The global system needs to restore a sense of economic balance.  The major market rally, which began part way through the first half of last year, continued during the first quarter of this year.  However, we have witnessed significant weakness in global equities during the second quarter as large fiscal deficits and unsustainably high debt levels have once again raised uncertainties, whilst reports of China’s putative slowdown have also gathered pace.  Indeed, slower growth fears are not confined to China, with recent figures from the United States, such as export data, suggesting that the delicate economic recovery in the US is losing momentum.

With mounting anxiety regarding a less rapid growth rate in the world economy, investors have driven markets lower in recent weeks and worries have been escalating that this apparent slowdown will lead to a ‘double dip’ and possible renewed recession.  We consider that this is too early to call and several more poor data points would be required.  In broad terms, we feel that attractive market valuations are once again emerging, predominantly as a result of this nervousness.

We have long felt that this healing process would be both patchy and bumpy, but that global economic statistics point to a sustainable worldwide recovery within which asset prices can continue to respond positively as confidence stabilises.  Valuations do not seem stretched at present.  In part due to the extent of overseas earnings exposure, the UK equity market looks attractive even if the economy does not.  UK economic growth is forecast to be sluggish at 1.5% in 2011 and 2% in 2012 whilst earnings growth and momentum look set to provide good support.  Increased levels of volatility in equity markets may understandably dissuade certain investors, who may look for an assortment of returns from areas, such as credit and corporate bonds, at this point in the recovery.

The ongoing weakness in money and credit trends signals that debt reduction remains a major headwind for many Western economies.  The ‘unavoidable’ emergency UK Budget delivered by the new Chancellor of the Exchequer, George Osborne, on 22 June was calculated to persuade bond markets and global organisations that it was a realistic fiscal reduction programme, thereby protecting the UK’s credit rating, and thus far this seems to have been largely achieved.

The newly established Office for Budget Responsibility project a decline in public sector net borrowing from 10.1% of GDP in 2010/11 to 1.1% in 2015/16 which the Chancellor indicated should be achieved by a fiscal contraction of over 6% of GDP over the next five years.  Whilst 77% of this reduction is forecast to come from cuts in real spending, 23% is expected to result from higher taxes.  The proposed increase in VAT to 20% from January 2011 will be material in this respect and will put upward pressure on next year’s inflation estimates, albeit the postponement of the increase provides time for inflation to decline in the interim.

The debt crisis in Europe has at long last resulted in a tough policy response from the EU.  Arguably, this has been primarily designed to protect the banking system, which remains overleveraged and undercapitalised.  Should the combined governments not have agreed to help support Greece and other Eurozone countries financially then several German banks may have been directly at risk.  Concerns persist about the health of a number of the Eurozone banks and we will see the result of stress tests later this month, which will determine how much fresh capital will need to be raised.

In coming years, it seems probable that there will be partial sovereign debt defaults and significant reforms to the euro.  An adjustment to repayment terms, perhaps by extending redemption periods and altering the coupons payable, coupled with the creation of a two (or more) track currency, seem possible.  In the near term, it seems unlikely that the euro will strengthen significantly from its present global trade weighted exchange rate.

Decisive cost-cutting implemented by businesses while going into the economic downturn, most notably by US corporations, means that the resulting sharp increase in profitability should continue.  Ongoing benefits of operational leverage lead us to remain focussed on cyclical sectors alongside core themes of multi-nationals, solid cash generation and powerful global franchises.  Given an apparently cheap relative valuation and a broad desire for reduced volatility, support for defensives is growing. 

Quality companies that should show consistently better than average growth, in what may continue to prove to be an otherwise challenging environment, are favoured.  In short, the current environment should lead to strong companies getting stronger.  There is mounting evidence of a rise in protectionism, which may prove to be a double-edged sword, as it risks extending the Western world’s woes, but specific businesses should benefit from this shifting political environment. 

The dollar is experiencing something of a two-way pull:  it continues to strengthen against the euro, but the recent move by the Chinese government to allow the Chinese renminbi to appreciate, as the nation continues its unmatched economic progress, seems likely to put some downward pressure on the dollar’s trade-weighted value.  Beijing does not want to dampen domestic demand just as government-fuelled stimulus programmes are coming to an end and Beijing recognises that its future lies in domestic demand and it will, as a result, worry less about whether its currency can support its exporters. 

There is seemingly little short-term inflationary pressure across the major economies and levels of excess economic capacity remain high.  It is suggested that recent fiscal tightening may hasten the descent into an even more deflationary, near-term situation and we do not disagree that a short period of deflation may materialise.  The unprecedented economic stimulus packages and continued low interest rates are expected to distort key policy and investment decisions and pose further risks to financial stability.  The likely response to such a turbulent situation is the printing of yet more money with consequent inflation risks in the medium-term, a situation we will be monitoring particularly closely in the coming months.



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