Global Markets Weekly – 5^th March 2007

Key Macro economic developments

• The financial markets were subjected to a bout of pronounced volatility last week, with the most commonly accepted explanation suggesting that investors, spooked by a 9% drop in Chinese equities within a single trading session, rushed to bank profits and remove a degree of risk from the table. Various other headwinds, such as further weak data from the US, some perhaps misinterpreted comments from ex-Fed chief Greenspan and a general anxiety over the vulnerability of so-called carry trade activity (following the long-awaited yen rebound), also weighed upon equities.
• However, the market movements of the past week are arguably as reflective of the market conditions that had previously developed, and the earlier increase in risk appetite in particular, than any ‘new’ developments or significant, underlying deterioration in the macroeconomic environment. Risk appetite (on some measures at least) had approached elevated levels, with surveys of fund manager sentiment pointing to almost uniform bullishness on the outlook for equities. The manner in which the usual risk premium attached to emerging market equities (vis-à-vis developed markets) had been steadily eroded also suggested unerring confidence amongst investors, if not quite complacency. With volatility, both realised and implied, having fallen to unusually low levels across a variety of markets, some increase in uncertainty and a move towards less stable trading ranges had appeared more likely than not. But we do not believe that recent events have challenged the underpinnings of the equity markets sufficiently to warrant a change in our fundamental viewpoint. The current level of valuations attached to the major equity markets provides ample scope for the asset class to outperform bonds over the coming months, and is far removed from that which typically develops in the closing stages of a bull market.
• As the effects of the housing market downturn moderate, growth in the US should prove to be stronger in the second half of the year than in the first, and the running-down of inventories across the economy also points to an imminent upturn in production. That is not to say, of course, that uncertainties around the economic outlook do not exist. While a degree of the recently weak US data may indeed be weather related, the precipitous drop in durable goods orders in January is more difficult to dismiss as mere noise. Nevertheless, the level of attention afforded to former Fed Chairman Greenspan’s comments last week, surrounding the ‘possibility’ of a US recession in late-2007, appears to be more reflective of the sudden up-tick in volatility than any great economic insight (given that there is rarely seen to be a nil probability of such a downturn). A further support comes from the more balanced nature of global growth, with the indicators from Europe and Asia retaining a firm tone, a factor that should again be underlined by this week’s expected rate hike from the European Central Bank (25bp to 3.75%). While investors may remain sceptical over the ability of global growth to withstand a softer US economy, possibly leading to further weakness in riskier assets in the short run, the impetus of growth should certainly be less ‘US-centric’ in 2007.

Key global market developments

• More defensive assets and markets have outperformed during the recent market falls. While we remain positive about the outlook for equities, we would reiterate our preference for more defensive markets as volatility rises from previously very low levels. In bond markets, US Treasuries have risen, pushing down yields by around 10 basis points to 4.5%. However Treasury yields had already peaked at the end of January, as the news flow from the economy became less positive, making the recent gains seem part of an existing trend. By contrast, High Yield and Emerging Markets bonds have underperformed, with their yields rising by around 20bp from the recent record low levels against Treasuries, though part of this correction has been caused by Treasury gains, reducing the scale of absolute falls.
• In global equity markets, the 4%-plus falls take equities broadly back to their levels at the start of the year. However, the S&P 500 has marginally outperformed over the past few days, while the more volatile Small Capitalisation stocks and Emerging Markets underperformed by 0.5% and 2% respectively.

Indices, Interest rates and Inflation

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