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As it has to some for several years, the global economy looks like a train wreck in slow motion these days: slower growth, largely resulting from a tightening of monetary policy in a number of countries, oil price increases, a collapse in the US housing market and difficulties in global financial systems. The key issue is whether we now face deflation induced by the credit crisis and the ensuing recession, or high inflation (reflected in higher prices for all sorts of commodities, goods and services), or whether we’ll just muddle through?

Gains in equity markets during the first half of the year have been broadly based from a regional perspective, the greatest disparity of returns has been at a sector level with resources performing significantly better than financials, healthcare, telecoms and consumer sectors. Equally there has been a divergence of fortunes between the US and emerging markets. While emerging markets are decelerating, the slowdown is moderate. Despite exports to the developed world having weakened slightly, there are still positive trade flows between the emerging economies - and in some instances they are strengthening further.

There has been much talk of the decoupling of various economies. It is important to identify why there has been a divergence between developed and emerging economies. One of the key reasons is the effect of low real interest rates and attractive exchange rates. Furthermore, the financial systems of emerging economies have not experienced the problems of more developed countries. There has not been a melt down in the housing sector as there has been in the US - or, indeed, even a slowing of property prices in many emerging economies. Emerging markets are often significant commodity exporters and consequently have benefited from the commodity boom. The resilience of such economies may suggest that global growth is actually more robust than a US focus may imply?

A subject where there is more of a consensus is inflation. Headline rates are at the upper levels of where central banks feel comfortable and countries such as China, Taiwan and Singapore (who are new to inlationary pressures) are now experiencing rates in excess of 5%. In developed countries, inflation increases have largely been driven by higher commodity prices. If food and energy inflation is removed from the calculation, there is little sign of acceleration. This is not the case for emerging markets, where core inflation rates are steadily increasing. The bears will argue that inflation rates in developed countries have been uncomfortably high for sufficient time that central banks will need to re-define their expectations. Conversely the bulls are suggesting that there is little sign that commodity-driven issues are being passed to the wider economy and it will all play out, given time. This could be the case in developed countries as many of them show signs of slowing. Sub-trend growth could continue through 2009; so monetary tightening measures are not expected to be overly stringent. The converse is true of emerging economies where growth is slowing only moderately, core inflation is increasingly substantially and capacity pressures are evident.

What next for equities as we enter the second half of the year? The rally in equities has not been driven by strong fundamentals. It was more a short-term bounce in a period of slowing growth. While results from US earnings have been much more positive than expected, there are dangers on the horizon. Slow economic growth and threats to corporate profits spell danger for equities. Profit margins remain high and have largely been driven in the recent past by the financial sector. With concerns that earnings are too high given the current climate, falling profits are likely to result in lower PE multiples and equities are likely to feel further pain as this year progresses. The overall macro environment shows little to support an argument to the contrary.

There are two areas that can provide support to equities, firstly PE ratios are fairly low and equity valuations relative to bonds seem supportive which can imply that earnings concerns have already been priced into the equation. Secondly an easing of monetary policy will be supportive for equities. This will not happen immediately or significantly while inflation concerns loom but looking into next year central bank policy may ease. Further discomfort for equities looks certain therefore in the short term, a weak macro environment clashing with supportive measures and a reasonable valuation background leads to volatility. Hold on to your hats.

Despite commodities driving headline inflation higher, an ailing housing market and a general economic slow down, the US may have managed to avoid recession. The coming months will call for a careful balancing act from the Fed in trying to create a soft landing whilst desperately hoping the financial crisis does not spread to other sectors, inflation remains under control and earning do not start to disappoint.

Europe is now starting to slow. Energy costs and the strength of the Euro are starting to take their toll. Regional performance is likely to be a key differentiator as the earnings season has delivered a range of results in which automakers and technology companies have been affected by disappointments in other markets, primarily the US. Whether Europe can decouple from events in the US over coming months will be important for the non-emerging-market countries.

The consensus is that the UK will weaken further. Business spending and exports remain weak despite the ever-optimistic consumer. Further falls in the housing market will ultimately affect confidence as interest rates are unlikely to fall until next year. Two thirds of UK profits come from overseas and large cap M&A activity could be positive for the economy but earnings disappointments and a heavy reliance on the financial sector could continue to undermine equities.

The two main threats to Asia are the slowdown outside the region and high commodity prices. While conditions remain positive in most of the region there is a visible lack of momentum as inflationary pressures start to affect some economies. Domestic demand is important to prevent the slowdown hitting too hard but equally, if there are no signs of weaker economic activity, shortly monetary policy will have to be tightened in a number of economies which can have the knock on effect of currency appreciation problems. Some Asian central banks clearly favour this approach in the hope of suppressing imported food and energy price inflation in particular.

Although data from Japan have exceeded certain expectations recently, if expectations are low it is still no cause for great celebration. The economy still seems unable to gain traction. There is scope though for gains in global industrial recovery and for investors to continue their dalliance with equities over bonds proving positive for the economy. At the time of writing there has been another increase in inflation just as the Bank of Japan ceases to speculate on increasing interest rates and the appetite of local investors can change erratically making this an area to watch closely.

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This commentary should not be seen as a recommendation or solicitation to invest. Anyone considering investing should first seek advice specific and appropriate for their own needs, objectives and risk appetite.