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The recovery of the world economy remains on track. The European debt crisis is showing signs of intensifying. Optimism about inflationary developments in emerging markets is on the rise.
Equities will probably continue to find it difficult to move forward in the months ahead. Most negative economic surprises have probably now occurred. But the eurozone debt crisis rumbles on and it is increasingly likely that markets have to deal with a default sooner rather than later. Although earnings growth is a positive factor, further downgrades could hurt sentiment in the short term. Valuation is in neutral territory, despite increasing market talk about stocks being cheap.
The outlook for corporate bonds has become more challenging. We are still positive on investment grade corporate bonds, but during the month we lowered the outlook for high yield to neutral.
Within equities, emerging markets remain our favorite region. The economies are cooling but growth is still decent. Inflationary risks are decreasing; we thus expect monetary tightening to end in the second half of 2011.
One could take the view that after having negotiated a cluster of negative economic surprises, it is now time to move back into cyclicals. But we maintain a slight preference for defensives for two reasons. First, defensives such as consumer staples and telecom may benefit from the ongoing uncertainty about the eurozone debt crisis. Second, the seasonal factor is supportive; the May-to-October period is generally good for defensive stocks.
This month’s special: The Chinese economy is slowing. Inflation will peak soon. A Chinese credit crisis thus remains unlikely, despite reckless lending by local governments.