Financial Management (Scotland) Ltd

Since the financial crisis erupted last year, the authorities have resisted the temptation to raise interest rates despite the sharp rise in commodity prices but - with headline inflation exceeding government targets in 80% of countries - central banks appear to have been forced into a 'U' turn and investors now expect rates to rise rather than fall. This comes at an inauspicious moment as banks struggle to raise large amounts of capital to rebuild their balance sheets.

While the developed world remains at the heart of the global economy, the rapid industrialisation of countries like China and the transfer of wealth to emerging economies remains a dominant theme. China - and others - is generating substantial incremental demand for oil and other commodities and distorting markets in the process. Within this structural theme, the economic cycles need to be managed appropriately and this includes inflation where the pressures are acute. Measures are being taken to bring growth back to a more sustainable trend with adjustments in reserve requirements, policy rates and currency appreciation. This is happening not just in China but in other Asian countries and Latin America. Under these circumstances, risk asset valuations tend to contract despite continuing high growth rates.

The Organisation for Economic Co-Operation and Development (OECD) leading indicator has been in decline for ten months leaving the developed world at its weakest point since the last recession. We see high-energy prices as more of a threat to growth than inflation and believe a 'tipping' point has been reached which should result in significantly lower demand in both developed and emerging economies. Total real expenditure on energy is now approaching levels last seen in early 1980's while globalisation means there is little scope to pass on cost increases. Although parts of the emerging world are cushioned by energy subsidies and those with large fiscal surpluses theoretically still have considerable leeway, the situation overall is unsustainable. Given that core inflation in the developed world remains low, wage settlements are modest and unit labour costs are even falling in some regions, it seems an inappropriate policy response for western central banks to be considering higher interest rates in order to combat a global - rather than home grown - problem.

The US economy has slowed but the rate of decline is not precipitous and so far outright contraction has been avoided (2008 GDP 1.6%). Aggressive interest rate cuts have helped but the housing market remains in the midst of a substantial correction and the backlog of inventories may not clear until 2009. Against this background, it would not be surprising to see financial problems extend across the wider banking spectrum. Energy and food costs have undermined consumer confidence but tax rebates should help boost growth over the next couple of quarters. Business confidence has also now deteriorated which probably indicates that tighter credit as much as energy costs is the limiting factor in addition to the weaker outlook for exports. We expect the forthcoming reporting season to result in downward revisions to corporate profit estimates.

As with the US, UK growth is suffering the consequences of the financial crisis, a weak housing market and the erosion of real incomes as a result of higher energy prices. The Bank of England's focus of concern seems to have shifted towards inflation but the credit crunch remains all too apparent in the real economy as demonstrated by the significant premium on 3 month LIBOR, higher overnight versus 12 month interest rates, tighter lending criteria and the contraction in mortgage availability. On balance, we expect the UK to struggle through (2008 GDP 1.7%) but next quarter could see an outright decline in growth. Job losses associated with economic weakness will be mainly contained by lower participation rates and reduced inward migration so - even if house prices fall 20% from their peak - consumers should escape a material cash flow impact providing interest rates do not rise.

Two regions which have been performing relatively well are now weakening. We expect growth in the Eurozone to decline next quarter as weaker construction and stagnant consumer spending offset strong exports. Headline inflation is probably peaking but will stay above 3% for several months prompting the European Central Bank to signal a 0.25% interest rate rise in July as a warning to private and public sector wage negotiators. Strong exports over the last couple of years have also kept the Japanese economy alive and more than offset stagnant consumption and sharp declines in business investment and housing construction. However, as global activity slows, so too will Japan which in our view remains a trading market predicated on exceptionally cheap valuations and improving corporate governance rather than growth.

Investor sentiment is depressed but it is around this point that longer-term value tends to emerge in risk assets especially where valuations are reasonable. Periods of economic slowdown are usually associated with a significant decline in corporate profits as operational gearing works in reverse but the economic, profits and share price cycles do not move in unison. So, while economic growth started to weaken last summer and profits growth peaked last autumn, share prices in some sectors have already experienced peak to trough falls equivalent to those seen in previous recessions.

Glossary

Bear Market: A market in which prices decline sharply against a background of widespread pessimism

Dow Jones: A set of indices compiled daily from New York Stock Exchange closing prices. The averages are unweighted arithmetic indices, useful for showing general price movements. The Industrial Average consists of 30 industrial stocks. Referred to as the 'Dow Jones' and is probably the most widely quoted US index.

FTSE 100: An index of the Share prices of the 100 largest companies (by market capitalisation) in the UK.

G7: The world's major financial nations –Britain, Canada, France, Germany, Italy, Japan & United States

GDP: Gross Domestic Product – A measurement of the aggregate goods produced and services provided within an economy over a year and excluding income earned outside the country. Considered one of the main yardsticks of the health and vitality of an economy. See also Gross National Product.

RPI: Retail Price Index - A monthly indication of the average price changes to a particular ‘basket’ of consumer goods, and used as a general indicator of price inflation.

S&P 500: A United States stockmarket index, maintained by Standard & Poors.