Global Markets Weekly - 27 September 2010

• After dovish Fed comments, consensus shifts to support our forecast of QE2 this year
  Our prediction of further unconventional monetary policy measures from the US Federal Reserve (Fed) in the next six months got a significant boost from a dovish Fed statement this past week. With the Bank of England (BoE) also leaning in the same direction, investors anticipated a further round of quantitative easing (QE2), driving a sharp rally in government bonds in not just the US and UK, but around the world, substantially reversing this month’s losses. The dollar and, to a lesser extent, sterling sold off, with the Swiss franc and gold hitting new highs. Equities in general were more muted. European markets were notably weak amid a softening of business confidence, while emerging equities, which we favour, extended their outperformance to reach their highest levels since June 2008.
• Recent statements lead us to expect QE2 from the Fed this year, followed by the Bank of England
  While the Fed and BoE's statements do not tie them to any course of action, they did represent significant shifts in language and we continue to forecast that both will adopt further unconventional monetary policy measures. The Fed said that it "is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation...to levels consistent with its mandate". The BoE minutes showed that for some members the probability had risen that "further action would become necessary to stimulate the economy and keep inflation on track to hit the target in the medium term". How quickly the Bank of England follows is, in our view, likely to depend on the extent of cuts announced in the October Spending Review. The closer the UK government sticks to its target of 25% cuts in non-priority areas, the more likely it will be that the BoE uses QE2 to counterbalance fiscal tightening. Bonds would be the initial beneficiaries.
• Ireland – rumours unfounded, truth still bad
  Last Friday afternoon’s market rumours that Ireland was just about to announce that it had called in the IMF to deal with its rising debt problem proved unfounded. However, the truth of the situation is still bad, with the release of second-quarter GDP figures showing that the economy has slipped backwards against expectations that its recovery would continue. As a consequence, the yield spread for Irish government bonds over comparable German issues has remained at record levels. Ireland’s problems are among the issues that make us unconvinced by the euro’s recent gains against sterling and the dollar – a switch that we would regard as jumping out of the frying pan into the fire.
• Summer is over – volatility rises as autumn approaches
  September’s equity rally from the August lows, when double-dip fears dominated the headlines, has been against a background of mixed but generally muted economic news, which allowed investors to take a more considered and sanguine view. The VIX index of volatility in the S&P 500 touched a low of 21, but has started to tick up over the last week. Equity indices are also poised close to significant technical levels, just back above 200-day moving averages. The US manufacturing ISM business survey, due on Friday 1st October, is expected to show a fall from 56.3 to a consensus estimate of 54.5. Several constituents of the index point to risks of further falls by the end of the year towards the key level of 50, below which indicates contraction. By contrast, corporate results are expected to remain robust. Overall, supported by the Fed’s willingness to provide further monetary stimulus, a continued, albeit slow and unsteady, recovery is the most likely outcome in our view, as opposed to a double-dip.

Indices, Interest rates and Inflation

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