Global and economic outlook

In the first quarter of this year, ongoing weakness in the US as a consequence of the US mortgage crisis, the credit crunch, fears of potential spill-overs to other economies, and the bursting of real estate bubbles outside the US were the dominating theme in the capital markets. Since May, however, the fear of inflation has emerged as a second risk case among market participants. Regionally, our view has not changed compared to last quarter. We still like European equities. Our more cautious view on US equities reflects the uncertainties around the US real estate market. We are neutral on Japan strategically but are underweight tactically as Japan continues to disappoint economically. Even though companies are cash rich and even though Asia in total is booming, the equity markets are not recovering, as domestic demand remains weak. We are overweight emerging markets strategically, as we believe in continued strength in this these economies, especially in Asia.

Bond and equity markets

Since the last edition of the Global Strategic Outlook, both major asset classes, equities and bonds, have moved in the same direction – down. For the bond market, the decision by the Fed to bail out Bear Stearns by providing liquidity to JP Morgan turned out to be the turning point. Investors initially started to price in a re-flation of the US economy and, consequently, bond yields went up, because real interest rates, which had fallen to a low of 0.9% for Treasury Inflation Protected Securities with 10 years of maturity, have started to back up again. Equity markets globally started to come down again and have reached new calendar year lows in many markets.

Asset allocation

We have maintained our cautious view on bonds for several quarters now and it is only for tactical reasons that we have neutralized our bond exposure. We are also holding on to our overweight recommendation for equities strategically, as we expect policy measures to finally help turn around the economy, although this overweight position has been trimmed.

Thematic piece: expecting the unexpected: a closer look at the effects of inflation

Inflation is likely to surprise market consensus on the upside. Basically, because monetary policy globally has been too loose for too long in developed economies and still is in many emerging economies. Post the burst of the TMT bubble, central bank interest rates, in particular in the US but also in Europe, were cut to extremely low levels and far below ‘neutral’ levels, which are theoretically and empirically close to nominal economic growth rates. It’s no surprise, therefore, that money and credit growth has exploded in recent years and still runs at double-digit rates in the European Monetary Union (EMU). But monetary policy has not only been too lax in developed economies; in many emerging market economies, interest rates are way below economic growth. Hence, from a macro liquidity point of view, inflationary pressure persists.

US outlook

In the US, it is now evident that sequential, manufacturing production has dropped well into recession. Year-on-year (YoY) momentum in production activity for final goods has just begun to slip into recessionary territory, and given the sequential progression of manufacturing production, this is only just the beginning. Accordingly, it still feels too early to be positioning portfolios on a look through the valley base case, which many professional investors appear eager to adopt following the Bear Stearns bail out financed by the Federal Reserve Bank in March. Until sequential manufacturing production activity stabilizes, there remains too much risk that the depth and duration of the valley will surprise professional investors. Looking through a valley, especially one that may not have been accurately surveyed to begin with, can be costly from time to time.

Continental Europe outlook

European economies have continued to make steady progress in the face of a weakening US-centric global economy and a resilient euro. This overall summary, however, masks an emerging divergence between some of the stronger northern economies, like Germany, where recent economic success has not been built on rapid property appreciation and leverage, and the more-Mediterranean economies, like Spain and Greece, where their inherited competitive position post the euro has facilitated a dramatic rise in economic activity.

UK outlook

Along with everywhere else, the main change in the UK over the last three months has been the deterioration of the inflation outlook. The latest numbers recorded CPI inflation at 3.3% for the year to May compared with 2.5% for the year to February, but more important is the change in inflation expectations. This has had a profound effect on interest-rate expectations. Whereas three months ago it was confidently predicted that there would be room for significant interest rate cuts, the view now is that the next move will probably be up, although there is not much consensus as to when this might be.

Japan outlook

Japanese companies’ recurring profits in the fiscal year March 2008 were down 0.8% compared to the last fiscal year. At the beginning of 2008, it was expected that March 2008 profits would be up 3.5% (YoY). Due to the appreciated yen, increased cost of raw materials, and the subprime problem, the actual results were worse than recent expectations. Consensus for the new fiscal year (ending March 2009) is that recurring profits will be down by 0.5%, because analysts expect that the same negative factors will continue to affect corporate earnings over the new fiscal term.

Asia-Pacific outlook

In the first half of 2008, economies in Asia have been subjected to a series of severe natural disasters, political turmoil, dramatic stock-market declines, and high inflation. Despite this, the difficult tasks for Asian economies, particularly China’s, still lay ahead as they transition their massive industrial base, currently geared toward exports, toward more domestic endeavors, particularly agriculture and domestic consumption. With high inflation now sidelining the asset re-flation and infrastructure themes, Asia is now in the position to have to face the growing pains and tough choices associated with the recent, rapid shift away from a largely agrarian base to overcapitalization in other labor and capital-intensive export-oriented industries.

Commodities outlook

We have discussed the issue of the oil price in recent Global Strategic Outlook issues. Since then it has become a raging, high-profile debate – a debate we believe is worth reviewing. Let’s start with OPEC: they say the rising oil price is all speculation – nothing more. Treasury Secretary Henry Paulson disagrees: it’s all fundamentals, according to him. The Commodity Futures Trading Commission swings like a pendulum: a year ago, there may be manipulation; a month ago, no speculation or manipulation; a week ago, there may be manipulation.