A semblance of normality in sight

Like a football match, the second quarter of 2008 was a game of two halves. Equities did well during the first half, but then gave up all of their gains (and more) as fears about inflation mounted, thanks to a renewed surge in oil prices. Falling equity markets were not even accompanied by the usual silver lining of a rally in bonds. Instead, bonds also sold off.

In retrospect, July looks like a repeat of the second quarter, but in reverse. Early on in the month, equity markets were in free-fall, as fears over the US mortgage lenders Fannie Mae and Freddie Mac reached fever pitch.

However, better-than-expected second-quarter corporate results and a sharp drop in the oil price soothed investors somewhat. As a result, most of the major markets finished July where they started it. Most bond markets also rallied a little.

RISK APPETITE RECOVERS

Perhaps unsurprisingly, these market ructions were accompanied by sharp changes in investors' risk appetite. Barclays Wealth has tracked risk appetite using a proprietary measure, its Risk Appetite Index (RAI). At the low point of confidence in equity markets, for example, the 15-day moving average of the RAI fell three standard deviations below its long-run average. But by the end of the month it was back in positive territory.

Over the past year or so, the RAI has nose-dived on five separate occasions, only to regain its poise again a few weeks later.

We tend to use the RAI measure in two ways: first, looking for it to 'mean revert' following extreme moves and, second, looking for momentum effects. After big drops, for example, it is normal for it to find its feet again, but to take some time to recover fully. Rather like a patient who has been ill, it is common for relapses to occur during these recoveries.

But it's really worrying – for patient and doctor alike – when these relapses are strong enough to leave the patient weaker than before. Usually each trough is higher than the previous one. When the opposite happens, and each trough is lower than the previous one, this can be the beginning of a much more serious adjustment: a potentially life-threatening situation.

Looking at the more recent episode of market panic, we see a silver lining to this particular cloud. The mid-July trough in the RAI was not significantly lower than its predecessor – as it was in November and January. Rather, this time it was more or less the same.

More reassuringly still, its predecessor (the Bear Stearns-related collapse in confidence in March) was a higher trough than January's.

The patient is doubtless severely weakened by these relapses. Market sentiment is vulnerable to further negative 'shocks'. But the patient's body may now be gradually fighting off the disease – thanks largely to regular doses of support from the authorities.

INFLATION CONCERN

There was little macroeconomic news to surprise investors during July. Growth continued to disappoint, generally speaking, while inflation is higher than expected. Consensus GDP expectations are now gloomier than they were at the start of the year, whereas inflation forecasts are a lot higher. We have continued to trim projections for real GDP, with the US the major exception.

When it comes to inflation, we have made few changes to our forecasts this month. We are still largely unconcerned about developed countries seeing 'proper' inflation, in the sense of a wage-price spiral. As yet, wages have remained quiescent almost everywhere. And comparing headline with 'core' inflation (minus food and energy prices) it is clear that underlying price pressures remain muted in the US, euro area, Japan and the UK.

But when it comes to emerging markets, we are rather more concerned that a wage-price spiral is already gathering force. The only major emerging market where inflation fell during June was China – and that could have been a blip rather than the start of a trend.

In many emerging countries, real interest rates are low, and in some cases negative. So, curbing price pressures from domestic demand will likely be more a story for 2009 than for 2008.

OIL IS KEY

If 'core' inflation is well-behaved in the developed world, then overall inflation will depend largely upon 'non-core' inflation – i.e. food and energy prices. Food price inflation is unlikely to keep building. Agricultural price rises have already slowed to a degree, reflecting higher supply. And oil prices, having soared in the first half of the year, fell smartly in July.

A key question, therefore, for policymakers and investors is whether the fall in oil prices is merely temporary. Barclays Wealth quantitative research suggests that a sustainable oil price is around $80 per barrel, well below current levels. Although such models should always be treated with caution, this nevertheless hints that recent drops in oil prices could be here to stay – especially if growth and demand slow in the developing world.

If oil prices have further to fall, then inflation fears are likely to be overblown. In other words, although many emerging markets do have significant inflation problems and will need rate hikes, it is hard to see inflation in developed countries – and the global economy as a whole – going the same way.

Rather, with headline inflation likely to fall towards year-end and through 2009, the pressure on developed countries to tighten interest rates should diminish. In developed countries, growth should again become the main factor behind interest-rate decisions, rather than inflation.

Time should be a natural healer, and as long as oil prices do not surge again, stock prices should gradually recover.

The writer is Head of Barclays Wealth Research