Quarterly Market Overview

as at 30th June 2011

The world economy began this year with strong momentum but appears to have stalled in the past few months. US corporate earnings have so far held up well. Investors’ appetite for risk waned in the second quarter as the end of the Fed’s second round of quantitative easing approached, the global economy showed signs of cooling and the euro-zone’s fiscal crisis intensified. 

Investors have scaled back their expectations of monetary tightening significantly in recent months, even in the euro-zone, where the ECB raised rates again in July. Concerns about the economic outlook and investors’ reassessment of the prospects for interest rates have led to a sharp drop in yields in highly-rated countries, but yields have risen further in troubled euro-zone countries. Spreads of developed corporate bonds have widened a little, especially further down the credit spectrum. In the US 7-10 year sector, spreads of BBB-rated bonds are now fractionally above their decade average. Emerging market bonds have had a difficult period, reflecting heightened global risks and local worries about inflation, monetary tightening and, in the Middle East, political unrest. 

Equities and commodities (with the exception of precious metals) generally struggled, but highly-rated government bonds fared much better as expectations of tighter monetary policy were scaled back. Even in the US bond market, worries about the economic outlook continued to trump concerns about a possible default or credit downgrade. US equities have struggled amid signs of slower economic growth and deepening fiscal crises at home and abroad. The end of QE2 in June has also curbed investors’ appetite for risk. Commercial property markets in the UK and in the euro-zone have remained fairly static with little movement in either rental values or initial yields.

Except for commodity producers, emerging market equities have generally underperformed. The worst laggards have been those economies where the risks of overheating are assumed to be the greatest, and those most directly affected by the unrest in the Middle East or the debt crises in the euro-zone. Many commodity prices have fallen back since May, notably agriculturals. But oil prices still include a substantial premium for the problems in Libya, while gold has continued to hit new highs on strong safe-haven demand. Perceived “safe haven” currencies have also benefited: The euro-zone’s rolling fiscal crisis has taken its toll on the euro. But with the US mired in its own debt spat, the Swiss franc and the yen have benefited most from safe-haven flows.

OUTLOOK 

The global financial crisis that began with the banks was only ever temporarily resolved by shifting risks to governments and has now resurfaced in sovereign credit markets. The necessary fiscal tightening will be a drag on developed economies for many years, undermining equities and the prices of industrial commodities, but also keeping interest rates and high-grade government bond yields low. Even if the US loses its AAA rating, we continue to expect 10-year Treasury yields to end the year at around 2.5% and stay there for some time. We also expect the dollar to be seen again as a less bad prospect than the euro. Gold should continue to benefit from strong demand for a safe haven, but some emerging markets deserve this status too.