Global Markets Weekly

• Uncertainties over the duration and impact of the credit crunch continue...
  Investors are facing an economic and market environment of heightened uncertainty. At its heart, this uncertainty stems from the impossibility of foreseeing the exact duration of the severe restriction in credit conditions or the scale of the credit crunch's ultimate impact on the real economy. Economic growth in developed markets is almost certain to slow over the coming year, but the rapid globalisation and industrialisation of emerging economies over recent years means that the degree of feed-through to these economies is unclear. Similarly, our cyclical analysis shows that a climate of slowing growth is not always negative for riskier assets, such as equities; other variables are also important.
• ...depressing equities to attractive valuations, but we remain cautious for now.
  Though unnerving at times, this uncertainty is a necessary negative condition for producing the current very attractive long-term valuations for global equities. However, portfolios still need to be managed with an eye to this near-term uncertainty. Acknowledging that neither we nor anyone else knows the future with certainty is a useful step towards building a robust investment process. As that famous US investor, Benjamin Graham, was fond of reminding his audiences, ‘an investor that thinks he knows all the answers hasn’t even understood the question.’
• We use scenario analysis to determine assets' potential relative performance...
  Our investment process uses a combination of scenario and cyclical analysis to form views on asset classes’ likely long-term and short-term relative performance. To determine if our current macro-economic view is playing out as expected, we track a broad range of economic and market variables. When the global economy seems to be deviating from our central case, we can assess which aspects of our risk scenarios are becoming more plausible. This scenario analysis is then used together with our cyclical model to calculate asset classes’ likely future relative performance.
• ...and our central scenario sees slowing growth reining inflation back in.
  Our current central scenario is for a protracted period of weak growth - to which emerging markets are only partly immune - with activity data worsening in coming months but with the economic downside limited by continuing fiscal and monetary policy action. Under this scenario, rising excess capacity will bring inflation back under control, enabling G7 central banks to focus on supporting growth rather than fighting inflation.
• But, if effective interest rates stay high, prolonged weakness could lead to a deflation scare.
  The key risk we see to this scenario is that, despite accommodative policy interest rates, effective interest rates in the real economy remain high, because the monetary transmission mechanism is broken. This would result in a longer period of weak growth and possibly result in a deflation scare next year. Our outlier scenario is one where growth does not slow further, and commodity and import price inflation feed through to a wage inflation spiral in developed economies.
• Although effective rates are rising, our central scenario still looks the likely outcome...
  Our current scenario-tracking work suggests that the central case remains the most likely approximation to the actual economic outturn over the coming year. However, some elements of the key risk scenario are already evident, particularly the continued rise in effective interest rates.
• ...which should help equities in the medium term. Improved credit conditions would give confidence a near-term boost.
  Our cyclical model suggests that the central scenario would be mildly positive for developed economy equities. However, because of the downside potential associated with the key risk scenario, we remain defensively positioned in portfolios on a near-term view. It also suggests that an important factor which could drive equity market confidence in the short term is any improvement in credit market conditions.

Indices, Interest rates and Inflation

	Close 25-Aug-08	1 Week%	1 Month%	3 Months%	YTD %
FTSE ALL Share	2,803	0.9	3.0	-9.5	-14.7
FTSE 100	5,506	1.0	2.9	-9.6	-14.7
S&P 500	1,267	-0.9	0.7	-7.9	-13.7
Nasdaq Composite	2,366	-2.1	2.4	-3.2	-10.8
DJ Stoxx (Europe)	311	-2.3	-1.4	-13.4	-25.0
Nikkei 225	12,879	-2.2	-3.4	-8.1	-15.9
Hang Seng	21,105	-0.8	-7.2	-14.6	-24.1

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Sep-08 Forecast	Dec-08  Forecast	Current	Next Date
US (Fed Funds)	2.00	2.00	2.00	5.6	16-Sep
UK (Base rate)	5.00	5.00	5.00	4.4	04-Sep
Euro-zone (Repo Rate)	4.25	4.25	4.50	4.0	04-Sep
Japan (Call rate)	0.50	0.50	0.50	2.0	17-Sep

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