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In recent months, the markets' mood remained largely unchanged from the start of the year and the same stories of rising oil, gold, and equity markets continued. That was until mid May when setbacks began and equity markets fell sharply. At the time of writing (9th June), the volatility continues. Generally speaking, it has been the markets which had risen the most in recent months that have fallen the most significantly.

For the last 3 years the UK market has traded in a narrow valuation range; but recent events have moved current valuations from the top to the bottom of this range. Profit taking and concerns over inflation and rising interest rates have created a shift in expectations and outlook. On a positive note exports are at an 11 year high and the strength in manufacturing is likely to be sustained throughout the remainder of the year, which will hopefully counteract the subdued levels of consumer spending.

The falls in equity markets were initially attributed to news that US core inflation came in for April slightly above expectations at 2.3%. The main concern was that rising energy and commodity prices could continue to push inflation levels higher in coming months. US rates increased to 5.25%, this could be the peak but the future will be very dependant upon forthcoming data releases. The current account deficit could become a driver of markets weakening the US dollar, and Sterling - which is currently over valued - is likely to fall in line with it.

Manufacturing remains strong in Europe as well as the UK. There has been an improvement in Europe which is hopefully a sign that consumer spending will see an upturn. Despite the anticipated growth in domestic spending there is still the likelihood of a slowdown in the second half of the year and a chance that the ECB could increase rates by another 0.5% before the slowdown occurs.

Japan released first quarter GDP figures confirming that its economic recovery remains on track. The GDP growth for the quarter was 0.5% (or 1.9% annually), which is slightly down on the last quarter of 2005 but it is the fifth consecutive quarter of rising GDP. The growth has been domestically generated which confirms the view that the growth is sustainable and the domestic-led recovery is looking more stable than it has done for sixteen years. Although global earnings growth is expected to slow throughout 2006 and 2007, the strength of Japan's domestic economy should ensure it does a little better than other regions.

China's domestic economy continues to surge forward. Furthermore, Chinese consumers are not as affected by the rising energy prices as consumers in the rest of the world since price caps on retail fuel are still in force. While the cap is likely to be raised (and the government has recently announced a price hike) the reality is that when compared to the rest of the world, fuel prices have barely risen in China. Interest rates have however recently been raised in China as there are some concerns about the economy over heating. In Hong Kong interest rates are anticipated to be 7% by August. Annual inflation is 1.7% but unemployment actually declined marginally in April from 5.2% to 5.1%.

The general consensus is that the markets that dropped the most were those that had increased the most in recent months, the implication being there was an element of profit taking in the market falls. For the next 12-18 months, markets look as though they could be subject to higher inflation, higher interest rates and slower global growth, this results from stronger than forecast GDP growth in the first quarter of the year. It is not yet clear whether the slowdown will result in market disruption or not; but the markets are expected to remain volatile in coming months. A downturn in the US normally means the same for Asia, but in this instance the slowdown in the US is focused on household consumption not business; so the outlook for Asia is not necessarily that gloomy. By comparison European growth is likely to remain more stable and is therefore an important factor considering the level of Chinese exports there. The rest of Asia's exports remain heavily linked to the fortunes of China and Japan. The region will look to these two countries to maintain robust export levels throughout any economic slowdown. Equally, we must not ignore the issues domestically affecting South East Asia resulting from reduced fuel subsidies, rising inflation and rising interest rates. While there will be regional fluctuations, the main threat globally - not just to Asia - is a slowing of China's GDP growth. Currently GDP growth for China is 15.4% (PPP-weighted basis) compared to 20% for the US, therefore globally as long as growth in China remains above 8% the outlook remains broadly positive. Should it fall below 8%, there is a good chance that Asian and global economies could fall into recession.

Rising inflation has lead to increased bond yields this year and the expectation is that high yield spreads will widen as newsflows deteriorate. Index-linked yields in the UK are over valued as a result of strong demand which shows no signs of slowing. Bond yields will fall later in the year as output growth slows and real rates are likely to remain at relatively low levels. The rise in short term interest rates and bond yields illustrates the tightening of monetary policy globally and confirms the anticipation of a slowdown in growth and activity during the second half of the year.

In May the US released unemployment figures that showed an increase of 75,000, which is the smallest gain in recent months, while the annual rate of wage growth fell from 3.9% to 3.7%. While this in itself is not particularly negative for the US, figures released on a weekly basis relating to employment do concur with the slowing GDP growth that is forecast for the US. The US now has to perform a balancing act of managing interest rates to curb inflation whilst being conscious of the risks if monetary policy is overly tightened.

The theory of a slowdown for the remainder of 2006 and into 2007 is now being substantiated by the majority of economic indicators. Some of the setbacks will be quickly reversed as has been seen in recent years and some of the falls will be merely corrections of over valued markets. At present, the markets do not suggest the onset of a bear market but the volatility is likely to remain in coming months, making gains difficult to achieve; and, as such, the upward trend in markets will become more difficult to sustain. At such times, investors generally become more risk averse. Everyone will be looking for a moderate slowdown with the hope that markets will not fall far or for long and the hope of monetary policy easing will help support this. The main threat is the uncertainty over inflation and growth. We continue to look for a resolution of this uncertainty in the coming months.

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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.