North America

  • Consumer sentiment in the U.S. continues to deteriorate but, thus far, it has not prevented shoppers from buying at a fairly healthy pace. However, the recent increase in retail sales was biased upward by auto sales, driven by low financing deals. So, overall, there are no signs of exhaustion but some signs of a slowdown.
  • Equity funds have been experiencing substantial outflows and bond funds have seen significant inflows. Investors’ risk aversion has resulted in government bond funds being greatly favoured. High yield was the only fixed-income category that was out of favour. Liquidity ratios in equity funds are low and fairly stable, which may reflect managers’ comfort level with exposure to the stock market. The risk is that weakness in the market and another round of redemptions may force liquidation to raise cash.
  • There is a cat-and-mouse game being played between Iraq and the United States. The mouse’s ploy to let UN inspectors in has not convinced the cat. In an eventual military confrontation with Iraq the United States is likely to win the war fairly quickly, but winning the peace will be a tougher challenge. Markets will react positively to the first event before possible problems with the second become evident.
  • The pragmatism and expediency of realpolitik point to the possible solution of a palace coup in Baghdad and the installation of a "friendly" dictator in Iraq, in charge of the security apparatus. Nurturing a democratic alternative may require the commitment of substantial military and economic resources to prevent the fragmentation of the country. However, a successful changeover would pose a threat to the legitimacy of various theocracies and autocracies in the Arab world. This would be very good for the global economy in the long run.
  • There are indications that Washington may be reviewing its relationship with Saudi Arabia. The rentier state has a model of economy and society that is not viable, longer term. It is failing to make a transition to modernity and its eventual breakdown could become a major source of instability in the region, and well beyond.
  • Apart from Iraq, the equity market’s main focus of attention is the outlook for earnings. Not much relief is to be had from interest rate reductions, so profitability is the major concern. The expected capital-spending rebound has not materialised and that will constrain profit performance.

Europe

  • With Germany running out of steam, the industrial sector in Europe continues to look weak. So the Euro-zone economy will experience only slow growth - - though there is little chance of a dip into recession. Unlike the United States, there are no significant outstanding imbalances to correct.
  • In the UK, fiscal policy is expansionary and will help to support the economy, even as monetary conditions also remain accommodating. This acts as an offset to subdued corporate spending and assists the consumer who is a little bit stretched in the face of slower income growth.
  • European equity indices discount slow growth in GDP and earnings per share - - and given low bond and money market returns, dividend yields are fairly attractive. One reason for the under-performance of equity markets is their relatively heavy weighting in cyclical stocks (compared to the U.S.) that acts as a drag in a slow-growing environment. Main European indices remain highly correlated with the United States and, currently, show few signs of decoupling.

Asia/Pacific

  • In Japan, the government is preparing another emergency package. Its main outline is: reform aimed at reducing the corporate tax rate, another try at disposing of the banks' non-performing loans and the use of public funds to sustain equity prices through the purchase of exchange traded funds. But the reduction in the corporate tax rate is going to be made revenue neutral, which will blunt its expansionary impact. Meanwhile, deflation is causing new additions to non-performing loans even as old ones are retired. As well, it is doubtful that equity prices can be sustained for long merely by support measures.
  • Sustained high oil prices will have a negative impact on non-Japan Asian economies, increasing their input costs and reducing their current account surpluses. On the other hand, a successful conclusion of the Iraqi situation and lower oil prices will be a significant boost to Asian economies.

Bonds

  • In the present situation, a quick "victory" in Iraq will have a positive impact on corporate bonds as risk aversion recedes a little. Currently, yields on investment-grade U.S. bonds are very high relative to equivalent-maturity Treasuries.
  • Low interest rates and bond yields have a damaging effect on corporate finances, via their impact on pension plans. Under-funded defined-benefit plans will have to be topped up. This will affect corporate profitability and constrain capital spending.

Currencies

  • The U.S. dollar has risen to a four-month high on a trade-weighted basis. This move is based on favourable geo-political developments and disappointing economic performance outside the United States.

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