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Market Outlook of the Week (13 - 19 Jul 08)
It is too soon to completely rule out interest rate hikes, but the next move in European official rates will likely be down. The Bank of England, as expected, kept UK rates unchanged this week at 5.0% whilst the data (as has also become predictable) stayed terrible - consumer confidence, poor manufacturing despite sterling’s fall, stresses on equities (from bank rights issues, homebuilders, retailers). High inflation constrains the BoE near term but we forecast sharply lower rates and a big UK gilts rally in 2009 - and the risk is that rates fall sooner. In the Euro-zone, soft May German and French industrial output points to sharply weaker Q2 GDP growth and a move up in unemployment. In the end, this should ease ECB fears that wage settlements will trend up, and Euro-zone inflation should fall later this year. · US equities, so far, have had another bad week, and we expect the market to stay under pressure over the next few months. The S&P 500 is now officially in bear market territory (20% down from its October 2007 high), with financials off 46% and with retailers/homebuilders/auto makers combined down 27%. Small caps. (the Russell 2000), which are more domestically focused, hit the 20% down level in January and have actually outperformed large caps. since then. This week’s stress points, which have outweighed lower oil prices (down around $10/bl from their early July peak), have been worries over Fannie Mae/Freddie Mac funding, tech sector earnings, and (as ever) the financials - where the continued price falls make capital raising more difficult. The market will get some relief if oil prices fall back further over the next few weeks, but we believe that the pressures set to bring more equities downside go far beyond oil - pressures from the on-going credit crunch, and the squeeze on profits from high inflation (high raw material costs), domestic demand which is likely to stay very weak, and increasingly softer foreign demand as well. · In the last six US recessions, the S&P 500 has on average dropped 31% from its peak and taken around 12 months to bottom out -but the current economic downturn is likely to be longer, although not necessarily deeper, than average. De-leveraging in both the financial sector and the households sector – which alone is 70% of the economy - looks set to last a long time. The housing slump will probably bottom in the second half of this year - although rising mortgage rates are making us less confident in that view. But any housing recovery is likely to be very slow. Profits are also very high relative to GDP and so a structural adjustment lower looks likely on top of all the cyclical earnings pressures - S&P 500 profits from their peak are now down around 30% but in the recessions in the early 1990s and early 2000s dropped an average 45-50%. Another indicator widely watched is the VIX which is up recently (now at 25) but usually needs to move much higher to suggest a market bottom (see chart) - in 2002 the VIX peak was 42, in early-March 2008 it was 32. Our asset allocations are underweight the US on both a short term (next 1-3 months’) view, and on a 12 month view. · Inflation should peak out in emerging markets during the second half of 2008 and will likely trigger a big bonds rally and a renewed stocks bull market. Central banks still have more to do to beat inflation - so expect more rate hikes (next week in Turkey, the Philippines, Thailand) and more moves to prevent sharp currency depreciation (as in Korea this week). But the combination of softer G7 economic growth and the squeeze from high inflation is now coming through in sharply lower GDP growth (in Singapore Q2 data this week, probably softer China data next week). Monthly inflation data are also now usually in line or below expectations. Emerging market local currency bonds should rally first - especially Brazil, Mexico, Turkey, India, and Indonesia. When equities will bottom is a more difficult call as “hard-landing” fears still need to be worked through. But our long run allocations are overweight.
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