Quarterly Review
The second quarter of 2007 has continued to be more buoyant than many of the perennial bears expected. There have, however, been a few upsets to keep investors on their toes - most notably in China when a large but short lived hiccup prompted China's Prime Minister to describe the economy as "unstable, unbalanced, uncoordinated and unsustainable". However, despite China reaching the highest level of inflation since early 2005 it is largely a result of increasing food prices. Non-food inflation remains relatively stable. It is the booming stock markets which are giving economic managers in China a headache. The US has continued to offer investment opportunities despite its slowing housing market and widening trade deficit. Indicators suggest that there could be scope for improvement in the second half of the year, contrary to the recession that was anticipated earlier in the year. The housing market remains a threat to the wider economy though. The strength of the UK housing market has resulted in further interest rates rises. Whilst they were left on hold in June at 5.5%, it was a close vote - and against the advice of the Governor of the Bank of England, Mervyn King, who voted to increase rates to cool inflationary pressures. Europe has continued to show strong industrial output, (particularly Germany and, to a lesser extent, France), illustrating that the region has coped well with higher interest rates and a stronger Euro. Overall the quarter has provided decent returns for investors with diversified portfolios.
Outlook Quarter 3 2007
Europe including UK Equities
There are signs that the UK economy is slowing slightly, with a small fall in inflation recently and earnings growth moderating; but inflationary pressures still exist and it is possible that there could be a further interest rate rise in August. Concern is starting to creep in regarding the slowing housing market and further rate rises could result in bad debts. The MPC faces a balancing act in coming quarters. Good news stories surround positive earnings growth, profits growth and valuations; but the latest CBI survey shows manufacturing companies' pricing intentions are at their highest levels since 1995. Since there is a close correlation between pricing intentions and price inflation it means that industrial inflation could increase in coming months. If this is passed on to households in higher consumer prices, then interest rate rises could be prevalent for longer than expected. There seem to be enough reasons to remain optimistic about Europe. The region looks well positioned to take advantage of domestic drivers of profit growth. M&A activity continues to be buoyant and capital spending continues to be strong. If interest rates remain favourable and the consumer continues to spend, the next quarter should continue to provide investment opportunities.
US Equities
There are indications that the US may have passed the low point in the current mini cycle, first quarter growth was less than 1% but sentiment in the manufacturing and non- manufacturing sectors has started to improve, this is generally synonymous with actual output growth. There are also early indications that the housing market is stabilizing and an increase in capital goods orders will hopefully lead to stronger investment spending. There is plenty to be positive about in the US but similar to the UK and Europe, improvements could easily be derailed by the Fed if interest rate policy is not handled correctly, or if the housing market worsens instead of improving.
Asia including Japan Equities
Japanese GDP continues to be disappointing. Although first quarter GDP increased at a reasonable pace (making recovery better than it has been since the 1980s), the sources of growth are uninspiring for long term stability. Consumer spending has risen strongly but business investment shows little sign of improving. Output remains heavily dependent on exports, which are largely responsible for the increases in GDP. It is unsurprising that the Bank of Japan has recently avoided increasing rates since slipping back into deflation (and the carry trade exploiting the differential between Japanese rates and those of the rest of the world) will do little to reduce yen weakness. Elsewhere in Asia the story very much depends on who you believe. Liquidity has driven global equity markets higher than expected recently and a significant proportion of this can be attributed to Asia where excess savings are making their way into western economies and inflating asset prices there. Domestic demand continues to grow and appreciation of currencies allows for more flexibility in monetary policies. However, some believe that the Chinese will come under pressure to slow the economy if it continues to grow too rapidly and this will have a knock on effect for other local markets. How positive you are regarding the region very often comes down to whether you reside within Asia or not. Western-based commentators appear to be skeptical regarding the sustainability of recent growth. Local sentiment however, acknowledges the scope for growth and continues to look for opportunities.
Summary
Bond yields have hit the headlines recently, this is a general indicator that the outlook for the US, Asia and Europe shows signs of strength and as such yields could continue to rise later in the year, particularly in the US if rates are not cut. While there is still the possibility that anything could happen (we still believe that growth will ultimately be slower during 2007), at the mid point of the year, key indicators are significantly more optimistic than they were at the start (when nervousness surrounded the US and the potential for a global slowdown). The current bull market is into its 4th year now and valuations are still reasonable as earning have soared. This does suggest caution should be considered as with earnings so far above trend a correction could be likely; but the near term outlook in the majority of areas (if we discount the completely unexpected) looks favourable based on forecasts for sustained output growth and low inflation. Although problems rippling out from the US sub-prime mortgage mean that the markets have entered a new and dangerous phase, we continue to believe that the markets will end this year higher than they started overall.
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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.
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