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Economy has knack of correcting itself

Only a few months ago the world was worrying about too much growth, the associated rise in inflationary pressures and the consequent impact on global interest rates. These concerns led to a temporary correction in markets in May and June, with those markets that had benefited most from abundant global liquidity suffering the greatest setbacks. Indeed, many emerging markets suffered the heaviest corrections, with declines of nearly 25 per cent in some cases.

But let’s not forget that these were the same markets that had risen in January and February this year, building on the very strong gains seen in the past few years. Make no mistake, we have seen corrections in the past and will see them again – twice last year, in April and October and once this year – but progress can still be made over the medium to longer term.

We should not get too downbeat. The global economy is mature, and although growth is perhaps more synchronised than for many years – helped in no small way by strong development in the emerging markets – there are already signs that activity is slowing in response to previous tightening in monetary policy led by the US. The US Federal Reserve is currently on hold and if evidence of recent pressure on the US consumer gathers traction – which seems likely – we may have already seen the peak in US short-term interest rates.

Equally, the Japanese economy is not as strong at this point as it was expected to be, and growth in Continental Europe is certainly not running out of control despite what the European Central Bank might have us believe.

So as the world returns from its summer holidays, what does the outlook hold? At the moment clarity is required on a number of issues, and markets do not like uncertainty. Any sustained easing in global economic data in the coming one or two quarters will inevitably give rise to growing concerns for corporate earnings, which have been very strong recently. We suspect that clarity on the key issues of growth and inflation will take a little time to unfold, during which time markets – fixed income and equities alike – will be vulnerable to individual data releases at both country and company level and of course we are entering the time of year which is traditionally a more unstable period historically.

But beyond the next few weeks or months, sentiment is likely to stabilise and investors should become more comfortable with the idea that the world is not falling apart and this is likely to coincide with a better outlook for interest rates.

Remember that, according to the Credit Suisse strategy group, since 1981, the average gap between the last Fed rate rise and the first cut has been 120 days (lowest 42 days and highest 232 days). On this basis we could be looking at a possible rate cut in the latter part of 2006 but more likely early 2007, with inflation pressures easing somewhat and company profits still able to grow healthily, albeit at a slightly more pedestrian pace?

With merger and acquisitions activity still likely to be a feature of 2007, and with de-equitisation (share buy backs reducing the supply of equity) still very much in vogue, we believe that there is not too much to fret about and 2007 is likely to again be a year of reasonable equity returns. With pressure easing on interest rates a strong possibility, fixed income should also prove a little more rewarding. Take a medium-term view, invest carefully and happy clients should be the result.

Gary Potter is co-head of multi-manager at Credit Suisse

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