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Looking ahead

There are clearly two main headwinds investors face as we move into the second half of the year - contagion in Europe and a further decline in the rate of global growth. From a European perspective, the two are very closely linked. Recent economic numbers point to a slower momentum in Germany and, should this persist, the peripheral crisis would escalate as Spain's growth hinges on exports to Germany, and France. A slowdown in the core economies could send Spain into a recession, causing an increase in bond yields as fears grow over its ability to service and repay debt. Commentators are universally agreed the euro project could not survive a Spanish default.

This is not our base case, but the need to contemplate this potential scenario illustrates the vulnerability and fragility of the current situation in Europe. Resolving the funding issues in Greece remains the focus for policymakers and they need to find a solution that involves some burden sharing beyond EU taxpayers, but does not trigger a default and a subsequent meltdown of the banking sector. A disorderly default runs the risk of creating a deep recession in Greece and throughout Europe. This, we believe, will be avoided but the Sword of Damocles that is the European sovereign debt crisis is likely to hang over markets for some time to come.  Looking ahead

Returning to the second headwind of global growth, the US economy has been showing signs it was entering a self-sustaining stage of growth. This has not materialised and one of the key factors to have caused this has been the global supply chain disruption caused by the Japanese earthquake. Exports of motor vehicle equipment from Japan to the US fell by 35% in May. The shortage in components this caused, led to an output fall in US automobile production of 7.8%. This, in turn, shaved an estimated 0.5% off US GDP in the second quarter. The good news is these supply chain disruptions have been addressed and production should return to pre-earthquake levels through this next quarter.

High oil prices also created a drag on the US economy, however, the decline during the second half of the quarter is creating a welcome tailwind for the second half of the year. Gasoline prices are down close to 20%, with the last 5% of this fall driven by the International Energy Agency announcement that the US, along with 27 other countries, had agreed to release 60 million barrels of oil from their emergency stocks. Goldman Sachs estimates a 10% change in gasoline prices impacts GDP by 0.7% cumulatively over the next two years. If prices stay at current levels, the US economy will clearly benefit from this.

These two factors are leading some commentators to present a positive outlook for the US economy, in the belief the soft patch in data has been just that, a soft patch. A slight improvement in the most recent Institute for Supply Management (ISM) reading, plus an increase in total hours worked have countered the poor unemployment figures reported for May and June. Sub-trend growth is still growth and with this should come earnings growth.

In the absence of further deterioration in Europe and assuming the US economic outlook improves - risk assets could surprise on the upside. We do not believe valuations are expensive and prices have simply kept up with increased earnings. Couple this with evidence the Chinese authorities appear to be engineering a soft landing for their economy and falling food prices are causing inflation pressures to abate across Asia, a case can be argued for further increasing risk levels across portfolios. We continue to believe, on balance, markets will end the year higher than they began, however, risks remain very elevated towards the downside and a policy mistake, particularly in Europe, is an ever present danger. Moreover, the recovery in the West is still dangerously exposed to commodity shocks until unemployment falls significantly, something that is a long way off. Finally, both sides of the balance sheet of commercial banks are shrinking as the household sector continues to deleverage and banks seek to manage their capital requirements in light of tighter regulatory demands. As a result, the flow of credit through developed economies continues to be constrained.