Executive Summary

The world awaits a plan for the Eurozone

• Global growth momentum continues to decline but is worst in Europe

• Solvency of national governments and now banks is creating fears of a crisis

• Coordinated policy action is key to stemming adverse market reaction

Although economic data has continued to demonstrate slower business activity, this is most obvious within Europe which has suffered from fiscal contraction as well as diminishing export demand from the emerging world. Unemployment levels remain elevated, and the reluctance to create new jobs is proving the Achilles heel of policymaker’s efforts to kick start private sector demand. The corollary to this global downturn has been lower energy prices which are beginning to impact headline rates of inflation, thus making it easier for sustained monetary policy accommodation or outright easing. However the effectiveness of easier credit as a policy tool is proving ever more elusive while consumers lack confidence and instead focus on shrinking their own personal balance sheets through debt repayment. Fiscal policy has been the only support to growth, but now investor, rating agency, and political pressures are forcing austerity upon governments, removing that prop.

Within Europe the degree of contraction has exacerbated the problem such that what was previously a limited sovereign debt crisis is now turning into a financial crisis. This is a critical period for the euro as the threat of default grows ever nearer. The problem seems more acute because there appears to be no policy coordination at an EU or Eurozone level. National governments continue to emphasize their own national interest in public deliberations over agreed remedies and future possible solutions. This political dislocation is incompatible with a monetary union and creates a sense of impending crisis.

Consequently, it is no wonder that risk assets have behaved poorly. While this paralysis prevails global market turmoil should continue and further declines in stock markets are possible. In late July we had been cautious that declining growth momentum and sovereign debt woes may cause further setbacks in performance citing 1250 and possibly at an extreme 1220 as possible levels that the S&P500 might retrace to. These supports did not hold and levels of 1000 to 1020 are now more realistic. However we would emphasise that this is a market being driven by political event risk, and both positive and negative outcomes will move the market violently either way.

Mike Turner

Head of Global Strategy & Asset Allocation, and manager of Aberdeen Multi-Asset Fund

Economic and monetary policy outlook

The global economic turmoil has been triggered by deteriorating conditions in credit markets, in addition to a generalized slowdown in economic activity. As a sweeping political solution looks unachievable, the financial crisis in the Eurozone is likely to weigh on global growth for some time. Austerity is only deepening the fiscal hole the Eurozone is in, and now European banks have stopped lending. Meanwhile, China may find it hard to avoid stagflation, caught as it is between supporting economic growth and controlling prices – just as its property bubble is bursting. There is still hope that U.S. growth could pick up in a few months, but the increasing correlation between regional economic growth will make this difficult.

U.S.

The hard data continues to support our more positive view on the U.S. economy – though we have lowered our expectation of U.S. growth for the second half of 2011 to 2-2.5% (which is still higher than the market consensus of 1-1.5%). Retail sales show that the consumer is still spending, supported by an increase in available consumer credit, mortgage refinancing, and weaker commodity prices. We still think manufacturing data will come in better than expected on inventory re-stocking, decent capex demand, and falling fuel prices. Yet sentiment is extremely poor – something the apparent policy paralysis in Washington may have contributed to. As the purchasing managers index is pricing in a recession, the fear is that the negative sentiment could become self reinforcing. Indeed, negative real yields on 10-year Treasuries imply that the market is bracing for a lost decade, as the economy deleverages.

Europe

The inability or unwillingness of the political establishment in Europe to take the necessary measures to end the Eurozone debt crisis has increased the risk of a euro break-up. The sovereign debt crisis is turning into a full-blown financial crisis as the solvency of Europe’s banking system becomes ever more questionable. By imposing economic austerity to restore credibility in the bond markets, Europe’s leaders are merely choking growth. A domestic credit crunch now means that even Germany, the locomotive of the recovery, is facing recession as 75% of its exports are to the EU. With Greece on the verge of a sovereign default, there are signs of an institutional run on some of Europe’s banks. There’s talk of putting a ‘firebreak’ around Greece by leveraging the European Financial Stability Facility. Germany is unlikely to agree to this – not least because it would lose its triple-A rating, alongside France. In these circumstances, the ECB will surely lower interest rates to boost confidence.

