Letter from the CIO

Global Capital markets finally came to realize this quarter that growth will be stronger for longer globally and that central banks were serious about reigning in runaway global liquidity and the ensuing inflation risks.

As a consequence, equity markets were volatile but ground their way higher to multi year and, in most cases, historic highs. On the other hand, fixed income markets saw sharp sell offs, particularly at the long end. The gradual shift upward of yield curves will have a significant impact on higher risk assets at some point – at the moment, however, the impact is largely restricted to sub prime blending in the U.S. and the housing market of the U.S. and Spain.

For now, capital markets continue to hold a sanguine view of the first episode of truly coordinated growth in a relatively low inflation environment. Some commentators have described this as a state of “open perpetual mid cycle” for company earnings – clearly an unsustainable state of affairs in the long run but perhaps an apt description of the current environment.

During this eventful quarter, a few developments stand out:

1. The outperformance of small cap value stocks seems to be finally coming to an end with large caps in several markets making a come back. For managers used to tail winds from these strategies, this could mean a rude awakening.
2. We have noted before in these pages the outperformance of the Euro zone versus the U.S. in terms of job creation since the launch of the Euro. Led by Germany, Euro zone year-on year employment growth is nearing 2% with average wage growth for the first time in many years set to outpace inflation. This all goes well for consumption, which could establish itself as the second pillar of the Euro zone growth story, despite the value added tax increase in Germany at the beginning of the year that many had predicted would spell the end of the current upturn. The election of Nicolas Sarkozy to the French presidency should further support the momentum of European reform.
3. Despite the increase in short and long term interest rates, the carry trades have not collapsed. While this has surprised some observers – we see this as a major risk to the health of capital markets – the current continuation of the carry trades clearly supports asset prices.
    

Overall, looking forward towards the end of 2007 and into 2008, the environment for equities is encouraging. Global growth across all regions is currently coordinated for the first time in decades, not at too strong a level; earnings are healthy and central banks appear in control of events with now ample room to cut interest rates aggressively at the short end to counter any unforeseen shock to the financial system.

Andreas Utermann

Global Chief Investment Officer

RCM

RCM Global Strategic Outlook 3Q07

Economic and Bond Market Outlook
Since May, economic data — in particular in the U.S. — have started to improve again.  While this came as a surprise to many market participants, we have been expecting this change for some months already, as indicated by our proprietary leading indicators.

In the U.S., both the industrial and the consumer sectors are showing signs of improvements. The housing market continues to be weak but is sending tentative signs of bottoming out. Our proprietary leading indicators are telling us that this rebound may very well last for the next several quarters, as long as rises in interest rates and bond yields remain moderate.

Equity Market Outlook and Asset Allocation
Are rising bond yields already a problem for equity markets? Admittedly, bond yields and interest rates are approaching levels that could ultimately slow economic growth. However, we think there is still some way to go until we reach critical levels. Our research shows that central bank rates are still accommodative in most currency areas.

Global Outlook
Recently, we have seen further extensions, and sometimes big extensions, of markets movements that started when policy rates were extremely low in 2003-04. We have also seen central banks hike interest rates in many parts of the world, which means that monetary conditions must be closer to equilibrium or neutrality now than in recent times.

Forecasting, therefore, is becoming increasingly risky. The combination of the two actors mentioned means that the distribution of potential outcomes should be less skewed than it was a year ago. Our forecasts for policy rates were assuming reversion to the mean. We are now forecasting some deviation from the mean.

U.S. Outlook
On currently available results, Q1 2007 U.S. real GDP delivered a near miss in terms of economic contraction, with only a 0.7% advance at an annualized rate over the prior quarter. A sequential bounce in Q1 consumer durable and capital equipment spending was offset by an unexpected deceleration in U.S. export growth, continued housing weakness and a larger-than-expected drop in inventories. Q1 also witnessed a compression in corporate profit margins as labor productivity dropped away, driving unit labor cost momentum up through corporate pricing power.

Continental Europe Outlook
Short-term fluctuations in headline inflation are very much influenced by the price of oil. At the level of producers’ prices, the rebound in the oil price is visible since February. During the three months to the end of April, the headline PPI increased at an annualized rate of 4.5%. During the three months to the end of May, the core CPI inflated at an annualized rate of 5.3%. The six-month rate of change is 2.8%, while the year over year rate flirts with the critical 2% level. Headline inflation reached an even higher level: 6.3% annualized in the three months to May. The sources of this acceleration in inflation are clear: services and semi-durable goods. Inflation remains well-behaved for durable goods.

U.K. Outlook
Inflation in the U.K. has now peaked. The headline CPI number for the year to May fell to 2.5%, which compares with its peak of 3.1% for the year to March. RPI inflation, a broader measure than CPI, has fallen from 4.8% to 4.3% over the same period.

This trend should continue as the rises in utility charges that occurred a year ago fall out of the equation. The Bank of England’s central forecast, as published in its Quarterly Inflation Report in May, is that CPI will fall below the target of 2% some time in the fourth quarter. Another encouraging sign is that wage inflation, which had been a possible worry, has recently softened. Nevertheless, some inflationary pressures remain.

Japan Outlook
There are three concerns about the current Japanese economy. First, machinery orders, which are a leading indicator of capital expenditures, remain weak, the figures are worse-than-expected for three consecutive months. Secondly, recovery of consumption is slow; household income improvement is not yet clear. Finally, exports are gradually losing momentum. Thanks to solid demand from emerging nations, the weakness of exports to the U.S. is being offset.

Asia-Pacific Outlook
Asian growth is expected to show regional differences throughout Q3 2007: We expect a rebound in the property prices in Hong Kong, and China to experience positive investment inflows. In India, we believe the tightening of the cycle of Reserve Bank of India is near an end and, in South Korea, robust readings in export growth suggest the industrial cycle there may be about to bottom out. Meanwhile, Singapore’s economy appears set to enjoy positive structural changes and sustained strong growth in a low-interest and low-inflation environment.

Commodities Outlook
Many commodity prices have risen in this cycle by as much or more in inflation-adjusted terms than they have in any prior cycle. Microeconomic theory and the experience of history say that much lesser increases in commodity prices should result in large increases in supplies. This quarter’s commodities report looks at whether these increases have occurred in this cycle. However commodity bulls, who believe in a New Era of natural resource scarcity, believe that the supply surges of the past will not materialize this time around.