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Significant Breakdown

August 10, 2011
US and European politics have failed to provide credible solutions to their respective debt problems, adding momentum to potentially self-fulfilling prophecies of gloom. As a result, the economic outlook has become more uncertain, and a quick restoration of full confidence more unlikely. We therefore decided to reduce our equity exposure.

Global sell-off of growth-sensitive assets
Persistent worries about the sovereign debt problems in the US and Europe have been weighing on markets for some time. They culminated in a significant and accelerated global selloff in equities and commodities last week. Economic growth has slowed by more than expected in recent months and the debt issues highlight that most big economies won’t be able to respond with fiscal countermeasures if they fall back into a recession. The MSCI World global equity index dropped by more 10% since last Wednesday, on top of a more normal 6% decline in the preceding week. As a result of last week’s selloff, most stock market indices have now technically broken down in a manner that suggests the bull market that began in 2009 may have been aborted.

US appears incapable of producing credible long-term compromises
This selloff came after US lawmakers failed to agree on a credible long-term fiscal consolidation program, and as Italian and Spanish sovereign borrowing costs continued to rise. It intensified after Standard & Poor’s, one of three major credit rating agencies, downgraded the US long-term rating to AA+ from AAA. Belated efforts by the European Central Bank to support Italian and Spanish bonds failed to revive broader confidence in financial markets. The US and Eurozone had reached framework agreements on their respective debt issues, but in both cases many important questions had been left unanswered. In the US, most of the savings will be decided at a later date and many issues remain contentious. In addition, the overall amount of savings was considered as too small by S&P and many other analysts. In practical terms, the S&P downgrade is negligible, but it was nevertheless a serious and visible expression of concern about the ability of the US political system to reach pragmatic and workable long-term policy compromises on important matters.

Belated efforts to avert debt crisis reaching Italy and Spain
The Eurozone has its own political divisions, and has also postponed difficult decisions into the future. European leaders had recently agreed to expand the powers of the European Financial Stability Facility, but failed to provide additional capital to make that decision credible. Partisan politics in Italy and opposition to helping weak member states in core countries represent further obstacles that could derail joint efforts to resolve the problem. Consequently, the borrowing costs of Spain, Italy, and even Belgium had been rising over the past weeks, in sharp contrast to the prevailing trend in all other developed economies. US, German, British and Japanese debt yields have slumped to levels that imply another global recession, if not a deflationary depression.

Markets are likely to come under pressure again
Indeed, economic conditions have worsened somewhat since June, when we set our investment strategy for the current quarter. At the same time, it’s worth noting that we still see little evidence to
suggest another recession. However, markets can create their own realities. Negative perceptions can reinforce themselves, and add momentum to a downward cycle of potentially self-fulfilling prophecies. Such cycles can only be ended by extraordinary measures, such as the US Federal Reserve's pledge yesterday to keep interest rates near zero for at last another two years. Unfortunately, many unorthodox policies have already been tried over the past three years and there is little room for further fiscal largesse, which means that new measures are likely to be less effective than in the past. Given that the economy is not in recession and many companies remain financially strong and profitable, policy makers will have some success in stabilizing the market after such a big selloff. But it remains to be seen whether the new policy measures will contribute to a steady improvement of economic and market conditions in coming weeks and months. We believe that uncertainties about the economy and the debt issues are likely to persist for a while, and exert pressure on markets again in the near future. We thus decided to reduce our exposure to equities to an underweight position.