UK

In the UK, sluggish growth is being exacerbated by inflationary pressures. Inflation, which is still twice its target level, is hitting disposable income and depressing economic activity. And now, the UK faces the prospect of recession in the EU, its largest market. While UK services activity has accelerated, the manufacturing environment has weakened. The Bank of England is now arguing therefore, that there is an urgent need for extra monetary stimulus. At the same time, slower growth is hitting government finances. The government appears to have underestimated the difficulty of reducing debt without a recovery in economic activity. Tax cuts and/or infrastructure spending and enterprise zones are mooted as solutions. The entire gilt curve is yielding less than inflation, so real yields represent atrocious value in the medium term. We remain strategically bearish on gilts.

Japan

Life and work in Japan is almost back to normal following the V-shaped recovery. Consumers are bouncing back, and we expect a broader recovery by the end of this year as the Bank of Japan continues to inject liquidity into its economy. Manufacturing companies like Toyota and Honda, which had been expected to bounce back by December, are already returning to pre-earthquake levels. However, mounting concerns about the global economy are stopping investors from buying stocks, and Japanese bond markets are now pricing in another slowdown and recession.

Asia and emerging economies

The IMF warns that emerging markets face the risk of a “sudden stop” if there is further spillover from Europe. Asia and Latin America are also looking extremely exposed to a hard landing in China. China’s bursting property bubble is increasing fears about a credit crunch, given that local government debt in China may be as much as 200% of GDP. Signs that Chinese factory output is shrinking is a big worry for commodities exporters in Latin America, like Argentina, Chile, and Brazil. Weakening EM currencies also complicate the inflation picture. Sliding currencies couldn’t come at a worse time for countries like Brazil, whose credit boom is peaking, which is why it has been intervening to prop up its currency. On the bright side, fiscal deficits, in Asia are small and declining, which gives regional policymakers some room to maneuver.

Equities

Equity markets have fallen significantly over the last two months with volatility rising commensurately. Some analysts suggest that there is now considerable value embedded in prices, as PE ratios based on historic earnings approach the lows of 2008/9. The same could be said of price-to-book ratios although these are not as extreme. Likewise dividend yields are now substantially higher than government bond yields in some countries suggesting that equities are attractive compared with fixed income. All of these notions of value are of course predicated on the movement of stock prices and not earnings, dividends or even asset values. What is currently pre-occupying investors’ minds is that company cash flows will soon fall as we flirt with a recession. As has been permanently the case since 2009, the macro environment is crucial in determining the eventual outcome.

Markets have remained volatile since our last report. On the macro-economic front, data continues to weaken but is less soft in the U.S. than elsewhere. We still believe that it’s possible to escape recession, but much depends on a quick resolution to the financial crisis within Europe, otherwise recession becomes certain. We guesstimate that the window of opportunity the authorities have will close at the end of October. We are already experiencing a degree of credit crunch within Europe directly impacting credit flow to non-financial corporations, and this cannot last long without severe disruption to business activity. Greek default is now unanimously thought inevitable, so the question has turned to when and not if this will happen. Banks need to be recapitalized before a Greek default so that any impact is contained, as the threat of contagion of other sovereign debt markets presents more risks. Markets need to stabilize so that the necessary capital can also come from the private sector, since fiscally challenged governments have limited resource. All of this is extremely difficult to accomplish, but not impossible. As the IMF says, we need effective global coordination to achieve it, but the catalyst for global cooperation needs to come from within Europe and European politicians are still focussed on their own domestic political agendas.

Consequently this is a market being driven by political event risk, and both positive and negative outcomes will move the market violently either way. Meanwhile the path of least resistance still seems to be down, and a further 5 to 10% fall is possible from current levels (S&P500 1136, FTSE100 5066). We recommend that investors pay very close attention as we near targets as any announcements of a concrete plan to solve the problem may lead to a quick turnaround in sentiment on risk.

Bonds & currencies

U.S.Treasuries, gilts and bunds have benefited from a ‘flight to quality’ as investors avoid non -German Eurozone related assets, and look to repatriate money. As the news flow in the euro region has deteriorated, the U.S. dollar is seeing increased strength across the board, and may have started a longer term rally, at least from a technical standpoint. But, in our opinion, gilts and Treasuries are priced for a prolonged recession/depression, so represent very poor medium term value. Against this background positive economic news is very likely to take the bond markets by surprise - though that seems more likely in the U.S. than the Eurozone given its recent decline in business confidence reflecting negative euro news flow. Looking ahead, Bunds, which have also rallied as the economic environment has deteriorated, are clearly vulnerable to a more aggressive policy response from Eurozone policy-makers.

