■ What is happening currently in international markets?

Investors have had a rocky ride in 2008 as uncertainty continues to plague international financial markets across virtually all asset classes. This uncertainty, which has resulted in falling equity prices, lower yields on government bonds (across all maturities) and widening yield spreads, has been fuelled by concerns of a potential recession in the US economy, as well as ongoing turmoil in the banking sector and the money market. The major stock markets across the world started the year on a bearish tone, with the main indices dropping sharply as shown in the table below, before eventually picking up on hopes that lower borrowing costs (following the surprise 75bps1 rate cut by the Fed on Tuesday 22nd January), the announcement of a US government economic stimulus package2 and plan to bail out bond insurers will restore confidence in the financial system and provide a much-needed boost to the US economy. That rally was, however, short-lived and as an indication of the prevailing uncertainty, stock indices across the globe resumed their downward trend on Monday on fears that the US is already in a recession.

1 : The biggest cut in 25 years.

2 : Amounting to $150bn in corporate investment incentives and personal tax rebate cheques.

■ Where does this financial turmoil stem from?

The root cause of this financial turmoil is the US sub-prime crisis, which led to heighten investors concerns about the credit quality of sub-prime mortgages with adjustable interest rates. In essence since July 2007, following the rising rate of delinquencies of sub-prime mortgages imposing large losses on the holders of those securities, coupled with investors realizing their inability to value these complex financial products, resulted in a deterioration of investors? confidence. The immediate impact was a sharp increase in interbank borrowing rates as banks became reluctant to lend to each other. At first, the risk of a recession in the US economy was considered to be rather low, but in particular following the drop of the Dec US ISM manufacturing index into the contraction zone and the rise in the Dec US unemployment rate, investors became concerned that the US would slip in a recession in 2008, with its ensuing implications for the global economy and financial markets.

■ What can further happen?

Global financial markets are expected to remain volatile with investors likely to remain jittery ahead of all incoming economic data and corporate announcements (business outlooks and forecasted earnings growth in particular). In essence, uncertainty should remain well entrenched in markets, at least towards the end of Q1 08, when investors should have enough data to analyse whether the US is in a recession or not. In any case, the main scenario so far seems to be that of a sharp slowdown in US GDP growth with a probability of a ?mini US recession? in H1 08, driving down global growth. Indeed, some of the major banks are already forecasting3 that the US will likely enter a recession in H1 08, with a pick-up possible in the second half of the year.

The Fed, however, is only anticipating a sharp slowdown in growth. Nevertheless, to restore market confidence, the Central Bank has stated that it stands ready to intervene to prevent the US economy from entering a recession. Moreover, the US government has already approved an economic stimulus plan of as much as of $150bn in corporate investment incentives and personal tax rebates.

Although these expansionary policies are welcomed, it should be noted that the impact on the real economy will likely be felt only after many months (i.e. with a lag). So the odds are that sentiment in major markets should err on the bearish side in Q1 08 at least, which should keep risk aversion among investors at a high level.

■ Impact on Emerging Markets:

Despite a likely slowdown in exports, the outlook for emerging market economies remains good with expected strong domestic demand expected to mitigate the negative impact that slowing exports could have on growth in those economies. Nonetheless, should the bearish scenario for major markets hold true, emerging markets would also be adversely affected. Both market sentiment as well as the underlying economic fundamentals in those markets would be impacted.

On the sentiment side the perception that emerging markets are inherently risky (or riskier than mature ones) which is still well present among investors, suggests that whenever risk aversion rises, emerging markets are not spared. Indeed, a high correlation between the developed market and emerging market stock indices is testament to this observation.

In any case, the deterioration of the global economic climate, the fundamentals for emerging market economies would also change drastically and will undoubtedly have a negative impact on valuation of companies in those regions. Earnings growth would be the input that would change, leading to a downward re-rating of these markets.