Global Markets Weekly 23 August 2010

• Risk aversion increases, but emerging equities move further ahead, while corporate spending may be stirring

  Further weak US data hit equity and other risk asset markets, while safe havens rallied - gold, high quality sovereign bonds, the yen and the Swiss franc moved higher. We believe the Federal Reserve is closer to resuming quantitative easing. However, emerging equities were broadly ahead, and are around 10% up on their May low, having significantly outpaced developed equities over the past three months. Increasing merger and acquisition (M&A) activity potentially signals a revival in corporate spending.

• High-quality sovereign bonds led the fixed-income market, reflecting the view that interest rates will remain low for longer than anticipated

  Lowered growth expectations have boosted bonds, which we believe will strengthen further. Consensus expectations remain ahead of our growth and inflation forecasts, while declines in bond yields could potentially overshoot amid renewed central-bank intervention, or the discounting of deflation fears. Yields on sovereign bonds are already at record lows in Germany, and are approaching a nadir in the US, Japan and the UK. Speculation of a bubble in bond markets appears premature. However, data setbacks, or cooling investor enthusiasm, could cause bond yields to fall, highlighting the relative attractiveness of the yield premium offered by corporate bonds.

• Corporate cutbacks prompt productivity gains and falling investment, but M&A activity picks up…

  Corporations have adopted a defensive stance during the credit crisis, cutting costs and delaying spending. Since mid-2007, US productivity per hour has increased by 8.8% and developed world capital expenditure has fallen by 20%. Meanwhile, cash - as a percentage of shareholder's equity - is near to a 20-year high of 19% in the US. Many are asking when corporate spending will pick up again, given impending government austerity measures. But productivity gains have levelled off recently and capital expenditure has risen by 6% for two consecutive months, the largest gain since early 2008. In past recessions, a pick-up in corporate M&A (which tends to lead capital expenditure by 6 months) has signalled a revival in investment.

• …potentially signalling a rise in corporate investment. Both bonds and equities can benefit from non-inflationary growth

  M&A is indeed now rising. Furthermore, seven of the 10 largest deals are being financed by cash rather than loans, suggesting corporates are starting to spend again. This bodes well for private sector employment, particularly in light of the recent peak in productivity gains. The last recovery in 2003 also showed that, providing growth stabilises, a bull market for bonds does not preclude positive returns for equities at this stage of the cycle. Hence, while bonds should benefit from falling inflation expectations, equities could also gain from low interest rates, evidenced by the pick-up in M&A activity.

• As long as economic weakness in the developed world is not sufficient to derail global growth, emerging markets can prosper

  A surge in US new weekly jobless claims back to the 500,000 level, the worst figure since November, dominated headlines. Japan registered weak GDP growth of 0.4% in the second quarter, and China passed another economic milestone when its GDP outstripped that of Japan. This achievement was accompanied by various new market liberalisation initiatives that underline China’s role as a driver of regional and global growth. With Taiwan, the beneficiary of recent trade agreements, announcing a 12.5% GDP growth rate, it is unsurprising that emerging markets outperformed. China’s foreign reserve management also bolstered emerging markets – Beijing has been selling US Treasuries and buying Korean bonds.

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