Global Markets Weekly - 19th November 2007

Key global market developments

• Focus on fundamentals - valuations alone are no longer enough for equities.
  As we have noted before, volatility is back. However, as the experience of 1998-2000 showed, higher volatility is not in itself reason enough to sell equities; missing the final stages of a bull market can prove a costly mistake. For long-term investors, valuation should provide a better guide. Currently, price-earnings (PE) valuations are not especially stretched in any developed equity market, and equities are still quite cheap relative to bond yields. Yet valuation alone is no longer sufficient to justify an automatic overweight position in equities versus bonds. We need to consider the fundamentals.
• The Fed is key - equity returns rest on inflation and interest rates.
  Economic and earnings growth are both expected to slow in 2008. In slowdown periods, much depends on the Federal Reserve (Fed). Historically, US equity returns during slowdowns have been close to cash when the Fed has cut interest rates but have been negative when rates have risen. That explains investors' interest in the future path of inflation. If inflation rises - perhaps in response to higher oil prices - there's a danger of slipping towards stagflation. At present, however, we expect lower growth to keep core inflation low, allowing the Fed to cut rates. That would support equities in what may prove the bull market's closing phase. However, the weather has worsened - and we are watching it very closely.
• Chinese outflows in 2008 to benefit Asian equities...
  Officially sanctioned overseas portfolio flows from China could soar to $250 billion in 2008, up from perhaps only $20 billion this year. That's according to recent combined estimates for qualified domestic institutional investors, insurers, the China Investment Corp. and retail investors. A new guideline suggesting a ceiling on investment in any one market means that perhaps 60% will be invested outside Hong Kong. That will only increase Chinese investors' interest in the equity markets of Singapore, Australia, Taiwan and India and particularly Korea. On a PE ratio of 13 times, Korea looks good value, as real GDP growth has been running at about 5%.
• …as well as Hong Kong.
  In recent years, the performance of the Hang Seng has been closely related to the amount of foreign currency on deposit or circulating in Hong Kong. After much uncertainty, outflows from individual Chinese investors are likely to start in the second quarter of 2008, pumping some $27 billion of investments into Hong Kong by the end of the year. The Hong Kong investment express has been delayed, but it has not been cancelled.
• "Your Dove is King" - UK rates to fall, amid worsening conditions.
  Recently, investors have been increasingly pricing in UK rate cuts, amid worsening leading indicators, tighter credit conditions and further sterling strength. Two-year gilts, which yielded 5.7% in August, now yield 4.5%, indicating roughly 75 basis points (bps) of cuts next year. The release of November's Inflation Report showed Bank of England Governor Mervyn King in broad agreement with the market - for once. Growth expectations for 2008 were reduced and, crucially, the Bank's CPI inflation forecast suggested 50 bps of cuts were needed to keep inflation on target - in line with our existing forecasts.
• More cuts may be needed, judging by tighter mortgage lending.
  Since July, two-year swap rates have fallen 50 bps in the UK, while fixed-rate mortgage deals have risen by 40 bps - a dramatic tightening of conditions, with more probably to come. So more than 50 bps of rate cuts will be needed to ease households' cost of credit relative to midyear levels. We think the risks to UK rates - and sterling - remain to the downside. Predictably, the weakening outlook drove sterling to a 4½-year low against the euro and 3% off its recent peak against the dollar. With much bad news for the dollar already discounted, we see significant further downside for sterling.

Indices, Interest rates and Inflation

	Close 16-Nov-07	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,226	-0.4	-5.0	6.4	0.1
FTSE 100	6,291	-0.2	-4.9	7.4	1.1
S&P 500	1,459	0.3	-5.2	3.4	2.9
Nasdaq Composite	2,637	0.4	-4.6	7.6	9.2
DJ Stoxx (Europe)	408	-0.9	-4.2	4.8	3.2
Nikkei 225	15,155	-2.8	-11.6	-6.2	-12.0
Hang Seng	27,614	-4.1	-4.6	33.6	38.3

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Dec-07 Forecast	Mar-08  Forecast	Current	Next Date
US (Fed Funds)	4.50	4.50	4.50	3.5	11-Dec
UK (Base rate)	5.75	5.75	5.50	2.1	06-Dec
Euro-zone (Repo Rate)	4.00	4.00	4.00	2.6	06-Dec
Japan (Call rate)	0.50	0.50	0.50	-0.2	20-Nov

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