Global Markets Weekly - 26th November 2007

Key global market developments

• Equity markets are likely to rally, but not by as much as they did from August's lows.
  With stock markets down some 9% since the start of the month, sentiment and technical indicators aligned late last week to signal that equities would probably rally from oversold levels. But, as evidence grows that the credit crunch is affecting the real economy and as central banks are showing reluctance to cut rates, the rally is likely to be more muted than the one from the lows of last August. For the rally to gain traction, a positive catalyst will be needed. That could come from banking sector results which are not as bad as feared or from signs that the Federal Reserve (Fed) will do whatever it takes to protect the economy.
• Amid today's over-pessimism, contrarian positions should prosper.
  In today’s environment, it would be easy to whip oneself into a bearish frenzy. Yet past evidence suggests that extremes in market sentiment frequently offer a tactical opportunity to take successful positions against the prevailing mood. As Warren Buffet said, ‘Be fearful when others are greedy and greedy when others are fearful.’
  In late October, our aggregate measure of equity market sentiment indicated over-optimism. Now, it’s approaching the levels of pessimism seen before the market rallied in August after the summer’s credit-crunch-induced declines.
• Equity markets are nearing key levels.
  Technical analysis shows that equity markets are close to the key levels they need to hold above if they are to remain in the bull trend they have been in since the autumn of 2003. Crucially, technical analysis currently suggests that these levels will hold, but trading over the next few days will be critical.
• The prospects for equities look good over the long term...
  Even holders of equities with long time horizons will of course be finding the current market volatility uncomfortable. But they can take heart from the fact that, over the past 20 years, buyers of US equities on the current forward price-earnings ratio of 15 times have seen returns of between 6% and 89% over the following two years, with an average return of 36%.
• …but the medium term is less clear-cut.
  For us, the main concern is the medium-term prospects for equities, not the outlook for the next few weeks or the next couple of years. It is becoming increasingly clear that, as the global credit crunch tightened its grip, the economic cycle moved from a phase of accelerating growth and headline inflation to one of slowing growth but rising inflation.
• This phase is generally better for bonds and commodities than for equities, REITs and the dollar.
  Historically, in this phase of the economic cycle, the best-performing asset classes have been commodities (particularly energy) and bonds, while REITs, equities and the dollar have performed less well. Although equities in aggregate have tended to fall, the performance of individual equity markets has diverged significantly. Pacific ex Japan equities, particularly Hong Kong, have tended to perform strongly, while US equities have generally been pretty flat. Yet European and, to a larger extent, Japanese equities have tended to fall, dragging down the global average. And that’s pretty much how assets have performed in recent months.
• Once the rally is over, we should expect lower equity returns than in recent years.
  The next phase in the cycle will begin when markets start to anticipate that inflation will fall in response to slowing growth. That may not happen until some time in the first half of 2008, unless the Fed gets back ahead of the curve. In periods when the Fed has cut rates, we have in the past seen strong performance from equities, especially emerging markets and the Pacific ex Japan. In the meantime, once the rally from oversold levels is over, the risk-reward trade-off for equities is likely to look less appealing than in recent years.

Indices, Interest rates and Inflation

	Close 23-Nov-07	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	3,198	-0.9	-4.6	0.0	-0.7
FTSE 100	6,262	-0.5	-3.9	1.1	0.7
S&P 500	1,441	-1.2	-5.2	-1.5	1.6
Nasdaq Composite	2,597	-1.5	-7.2	2.2	7.5
DJ Stoxx (Europe)	404	-1.1	-4.5	-0.7	2.0
Nikkei 225	14,889	-1.8	-9.5	-8.8	-13.6
Hang Seng	26,541	-3.9	-9.7	15.6	32.9

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