After continuing their gains during the first two months of the quarter, global equity markets reached a twelve-month high in early September before pausing for breath. Weakness came amid concerns over the sustainability of the global economic recovery. Overall the MSCI World index gained 3.3% over the quarter, giving a year-to-date gain of over 11%. While the markets in the UK, US and Europe advanced between 1% and 2%, the strongest market was Japan which continued to rally from oversold levels. Positive economic news buoyed the market, with business sentiment rising to its highest level in almost three years. Europe came under pressure from currency fears as concerns over euro strength prevailed, while the US, which had benefited from a strong second quarter reporting season, came under pressure late in the quarter from disappointing economic data, including a worsening of the labour market. By sector, technology and industrial cyclicals led the gainers. The more defensive areas of consumer staples and utilities were the laggards, although these areas found renewed favour with investors late on in the quarter, as disappointing consumer confidence data in the US prompted concerns over the pace of economic recovery there.

The recent upturn in economic activity has fuelled optimism that a recovery is now under way. While recessionary fears appear to be well and truly behind us, doubts nonetheless remain over the strength and sustainability of the recovery. For example, in the US, employment data remain weak, despite the recovery in profits. Recent falls in bond yields from summer highs (US ten-year treasury yields declined by over 50 basis points in September to below 4%) point to possible downside risks for equities in the coming months. Nevertheless, provided the US third quarter reporting season does not disappoint, the fund manager's expect markets to make further progress during the final quarter of the year.

Following the weakness of the previous quarter, world markets fared rather better in the second quarter; at their peak they were up more than 25% from the low before the war in Iraq. Over the quarter, the World index gained around 15% in GBP terms, its best quarterly performance since the fourth quarter of 1999. Continental Europe led overall gains, after this region had been the weakest performer during the previous quarter.

As the Gulf conflict came to a conclusion early in the quarter, markets experienced a sharp rebound, referred to as the "Baghdad bounce". Investors became more confident about the economic and geopolitical prognosis and the oil price stabilised to trade in the mid-$20s, a level viewed as more conducive to stimulating global growth.

A stronger global recovery is predicated to a significant extent on accelerating US growth. US tax cuts will boost disposable income and it is hoped that easier fiscal and monetary policy (with the Fed cutting rates by a quarter percentage point to a 45-year low at the end of the quarter) will boost consumption and derail deflationary pressure, although this will remain a concern in the absence of a meaningful economic recovery. In the light of this, central banks are maintaining a close watch and are likely to cut interest rates further should this prove necessary.

The benign inflationary environment continues to be beneficial for bonds, with Treasury yields declining to 50-year lows. Equities have been rising simultaneously, as geopolitical uncertainty and corporate accounting malfeasance have given way to improved investor sentiment.

Global equity markets fell sharply early in the quarter amid ongoing economic weakness, poor corporate newsflow and expectations of escalating military activity in the Gulf. Some of the losses were then clawed back midway through March as months of nervous anticipation finally culminated in the outbreak of war. But growing concerns that the conflict would be more prolonged than had previously been envisaged created renewed market weakness. Continental Europe led the weakness with a local currency fall of almost 10%. Markets in the UK and Japan also suffered sharp declines, while in the US the market held up rather better; a dollar decline of around 1% helped to mitigate the overall loss.

A spike in the oil price in early March compounded fears that the global economic recovery would take longer to emerge than was previously expected. Furthermore, despite another round of interest rate reductions, Middle East concerns weighed heavily on the consumer sector, with confidence in the US falling to a 13-year low.

Expectations now are of continued near term economic weakness, before growth starts to recover towards the end of the year. An improvement in the geo-political environment should enable the oil price to stabilise at a lower level, providing some stimulus for economic growth. Global equity markets remain attractively valued, although there is unlikely to be any meaningful upward progress until the successful resolution of the Iraqi situation. In the meantime a continuation of recent volatility is anticipated.

Having reached new lows in early October, equities rallied from their oversold positions, advancing for much of the quarter. The gains were, however, too little and too late to counter the weakness that had been seen throughout the earlier part of the year. World markets moved up around 6%, with the strongest performances coming from the US and continental Europe. The UK just made it into positive territory, while the laggard was Japan, which lost a further tenth of its value amid a lack of decisive action in resolving the bad debt crisis in the banking sector.

Economic data remains weak, particularly in Europe where consumer confidence is depressed and unemployment remains very high. In contrast, the economic prognosis in the UK remains more favourable, while in the US, data is also expected to weaken further. Expectations of monetary easing in the US materialised early in November when the Fedfunds rate was cut by 50 basis points to 1,25%. The European Central Bank followed the Fed's lead with a 50 basis point cut in the repo rate to a three-year low. The Bank of England left rates unchanged at 4,0% as buoyant consumer spending (most evident in the housing market where prices continue to grow close to record levels) continues to cushion the UK economy from the effects of a faltering global recovery.

The fund manager's expect global growth to remain below trend in the immediate term, but to show some acceleration as we move through 2003. Recent monetary easing gives the fund manager's more confidence that by the end of next year the global economic growth rate will be accelerating. Despite expectations of a firmer economic environment a year from now, the fund manager's do not expect any meaningful pick-up in inflation. Once geopolitical tensions have eased the fund manager's expect the oil price to stabilise at a lower level, putting downward pressure on input costs. The equity market rebound has been accompanied by lower volatility, although the fund manager's are not convinced that this lower level can be maintained. Although markets are offering excellent value for long term investors, returns over the next year are unlikely to match those seen at the end of previous bear markets.