MARKET OUTLOOK – Summer 2010

We have long expected a half-speed economic recovery to materialize once the initial rebound ran its course, and that now appears all the more certain. The v-shaped recovery is moving into history and being replaced by a new, slower growth phase.

EXPECT SUBDUED GROWTH AND LOW INFLATION

In early May, there was a preponderance of bearish signs, both within markets and emanating from the global economy. This noise has temporarily drowned out the more positive signals coming from a gradual rise in U.S. employment and incomes, ongoing low borrowing costs, unusually attractive equity-market valuations and surging profit growth. Investors are still hypersensitive to global macroeconomic events, so even in the context of continued gradual improvement in underlying conditions, more short-term dislocations like the May sell-off in equities can be expected.

With the exception of the U.K., where a variety of temporary factors are clouding the data, inflation remains subdued in most developed economies. In fact it is the risk of deflation, particularly in Europe, that has emerged as a near-term concern.

U.S. DOLLAR STRENGTH SHOULD PREVAIL LONGER TERM

In a world of risk aversion and uncertainty, currencies have again proven to be the most liquid way for investors to pass judgment on the relative merits of national and regional economic policies. The U.S. dollar, which only six months ago was written off as the main reserve currency, has solidified its status, at least for now. Foreign investors realized that while the Eurozone constituted a single currency zone, it did not represent a single bond market and thus did not offer a true alternative to the U.S. dollar and Treasury bonds. While vulnerable in the short-term and extremely overbought, the U.S. dollar is still attractively valued and should strengthen over the next year as we near the beginning of Fed tightening.

SHORT RATES TO REMAIN LOW FOR NOW

Central banks in most developed economies remain focused on supporting growth and battling against any threat of deflation. Eventually, pressure to boost rates will begin to build as sustained economic growth returns, employment levels rise, asset values reflate and confidence in the financial system strengthens.

EXPECT LONG-BOND YIELDS TO TREND HIGHER

The crisis in Europe caused a drop in yields as investors fled riskier assets. In the near term, sentiment will continue to be dominated by worries of contagion from Europe, slowing growth and falling inflation. Once markets achieve greater confidence with how Europe’s governments are addressing their fiscal woes, the desire to earn a “normal” real rate of interest should once again push yields towards our mid-year 2011 projections.

EQUITY VALUATIONS REMAIN ATTRACTIVE

After the worst earnings recession in a half-century, profits have already recovered half the ground they lost on a peak-to-trough basis. More remarkable still is the fact that this has occurred even as revenues have only recently begun to move above recessionary lows. The main reason for these soaring profits is that companies responded to the severe recession by significantly cutting expenses. If revenue growth continues to build momentum, an epic profit cycle could be upon us. In addition, equity valuations remain near the most conservative levels of the postwar era across the major economies.

REMAIN OVERWEIGHT EQUITIES, UNDERWEIGHT BONDS

As a response to rapid shifts in volatility, our approach to asset mix has become somewhat more tactical, while still adhering to our longer-term view that stocks are trading well below normal valuations. As a result, we have made some adjustments to our asset mix over the past quarter. We remain overweight equities given the upside potential as the economy gradually evolves from recovery to expansion. We are underweight bonds versus the benchmark as a result of low total-return prospects.

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