So far central banks have been able to contain the turmoil but what is the outlook?

Thanks to the injection of liquidity in the money market by the Fed and the ECB in particular, coupled with the likelihood that the Fed will reduce its Fed Funds rate in September, the stock market has begun to rally since mid-August. Note that the ECB, despite stating that it will inject more liquidity in its money market in the coming months, has not yet decided whether it will raise its main refi rate or not . Against this backdrop, markets are likely to remain volatile and everyone will lend a very cautious ear as to what the central banks have to say and what actions they will take. Furthermore, it appears that the era of cheap credit is over, which is probably a good thing in the longer term.

Impact on the US dollar and Mauritian Rupee?

Despite the recent appreciating trend of the US dollar vs. the EUR, the greenback is expected to weaken to 1.39 per EUR over the next six months. Furthermore, we have revised our valuation of the Rs which in our view should hover around the low Rs 32 range by next June. This valuation is based on forecast fundamentals barring the liquidity context in the domestic foreign exchange market. This essentially means that the local currency is likely to hover below this figure.

With regard to the local stock market, foreigners have not stopped buying local stocks since the beginning of the subprime woes. In fact, at a time when major emerging markets are increasingly correlated with developed markets, the trend to seek out markets such as Mauritius and other emerging African markets (that show a low correlation with global equities) will continue as long as earnings expectations remain attractive. In any event, given that domestic investment firms and banks are likely to only have a very limited exposure (if any) to those structured products, no major impact is expected

What to do then?

As it stands right now, it is difficult to predict when all the subprime skeletons will come out of the closet. Suffice to say that global markets are likely to remain volatile in the months to come as investors await the next move by the Fed and whether the housing slump will eventually lead the United States (the world?s largest economy) into a recession. As stated in our previous contributions, the local market hovers at around fair value and the number of attractive stocks remains limited. Local mutual funds will have no choice but to diversify their portfolios by investing abroad in order to maintain a satisfactory return stream in the coming years. Portfolios will need to be optimised in order to deliver satisfactory risk adjusted returns. Investing in different asset classes such as property funds is likely to remain interesting. Furthermore it will increasingly become important to track global markets carefully and shift to those markets that not only deliver the best earnings growth potential in the coming years but that also share low or negative correlation with the MSCI World index.

Related quotes over the past month

The ECB?s President Trichet said:

?We experience a period of market nervousness, a period in which we see increased volatility in many markets and a significant re-appreciation of risks. In some respects, what has been observed can be interpreted as a normalisation of the pricing of risk.?

IMF Managing Director Rodrigo Rato:

?I think that the response of central banks to provide liquidity, short-term liquidity to the markets is an appropriate one to overcome the lack of liquidity among participants.?

The National Association for Business Economics:

?The combined threat of subprime loan defaults and excessive indebtedness has supplanted terrorism and the Middle East as the biggest short-term threat to the U.S. economy?

Julian Jessop at Capital Economics:

?The turnaround in market sentiment since the Fed?s discount rate cut on 17th August and the additional injections of liquidity from the European Central Bank have taken major equity indices back to levels which are only a little lower than they were at the start of the month.?

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IPRO Jargon Buster

ARM: Adjustable Rate Mortgage.

Volatility: The spread of returns for a given security. The higher the spread, the higher the volatility. Volatility can also be used as a measure of risk.

Correlation: A statistical measure of how two securities/variables move together. The closer this figure is to 1, the higher the correlation. Correlations are used in advanced portfolio management in order to optimize portfolios and reduce risk.

Refi Rate: This is equivalent to the repo rate in Mauritius.

MSCI Indices: The Morgan Stanley Capital International Indices track various global markets and are often used as benchmarks for equity investments.

Asset Class: Bonds, property, hedge funds, equity etc are each examples of asset classes.

Valuation based on fundamentals: The use of various models in order to predict a fair value for a given stock/property/exchange rate based on forecast fundamentals.

Leverage (used in the context of this article): The use of debt (borrowing) to invest in securities.

Disclaimer:

This analysis report is provided by Investment Professionals Ltd. for information purposes only. Neither the information nor any opinion expressed constitutes an investment advice, an offer or an invitation to make an offer, to buy or sell any fund or stocks. This report does not have regard to the specific investment objectives and financial situation of any specific person who may receive/read this report. Investors should seek financial advice regarding the appropriateness of investing in any funds or stocks and should understand that future expectations may not be realized. Investors should note that the price or value of any funds or stocks may rise or fall. Past performance is not a guide to future performance.