Macroeconomic fears set off a major sell-off in global equity markets after US core inflation rose by 0.3% in April. Investors had been enjoying benign inflation, low interest rates, and exceptional global expansion driven mainly by stable US demand and robust growth dynamics in China and other emerging economies. Now the US is facing a slowdown in the housing market, currency weakness and rising consumer prices. Under the untested leadership of new Federal Reserve Chairman Ben Bernanke, monetary policy makers must balance several variables to orchestrate a soft landing. Facing uncertainty, investors moved quickly to shed risky assets, selling commodity stocks and emerging markets most aggressively. Though the classical conditions for a secular bear market are not evident, the extent of this correction in the more speculative segments of global markets has yet to fully play out.

Much of the outlook in commodity prices continues to be driven by growth prospects for the Chinese economy. With consensus expectations of 8.5% GDP growth in China, commodity prices worldwide are experiencing upward pressure. Geopolitical events such as the tensions surrounding Iran’s nuclear programme and instability in Nigeria have exacerbated the issue. If the global economy hits the 4.0% consensus target, it is unlikely oil would dip significantly below US$50 for any sustainable period. Large diversified mining companies have already announced doubledigit price hikes for iron ore in 2006, and the fundamentals for copper, base metals and aluminium continue to look favourable from a supply and demand perspective.

The appreciation of the US dollar versus the euro during 2005 was largely the result of the short-term yield differentials.

The Federal Reserve's consistent tightening attracted significant money flow into the US dollar as the European Central Bank (ECB) remained on hold until December. While the longer-term outlook for the US dollar implies weakness against the euro due to the continued and sizeable US fiscal and trade deficits, the first few months of 2006 saw further US dollar strength as the Federal Reserve raised interest rates. The trend in US dollar strength relative to the Japanese yen looks clearer as the interest rate differential continues to widen into 2006 between each country. While the domestic Japanese economy is in the early stages of recovery, the Bank of Japan (BoJ) has been quite cautious in terms of ending the zero interest rate policy. But China's revaluation of the yuan upwards against the US dollar again, which would drive most Asian currencies higher versus the dollar in sympathy together with Japan's July 0.25% interest rate hike are likely to reverse this trend.

We have been cautious regarding international markets noting the speculative behaviour of the materials sectors in particular.

Eurozone economic growth forecasts average 2.1% in 2006, while the UK is forecast to grow by 2.4%. Inflation is expected to remain benign at 2.0%, although the ECB is expected to hike interest rates again this year. The UK will likely keep rates on hold as the local economy begins to rebound from a relatively weak 2005.

US core inflation came in higher than expected, which could lead to incrementally higher rates. Policy makers are facing the challenge of balancing trend line growth with contained inflation. A possible end to rate hikes has contributed to the recent sell off in the US dollar in favour of the euro and yen. The ECB will very likely continue to incrementally raise rates in 25 basis points stages, with the market assuming it will re-evaluate conditions once rates hit 3.0%. If the euro strengthens considerably versus the US dollar, the necessity to tighten will dissipate, as exporters will become less competitive, potentially stalling the GDP recovery of the Eurozone.

Asian markets face the strongest currency headwind as US rates peak and Japan ends its quantitative easing. The yen should appreciate this year relative to the US dollar, with Japan’s economy expected to expand by 3.0%. That said, interest rates will likely remain stimulative, and despite last year’s surge in Japanese equities, the market is still well off its record high. With solid employment, exposure to the world’s fastest developing economies (China and India), the very beginnings of a consumer recovery, and corporate profitability still among the lowest in the world, Japan has ample room for further gains.

Our initial assessment of the recent market decline is that it is a cyclical correction, not the beginning of a secular bear market. We feel that emerging markets should remain in a secular bull market. However, certain market and sector valuations were becoming stretched and overdue for profit taking; namely, metals, energy, India and the Middle East. Even so, the economic fundamentals remain intact, foreign reserves are high, inflation is benign, monetary policy is accommodating while local consumption is becoming increasingly more critical to expansion. Despite three years of superior performance, there are still interesting opportunities as valuations remain attractive in certain countries like Brazil, South Korea and Turkey where earnings has driven much of the strong performance. It is important to note that even under a cyclical correction scenario, additional selling could trigger more weakness given the extent of the 2005 and 2006 speculative excesses.

As we enter the second half of 2006, the US economy is expected to decelerate to more “trend” like growth for the latter part of 2006. On the inflation front, the core PCE deflator – the indicator of the average increase in prices for all domestic personal consumption – is well above the Federal Reserve’s 2.0% comfort zone. It has therefore become increasingly unclear whether the June meeting will mark a pause in interest rate increases or a resumption in its tightening stance.

There are broader implications for the rest of the economy as we witness the cooling off in the housing market and a weakening dollar. There is some debate over the severity of the housing market’s decline, while it is widely expected that the dollar’s decline will be led by a reduction in differentials in interest rate levels.

Notwithstanding these pressures, we expect US equity markets to unfold in a cyclical correction, without the conditions for a more damaging bear market. While decelerating, profit growth remains healthy and overall valuation levels are reasonable relative to US government bond yields. In this environment, we are focusing on attractively valued companies with sound fundamental businesses, with a preference for higher-quality as opposed to higher-risk assets.