International equity markets, as measured in US Dollars by the Morgan Stanley Capital International World Index (MSCI), made positive progress during most of the first quarter of 2007, gaining 2.06%. Currency movements continued to play an important role for internationally diversified investors, with the same index delivering performance of 1.46% and 0.67% for Sterling and Euro based investors respectively.

On the face of it, these headline numbers might indicate an environment of steady progress, and this is certainly how the quarter began. However, a five day decline of 6.1% through the end of February, along with the usual accompanying media frenzy, served as a stark reminder that equity market progress can rarely be described as steady. Subsequently, market composure has returned, but the reasons for the short-term setback are an extremely useful reminder of some critical factors which will dictate future market progress.

Initially, markets were unsettled by a one day decline of over 8% in the Shanghai market, the largest fall in a decade, in response to rumours that the authorities would clamp down on speculative excesses in the trading of Chinese stocks. In reality, for some time the Chinese authorities have, quite sensibly, been gradually trying to reduce the liquidity available for speculation, and Chinese equities quickly reversed the setback. The point here is not whether the Chinese equity market is currently overvalued, or if recent progress has been too swift. Rather, this highlights the increasing importance the world places upon developments in this area which, along with countries such as India, currently provide the global economy with a natural offset to what might otherwise be a far more inflationary environment. This dilution of global inflation is due to the fact that the capacity to produce goods in the developing world has expanded much faster than domestic demand, thus creating a very broad base of excess capacity for the global economy as a whole. Rapid development has created pockets of global price inflation, most notably in some commodities, where China has become the world’s most dominant consumer. However, outside the arena of commodities, China has a very long way to go before its potential for more broad based consumption is fulfilled, as reflected by average annual urban earnings levels of approximately USD 3,000 in 2006. Going forward, maintaining growth at rates comparable to recent years will bring enormous challenges to the Chinese authorities, and it is unlikely that the path to global consumer dominance will be completely smooth. Nevertheless, it seems reasonable to assume that, at some point, the combined purchasing power of Chinese consumers will reach a level at which the world’s current inflation buffer is significantly reduced, if not removed. It is our opinion that this remains some considerable way off and, as such, global inflation rates are likely to remain below the levels that might otherwise accompany robust global growth rates.

This brings us to the other, and arguably far more important, catalyst for the sharp sell-off in late February, namely the outlook for the US economy. Whilst economies such as China’s may hold the key to future global prosperity, the US still firmly occupies this position at the current time. The US consumer is often referred to as the world’s "consumer of last resort" reflecting their apparently insatiable appetite for spending. However, as the population ages, and with the core of the economy gradually being outsourced to cheaper global producers, such as China, the spending of the US consumer has increasingly become independent of wage growth. Instead it has been funded from areas such as investment growth and home equity release, which are clearly not indefinite sources of spending. Together the importance and potential fragility of US consumer spending means that the outlook for the US economy will continue to dominate the fortunes of global equity markets for some time to come.

So, whilst the setback in China attracted a great deal of attention, it was weaker than expected US Economic data, and a misinterpreted quote from former US Federal Reserve Board Chairman, Alan Greenspan that really unsettled markets. Headlines reported that Mr Greenspan had warned of a likely US recession, whilst what he actually said was that there are some signs that the US is in the later stages of the economic cycle, and that it is possible we may see a recession. He added that forecasting one is "precarious" and that, while a recession may be possible, in his view this scenario was unlikely. These comments came at a time when the markets had enjoyed a period of unprecedented risk complacency, and also coincided with the release of data generally indicating slowing US economic conditions. As such, markets were due a period of more nervous behaviour, which was exacerbated by dramatic headlines around the US housing market, and lower quality "sub-prime" debt.

In relation to slowing US economic activity, this comes as no real surprise. For some time our outlook for US growth has been below consensus levels, and recent developments have simply moved consensus back into line with our outlook for a mid-cycle slowdown in growth. We remain of the view that this is the most likely scenario, under which current equity market valuations should continue to support further progress. However, the picture is certainly mixed, as reflected by present market positioning. Whilst equity markets appear to now be reflecting this consensus view, fixed interest markets are reflecting a far more aggressive slowdown in US activity.

In general, recent comments from the US’s monetary policy setting committee reflect our prevailing view. The Fed have an expectation of solid consumer spending, and a "moderate" overall expansion in coming quarters. They highlight uncertainty regarding prospects for the housing market, and "sub-prime" woes which are causing tighter credit conditions, although they believe that broader impacts on the economy are "likely to be contained". Where our outlook deviates is on inflation, which the Fed sees as the "predominant concern", with core inflation "uncomfortably high" and risks being to the upside. As outlined, we believe that global forces will serve to contain this "up-side" risk, thus creating a relatively supportive environment for equity markets, both in terms of economic activity and also relative stability of interest rates. Add to this factors such as persistently high merger and acquisition activity, and an enormous accumulation of purchasing power within the field of Private Equity, suggest to us that the environment will remain supportive for equity markets.

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