects...
  So, although investors appear more confident that policy action will succeed in avoiding deflation and keep long-run inflation in the comfort zone of 1.5-2.0%, they are less confident about the prospects for growth – with real yields actually declining moderately since the start of the year.
• ...even though a debt deflation cycle appears to have been averted.
  This bond market behaviour is consistent with our own interpretation of recent data – namely, that most developed economies will probably continue to contract throughout 2009 . However, aggressive policy action has significantly reduced the risk of a Great Depression-style, debt-deflation outturn. The diminishing probability of this tail risk has a disproportionately large impact on inflation expectations relative to growth expectations.
• The US authorities will try to avoid spooking investors with the bank stress tests.
  This week, investors’ focus is likely to return to the financial sector, with the release of the results of the US government’s bank stress tests . With investors in a broadly positive state of mind, policy-makers will feel the pressure not to upset this still-fragile return of confidence. Financial sector instability and weak credit growth remains a drag on growth, and it would be dangerous to draw attention to this risk without simultaneously proposing a comprehensive and credible solution.

Indices, Interest rates and Inflation

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