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Market Oulook of the Week (7 July – 11 July 2008)
Last week’s economic data and central bank moves have further diminished the chance of early rate hikes in the US and UK, and point to Euro-zone rates now staying on prolonged hold. In the US, manufacturing sentiment stabilised, with exports continuing to support, but the more important services sector deteriorated and labour market data still points to an economy in recession, albeit a mild recession. UK data remained terrible and points to an economy at almost a 50:50 risk of imminent recession (Q1 GDP growth anyway was only 1.2% pa). But given high inflation, UK official rates this week (Thurs.) are virtually certain to remain unchanged at 5% - a level that is too high in our view. In the Euro-zone, the ECB hiked as expected (by 25bps to 4.25%), but then encouraged markets to assume it was “one-and-done”, by highlighting Europe’s developing (and quite steep currently) economic slowdown. What does this mean for currencies? The USD should stay range-bound over the summer - $1.54-1.60 for EUR/USD, 100-110 for USD/JPY. Sterling should fall against the EUR but not by much, if EUR/USD range-trades. Of the majors, only the AUD looks to have significantly more upside, but on the crosses, given the rising trade surplus and high rates - left unchanged last week and expected to stay high. · The Asset Allocation Committee expects market conditions to remain difficult over the next one-to-three months and the model allocations remain underweight equities. There are several reasons. Firstly, the credit crisis looks set to continue and will weaken economic growth in the US and Europe. Banks (despite some relief last week from Deutsche and UBS) have to do more capital raising and de-leveraging, which will keep credit conditions tight. In addition, the long overdue de-leveraging of household balance-sheets (in the US, UK and elsewhere) is now underway and will be prolonged (probably 2-3 years). Secondly, high inflation will squeeze household incomes and spending, will curb investment and, in the context of slowing economic growth, looks certain to squeeze corporate profits - which are at 40-year highs anyway, so far more likely to fall than rise further. · Furthermore, the policies needed to defeat inflation - higher interest rates or delayed rate cuts - will make the economic downturns even worse and pile yet more pressure on corporate earnings. So-called earnings multiples (PE ratios) should drop, as high inflation increases risk premiums and the uncertainty surrounding future profits. Finally, there is oil. Prices are up another $5/bl last week (to $145) and the risk is now very high that a “bubble” is developing which will crash. But it is difficult to predict when this will happen and near term at least the potential for supply disruption (from Nigeria, Israel/Iran tensions, the US hurricane season), with spare capacity still low could well continue to send prices up. Investment opportunities are difficult to find in this environment and cautious, yield generating, strategies may be best near term. Alternatively, being diversified across asset classes and playing the long game is usually a good strategy. Stocks should rally on a 1-year time horizon, so averaging into any more downside over the next few months should work out. · Bonds will probably rally during the second half of 2008 and this time next year deflation may be the markets’ biggest fear, not inflation. There are no quick fixes for inflation. Interest rates need to rise further in some countries, especially in Asia where real rates are low. But we believe current high inflation will prove temporary. Slower economic growth and higher unemployment should hold down wage settlements and curb corporate pricing power. It is too early to be aggressive now, but bond yields should start to fall soon in the major markets (the US, UK, Euro-zone, but not Australia) and, based on our forecasts, should bring bond returns in the 5-10% range over the next 12 months. 2-10 year yield curves should also steepen. |
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