The monthly pattern of "risk on, risk off" persisted through the third quarter. Markets advanced strongly in July on better than expected earnings from a range of US companies, before risk aversion dominated in August, with the fragility of the US economy fuelling double-dip fears, and heightening expectations of further quantitative easing. Markets benefited from renewed risk appetite in September as concerns eased over the European debt crisis and a number of key economic data releases came in ahead of expectations, including US employment data and Chinese retail sales and industrial production.

Over the quarter the MSCI World Index returned almost 14% in dollar terms, propelling it into positive territory year to date, with the UK and Europe ex UK regions gaining over 19%, Japan the notable laggard and the US broadly in line. By sector, cyclicals led overall performance, notably capital goods, retailers and technology, while defensive areas such as utilities and healthcare were among the weaker areas, albeit still making significant absolute gains.

Economic activity is expected to slow during the remainder of the year, even though a double dip remains unlikely. Given recent weakness in the economic data, monetary policy is likely to remain accommodative for a sustained period, with the possibility that further stimulus may be applied if necessary. Equity market valuations continue to remain attractive, although further volatility is anticipated as progress continues to be determined by the extent to which investors' focus switches between corporate fundamentals and expectations of slowing economic growth.

Global equity markets made a positive start to the quarter, buoyed by optimism over the prospect of a European Union (EU) financial rescue package, although early gains were reversed as sentiment was dented by a number of factors, primarily sovereign ratings downgrades in Greece, Portugal and Spain, which led to fears of Euro-zone debt restructuring. Despite the approval of a €750bn package by EU finance ministers in May, many commentators believe that a Greek default is now unavoidable. This weighed heavily on sentiment throughout the remainder of the quarter, while more general concerns over the strength of economic recovery in the West also remained at the forefront.

As a result the MSCI World Index lost 12.5% in dollar terms, its weakest quarterly performance since the last quarter of 2008. All sectors posted significant declines, with the more defensive areas of consumer staples and utilities outperforming and energy, materials and financials showing the greatest falls.

At the turn of the year, the global economy appeared to be well on the way to recovery, but six months down the line this is now in doubt. Although economic data releases in some parts of the world have been encouraging and resulted in upgrades to expectations, in the Western world leading indicators have become less positive, heightening concerns over the possibility of a double-dip recession. The real economy appears to be increasingly led by the financial economy, and with financial news appearing less favourable than was the case last year, policymakers look to be struggling as economic activity continues to be constrained by high levels of debt.

Several events conspired to cause nervousness early in the quarter, including concerns over fiscal deficits in the PIIGS markets (Portugal, Ireland, Italy, Greece and Spain), measures by the Chinese authorities to tighten monetary policy and President Obama's proposed banking sector reforms. However, as the period progressed, markets benefited from comments by Federal Reserve Bank Chairman, Ben Bernanke, suggesting an extended period of ultra-low US interest rates, mounting expectations that European Union (EU) leaders would work towards a resolution of the Greek debt crisis, and an improving tone to economic data releases and corporate news flow. A gain of more than 6% in March enabled the MSCI World Index to end the quarter over 3% higher in dollar terms, led by Japan and the US, while Europe and the UK lagged as the euro and sterling lost ground against the US dollar. By sector, cyclical areas including industrials, consumer stocks and financials were among the winners, while the more defensive areas of telecommunications and utilities failed to participate in the rally. Equity valuations remain reasonable at this point in the economic cycle and the medium term outlook remains positive. Policy is likely to remain accommodative, at least until the recovery develops its own momentum. In the near term conditions may remain uncertain pending the resolution of key macro issues, causing heightened equity volatility, while further out, markets should be able to make progress as economic improvement boosts corporate profitability. In summary, markets are likely to remain underpinned by modest economic recovery, although periods of consolidation are also likely on rising risk aversion and uncertainty over macroeconomic issues.

After a positive start to the fourth quarter of 2009, markets lost ground as news of the emergence of the US economy from recession failed to spur long term confidence while economic data suggested that the global recovery was less entrenched than previously thought. The Dubai World debt standstill agreement and Greek sovereign debt downgrade added to nervousness, although markets shrugged off these concerns to post positive returns in both November and December, with the MSCI World Index delivering an overall US dollar return of 4.2%. The strongest returns came from the UK (up 7%) and North America and Asia (both up 6%), while Europe lagged with a return of 1.6%, and Japan constrained overall performance, falling 2.8%.

The best performing sector over the course of 2009 was materials which, benefiting from continued strength in underlying prices, gave a return of 70% - twice that of the overall index gain. Other outperformers during the quarter included technology, healthcare and consumer sectors (both discretionary and staples), while industrials, telecoms and utilities all lagged, albeit making positive gains. The financial sector was the only area to post a loss over the quarter, although performance for the year was marginally ahead of the index.

We remain positive about equity market prospects for 2010, in spite of significant financial and economic challenges. Policy is likely to remain accommodative for the foreseeable future, with the transition from intervention to self-sustaining growth being crucial. Periods of nervousness over the strength and sustainability of the recovery may result in heightened volatility.