During August, the S&P 500 index (the least volatile of the major equity indices) dipped below 1400 having reached a peak of 1550 in July. At the time, there were fears of recession in the US, hedge funds were reporting double digits losses in just a few days and the money markets were closing down due to lack of liquidity. Not many strategists (us included) were predicting that the S&P would be back up to 1550 by early October but that's where we are. With the benefit of hindsight there was a great opportunity to buy equities in mid August levels and it would be easy to kick ourselves for not having been more aggressive at the lows. However, we should recall that there was a very negative scenario developing at the time and if the Federal Reserve had not cut interest rates by 0.5% on 18th September, things might have turned out very differently. Even today spreads in the money markets remain elevated so we are not out of the woods yet.

Having said that we can look at the equity rally and fully understand why it has occurred. First the Federal Reserve has stepped forward and indicated that it will not hesitate to act to avoid a recession. Secondly, company balance sheets have not been adversely affected (with a few notable exceptions e.g. Northern Rock) and profit expectations (outside of the banking sector) have held up very well. The equity cycle looks very different to that of 1987 or 1999. Equity valuations are very low, especially when compared to risk free returns and a lot of bad news has been discounted in the price. We are also in a world of plentiful corporate liquidity and that cash is looking for a home. If we take the top 20 companies in the world, they provide a dividend yield of 2.8%, which is growing at about 10% per annum (supported by strong balance sheets), which means that the yield on this basket of stocks will exceed the US Treasury yield in just 5 years time. Given that a crossover yield between equities and bonds has not occurred since the 1950's there is a very good chance that equity prices will rerate to reflect that growth in income. It's not hard to see why corporate investors continue to like equities.

Last month we mentioned that we could foresee some interesting opportunities ahead. One example of this was Emerging markets where the rally has been truly incredible. Many of these so called Emerging markets have grown up and probably no longer deserve that descriptor and we like their long term fundamentals. However, we are growing a little cautious given the re-rating that has been experienced. The region is now definitely flavour of the month and valuations are starting to look very full. Calling the top is always difficult and often the best returns are experienced towards the end of a bull market trend but we would urge caution in this space.

To the casual observer it would appear to have been an orderly start to the year in global markets. Global equities are off to a strong start, up 9.2% and Hedge Fund of Funds are not far behind with a return of 7.1% (MSCI and HFR index in USD). Commodities and Property have also rewarded investors prepared to take some degree of risk. US Treasury bonds however, have returned just 1.4% this year i.e. less than the accrued income from coupons. Since reaching a low point of 3.5% in 2003, the 10 year US Treasury yield has climbed above 5%, briefly touching 5.3% during June, and for some commentators the breaking of the 20 year trend is hugely significant. Possible explanations for the recent sharp upward move in yields are (i) the more robust projections for US economic growth (ii) inflation remaining slightly above the Fed's comfort level and (iii) a sharp reduction in buying by Asian banks. Of these possible catalysts the latter is of most interest given that the huge recycling of Dollars into the Treasury market has kept yields at subnormal levels since 2002 and this has acted as a further prop for both the US consumer and US equity market. If Asian banks are now looking to shift their exposure away from US Treasuries, this could be bad news for US Treasuries and indeed the US Dollar. There are now some signs that liquidity is contracting at the margin.

During June, Bear Stearns were forced to pump $1.6bn into 2 hedge funds which got into trouble with their holdings of CDO's with underlying exposure to sub-prime mortgages. Private equity firms have been backing away from a number of deals and in fact Blackstone's own IPO was not a success with the price going to a discount after the second day of trading. We hear anecdotal reports of tightening of bank lending criteria and we wait to see how the US Consumer will cope with the mortgage interest rate resets which are due to occur this year and next. Just to add to the mix, the Oil price is back up close to its highs with the obvious knock on effect to gasoline prices - this has a significant impact on the disposable income of middle to lower income families in the US.

