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Quarter Ended 30 June 2011 Global Macro and Markets Overview A US debt ceiling has been in place since 1917. Presently it is capped at $14.3tr which is likely to be reached by 2 August. Democrats and Republicans in the year before the election are using the debt ceiling to outline their future fiscal policy initiatives. Investors believe, based on the fact that the debt ceiling has been raised 74 times since 1962, that it will be increased prior to 2 August. However, continued speculation of a possible US default is making markets very nervous. Our confidence in the Eurozone project has been severely tested as politicians remain permanently behind the curve. The bond market, despite political protestations about the rating agencies, has indicated its thoughts with regard to the handling of this issue. At the time of this letter 10 year bond yields for Greece (17.10%), Portugal (12.28%), Ireland (13.69%), Italy (5.86%) and Spain (6.21%) had spiked significantly over their German (2.64%) counterpart. Based on these bond yields the market is pricing in a series of defaults and hopefully forcing European politicians into enacting appropriate corrective action that Appian has long advocated. We continue to remain acutely aware of the risks associated with this issue. Commodity prices spent most of Qtr 2 at elevated levels. This remains a concern for us as Corporations begin to report Q2 earnings and analysts have expectations of record margins. We think there will be greater margin pressure and hence analysts may have overestimated their expected earnings. However, the recent release of emergency oil supplies from the IEA will provide some short term relief. Chinese politicians are attempting to construct a soft landing of the economy. There is a concern amongst the ruling class that there may be a property bubble and high food prices provide a timely reminder that social unrest remains a continuing concern. The authorities wish to slow the level of investment in the economy and at the same time encourage consumer spending. This slowdown will not only effect neighbouring emerging market countries but also those countries that are rich in natural resources. The benefits of QE2 are difficult to evaluate but in all likelihood it was beneficial for risk assets such as equities. QE2 was the $600bn purchasing program of US treasuries by the Federal Reserve as the Fed Funds rate had been lowered to close to 0%. It enabled bonds yields to remain artificially low and may have provided US exporters with a weaker dollar. This program ended on 30 June and whilst this should be considered a relative negative we believe the Federal Reserve will keep interest rates at historically low levels until there is sustainable growth in employment. The possibility of QE3 should not be discounted. The after effects of the Japanese Tsunami and earthquake have been more negative in disrupting global manufacturing than originally anticipated. However, we suspect the fiscal stimuli provided by the Japanese government will be beneficial for global growth in H2. In the short term we remain comfortable with a suitable exposure to appropriate equities (as outlined below) based on their relative valuation to other asset classes and continuing monetary support. Highly rated bonds, whilst outperforming in the short term, remain overvalued. Appian remains wary of the effects of future inflation on the real return for bonds. The security of our cash holding remains a serious consideration as we move funds from commercial bank deposits to short dated German government bonds. We remain hesitant in materially increasing our clients risk exposure until we get greater transparency on the issues discussed. Henkel Novartis Northern Trust Pat Kilduff
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