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Safety thirst

The MSCI AC World index fell for a second consecutive month in July, down by 1.53 per cent in dollar terms, as the fallout from the US sub-prime mortgage crisis spread to lower-quality corporate debt, pushing yields higher.

We saw a flight to safety and strong demand for government bonds. Gains in government bonds and investment-grade fixed-income markets were enough to offset losses elsewhere and the Lehman Global Aggregate index rebounded from recent losses to post a gain of 2.03 per cent.

Stockmarkets posted strong gains for most of last month as investors took encouragement from generally robust economic indicators and mostly positive second-quarter earnings results. But markets plunged in the final days of July as sub-prime mortgage defaults showed signs of spreading.

Financials were the worst performers in the MSCI AC World index. The more cyclically sensitive information technology, industrials and materials sectors held on to some of their earlier gains to finish the month in positive territory. The energy sector outperformed as WTI Cushing oil prices surged.

All major equity indices suffered losses in local currency terms while the MSCI Pacific ex Japan index was the only one not to fall in dollar terms, due to a sharp drop in the dollar against some Asian currencies.

Emerging equities posted strong gains, with the MSCI Emerging Markets index up by 5.28 per cent. Asian stocks were pulled higher by gains in Hong Kong and Singapore.

UK and European stocks, having been the main beneficiaries of merger and acquisition activity, were some of the worst hit among major markets in July as steeply rising corporate bond yields in Europe, as well as the US, cast doubt on the future of LBOs.

US stocks were plagued at the end of the month by fears that housing market weakness and worsening credit conditions might drag the economy into a slowdown but the bulk of data and earnings’ reports were positive.

Yield spreads widened over the month as yields on riskier non-government bonds continued to rise sharply while government bond yields fell. The worst-affected sectors apart from the sub-prime market were poorer-quality corporate bonds, bank loans and asset-backed securities and emerging market debt. Investment-grade bonds all fared well.

A rebound in US economic growth in the second quarter and continued strength in corporate profits have alleviated some of the concerns of global equity investors over rising bond yields and weakness in the US housing market.

Mark McCarron is senior client portfolio manager at SEI

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