As mentioned last month, we feel that now is not the time to be increasing risk. We still expect equities to deliver better returns than bonds in 2007, but we expect volatility to pick up and it seems prudent to take a little money off the table. Of course we could be way too early (fundamental investors quite often are) and there is a possibility that the markets can still experience a 'melt-up' just like we saw in 1987 or 2000. At the stock level, earnings expectations are still rising and we should be cautious about calling the end to the M&A cycle at a time when stocks trade at reasonable PE's and financing rates are still attractive on historical comparisons. Markets are at an interesting juncture.

Last month, at the outset of a 'wobble' in global equity markets, we observed that corrections have tended to occur fairly frequently during the last few years and that we viewed it as a good thing in the longer term. We haven't changed our view so far. Some of the excessive risk appetite has been flushed out of the market and investors are now going through a process of re-evaluating the fundamental case for equities. The S&P 500 index currently sits around 3% below its recent peak having recovered some 4% from the low point in March.

Clearly the US is in a mid-cycle slowdown with much focus on the impact of rising mortgage delinquencies, particularly in what is now universally well known as the 'sub-prime' space. The key question is whether the problems in this small subset of borrowers start to spread to the rest of the market. Given the scale of indebtedness in the US and the anecdotal stories of bad lending practices, we suspect that this problem will need more time to work its way through the economy. Fortunately however the global growth outlook is not completely reliant on the US. Chart 1 shows GDP estimates from UBS for the major economic regions and whilst it is true all regions are seeing a slowdown predicted for 2007, the expected global growth rate remains above 3% with robust growth from the emerging economies. The second reason not to get too negative on equity markets is that valuations are not excessive. We can see clearly that the performance since 2003 has been entirely driven by earnings growth and not by an expansion of PE ratios as was the case in the late 90's. Therefore in our view, even in a modest growth scenario, equity prices are well underpinned and provide some valuation headroom before we need to worry about getting back to excessive levels. Clearly we continue to watch for more signs of economic frailty in the US as this can have an effect on investor confidence and corporate earnings, despite the fact that an ever increasing share of corporate earnings come from overseas. There used to be a saying that 'when the US sneezes the rest of the world catches a cold' but in our view, as the emerging markets become more developed with strong FX reserves and Govt finances in surplus, these markets can now stand on their own feet. Without being complacent, we continue to look for opportunities to add exposure to these higher growth regions of the world.

A few months ago during the sell off in global equity (and bond) markets we urged our clients not to panic and to have faith in our positive equity view. We are very pleased to point out that this call was a good one. Since the end of June, the S&P 500 index has rallied some 10% and with just a month of the year left, global equity returns for 2006 are looking extremely robust with gains of over 15%.

Now, however, we are "taking our foot off the gas" and have trimmed equity positions in most mandates. So why are we turning cautious at this stage? Firstly, we have enjoyed very good returns this year and, as the old saying goes, "it is never wrong to take a profit". Secondly there is a lot of uncertainty surrounding the extent of the expected US economic slowdown in 2007. In particular, the US housing cycle is experiencing its worst decline since 1970. It remains to be seen what effect this will have on the spending habits of the US Consumer which makes up over 2/3rds of the US economy. Another issue could be the direction of the US Dollar which is currently going through a period of weakness. China now has over $1 trillion in foreign currency reserves and is accumulating at a rate of $30m per hour. Will the Chinese banks start to diversify their currency exposure away from the greenback? And what effect might this have on the Federal Reserve's ability to cut rates in 2007?

These are important issues, but we are more concerned about the degree to which markets appear to be complacent in assuming that the Federal Reserve will cut rates in 2007 to offset this anticipated weakness. The futures markets appear to be building in two cuts of 0.25% during 2007. In fact we are not overly bearish about the economy, but the optimism implied by the market leaves us slightly nervous. If the Fed decided to move rates up rather than down in order to keep inflation in check, the reaction could be quite severe on the downside.

One way in which we can see this higher risk appetite is the implied volatility of S&P options. Volatility is at a 20 year low. Our concern is that the markets might be due a reality check and as always there might be a rush for the exit when the next global macro issue hits the headlines. So far we have trimmed some equity positions and left the proceeds in cash.