Economic and Bond Market Outlook
In mid-July, global equity markets peaked and experienced a correction that was similar in size and duration to those of February/March 2007 and May/June 2006.

What kind of message about the market and economic outlook is this correction sending to investors? How can we explain the fall in equity markets, the underperformance of financials, the rise in equity volatility, falling bond yields, and widening spreads in the money and credit markets? To what extent do we agree with market consensus? In what sense do we disagree?

Equity Market Outlook and Asset Allocation
So far, we have favoured a balanced sector allocation with regard to cyclicals and defensives, – for now, this remains the same. This has not changed yet. The major change that we have implemented during the past months is to add to energy stocks, which should continue to benefit from strong Asian growth, and to reduce financials.

Globally, continue to favour large caps over small and mid caps, because relative valuations are much more attractive. Large caps are less financially geared, and, hence, will suffer less from rising credit spreads; on average, they also have a higher exposure to emerging markets. We would reconsider our view, and become more optimistic on small and mid caps again, if we expected central banks globally to cut interest rates, thereby stimulating investors’ risk appetite.

Global Outlook
As we have already stated in previous issues of the GSO, ‘liquidity’ is probably one of the most dangerous words in the world of finance. Why is that? Because liquidity has an unstable meaning:  In some circumstances, it refers to the quantity of money outstanding in the economy; in others, it refers to the velocity of money circulation and more specifically to the demand for financial assets and the ability to trade securities without distorting their prices.

We maintain the view that there is a global excess of liquidity, a significant one actually, which has been growing ever since 2002, when policy rates were extremely low all over the world. But a global excess of liquidity is not incompatible with a sudden dry up of liquidity (in the second sense) a sudden collapse of demand for some securities, as we have seen recently for mortgage-backed securities.

U.S. Outlook
Credit market disruptions spread swiftly and violently out of the non-bank financial sector and into the banking system during Q3 2007, and this in turn provoked a reversal in U.S. monetary policy. Prior to the onset of the credit market disruptions, the pace of U.S. household borrowing was already cooling off as the housing contraction deepened.

The shift of the Federal Reserve onto an easing path no doubt helps speed the adjustments ahead in the U.S. economy, but it would be foolish to assume that Fed easing will magically and immediately remove the challenges of addressing the large financial sector imbalances that have built up in recent years.

Continental Europe Outlook
For a long time, we did not share the concerns generated in some quarters by the strength of the Euro. We argued that it was a factor second to the strength of global demand. Furthermore, we could not see any material impact in the trade balance data and thought that fluctuations in the price of oil were the critical factor. We must say that the accumulation of data is now prompting us to question our previous beliefs: the trend seen in the trade balance since late 2004 starts to support the argument that the Euro is too strong.

U.K. Outlook
Of all the major markets working their way through the credit crisis, the U.K. has probably had as difficult time as any. The simple explanation is that the drying up of liquidity had its origins in the U.S. sub-prime mortgage market, but local factors have also played their part, none more so than in the U.K.

The Bank’s initial response was to do nothing, since (so the argument went) pumping liquidity into the market would create moral hazard. The Governor, Mervyn King, was loathed to have his actions interpreted as helping those that had lent recklessly, since this would mean that there was no disincentive for them to do the same again.

Japan Outlook
During the period April-June real GDP annualised growth rate was -1.2%, which was below expectations. Backlash against strong growth rates in previous quarters (+5.5% in Q4 2006, +3.3% in Q1 2007), combined with a capital expenditure slowdown, dragged this quarter’s number down. Economists started revising down their 2007 real GDP forecasts, and consensus also declined from +2.2% to 2.0%. However, this is still above the potential growth rate of the Japanese economy, and given recent strong machinery orders of +17% month over month in July and sound Q2 corporate earnings, we still believe that an expectation of recession is too pessimistic. However, there are two concerns: political turmoil and the U.S. subprime problem.

Asia-Pacific Outlook
The quarter saw Asian economies continue to perform well with upward GDP growth revisions in most countries. In particular, robust domestic demand and strong industrial production explained most of the acceleration in the economic growth in the region.

Growth in India was led by a 10.6% rise in both industry and services. In China CPI inflation soared sine last November, largely driven by rising food prices; while Hong Kong posted a 1.2% rise in GDP for Q2 2007 fuelled by consumer spending. In Korea, limited holdings in sub-prime related assets has helped ensure sentiment here remains buoyant.

Commodities Outlook
Commodity prices are determined by both microeconomic and macroeconomic factors: when prices rise sharply and for a sustained period of time, as they have in this decade, high prices act to ration demand and encourage supply. We have been seeing some of this over the past two years or so.

If past central bank tightenings and the more recent global credit crunch adversely affect economic growth of the developed world, global GDP growth based on the exchange-rate measure should slow further, perhaps significantly. If it is valid that this measure of global GDP growth is what matters most to tradables, the macro case for the commodity bull market would be seriously undermined.