July 16, 2010

Global economic momentum has slowed over recent months, leading to volatility in the financial markets and reductions in economic forecasts. We have reduced our U.S. growth forecast because of several factors, including weak credit creation, reduced state and local spending, and the effect of global austerity programs on growth. Specifically, we lowered our forecast for the second half of 2010 growth from 2.5% to 1.8%. The new orders component of global purchasing manager indexes, a leading indicator of economic growth, peaked in March and has been moderating since. This slowdown is to be expected after the cyclical rebound of last year but is riskier this cycle because of the reliance on government stimulus and the continuing weak outlook for credit creation.

Government bond markets reflect this slower growth outlook, with U.S. and German two-year notes yielding less than 0.75% and inflation forecasts dropping. As we reduced our growth forecast, we also cut our fourth-quarter inflation forecast from 2.0% to just 1.2%. These developments are mixed blessings for central bankers — with short-term interest rates in many markets already at record lows, there is little room for conventional monetary policy to support economic growth. But the benign inflation outlook does provide some cover for more aggressive liquidity programs, should they be required. We think the Federal Reserve is much more likely to consider additional monetary policy actions than the European Central Bank, which remains more focused on inflation.

The coming months will provide important insights into the ability of the global economy to transition to a self-sustaining recovery. The health of the European banking system, and its ability to support growth through credit creation, should become clearer in late July through the release of bank stress tests. Second-quarter corporate earnings will provide some insight into management “animal spirits.” Finally, developments in the Chinese property markets will indicate whether policy-makers can start to take their foot off the monetary policy brake.

U.S. Equity

• The equity market continued to decline last month, led by cyclical sectors
• Risk levels remained elevated against a backdrop of economic uncertainty

EAFE and Emerging Markets

• There is broad euro support for cutting public spending
• The Chinese policy-induced slowdown continues

Fixed Income

• Long-term inflation forecasts have moderated
• Economic data is softening, but not the start of a “double dip” recession

High Yield

• High-yield bond spreads should compensate for credit default risk
• At current spread levels, we believe high-yield bonds look attractive

Global Real Estate

• The FTSE EPRA/NAREIT Global Index posted negative returns in June
• Europe and Asia/Pacific outperformed with positive total returns for the month

Hedge Funds

• Hedge funds were basically even in this year’s first half (–0.2%), besting equity markets
• Equity long/short hedge funds continue to outperform traditional indexes

Commodities

• Macondo well problems continue to pressure energy supplies
• Metals may rebound with Chinese infrastructure spending

Conclusion
While we still believe the global economy will avoid a “double dip,” the odds of a disappointing growth environment have increased as government spending falls and credit creation remains challenged.

The global economy may be at an important inflection point. Some European nations, pushed by the Greek debt crisis, have chosen a fiscal path that should shore up their credit ratings but hurt their growth outlook. U.S. policy-makers disagree, believing that additional fiscal stimulus is called for, given the fragile nature of the global recovery. This dispute leaves the transition of the global economy to a self-sustaining expansion unclear.