Asian currencies have come under pressure from heightened risk-aversion and repatriation flows. Reassuringly however, though nascent growth concerns are supplanting those of inflation, regional central banks have the ability to deliver easier monetary policy should it be required. Elsewhere, in marked contrast to the recent past, central banks have actually been intervening to support their currencies in an attempt to boost investor confidence. The environment could become challenging near term given how overweight the market has been in emerging market currencies.

In general, we are cautiously optimistic about credit, as corporate fundamentals and valuations support tighter spreads over the long term – though we favor investment-grade debt and emerging market local currency debt. We also remain relatively sanguine about European investment-grade credit which remains supported by strong valuation metrics. Elsewhere, commodity currencies like the Canadian and Australian dollars look exposed to weaker global growth. The Australian dollar, for example, remains about 40% above its real effective exchange rate.

Commodities

Raw materials have entered a bear market. Commodities are likely to continue selling off as the global growth outlook worsens, and will shadow the stock market performance of commodity producers in emerging markets. Copper is still vulnerable, even though it’s fallen 31% from its peak – given stock levels. Copper financing schemes in China now threaten a wider liquidation. Small and medium sized companies, including real-estate developers had been using commodity backed financing schemes to avoid the People’s Bank of China’s tightening measures. But falling copper prices now threaten these schemes, and therefore the real demand for copper, as building in China comes to a halt.

Oil is also likely to sell-off given that it is highly correlated with risk appetite, as is the dollar’s strength against the euro. In addition some of the supply issues that have supported the market are being removed. The surge in demand for December $50 put options suggests oil could come under sustained downward pressure. Meanwhile gold, which had until recently rallied strongly on safe haven flows, is losing some of its luster because it is a relatively illiquid asset. Not surprisingly, the price of gold has fallen dramatically because there was a lot of speculative money involved. As investors scramble to take profits and raise cash, they are turning to the dollar for security. Some investors may continue to hold it from a strategic perspective, even though price volatility is likely to remain elevated.

Real Estate

Capital values for institutional-quality assets appreciated in the past quarter, though at a slower pace than at the turn of the year because of concerns about the global economy. In most regions, prime property values have performed stronger than secondary assets, with little investment interest in the latter. Over the next six months, capital values for high quality property should stabilize, underpinned by a wide premium of property yields over bond yields, while a lack of debt financing for property may hold back the secondary sector. We are also concerned over the pricing of major office markets globally. They are in danger of overheating, which is why we favour de-risking office portfolios at this stage of the cycle. In contrast institutional retail and industrial assets continue to offer stronger prospective returns to medium term investors, as they remain fairly priced or underpriced in most advanced economies.

Within Europe, we expect a sharp divergence in property market performance, with northern European markets set to outperform in the next 12 months, whereas southern Europe should underperform sharply. Prospects for institutional property in the U.S. are good in a global context, as values have yet to show a significant bounce from their financial crisis lows, but the secondary market is likely to languish. Property market pricing in the advanced economies of the Asia Pacific region do not seem significantly out of line with fundamentals, and we expect capital values to be supported into 2012 by low interest rates and high levels of liquidity.

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Index Definitions

The S&P 500 Index is an index of 500 selected common stocks, most of which are listed on the New York Stock Exchange, that is a measure of the U.S. Stock market as a whole.

The U.S. ISM Purchasing Managers Index– Manufacturing is an indicator of the economic health of the manufacturing sector. The index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

The Morgan Stanley Capital International (MSCI) World Index is a free float-adjusted, market capitalization-weighted index that is designed to measure the performance of global developed market equities.

The ZEW Indicator of Economic Sentiment is ascertained monthly. Up to 350 financial experts take part in the survey. The indicator reflects the difference between the share of analysts that are optimistic and the share of analysts that are pessimistic for the expected economic development in Germany in six months. The survey also asks for the expectations for the Euro-zone, Japan, Great Britain and the U.S.

Important information

Aberdeen Asset Management (“AAM”) is the marketing name in the U.S. for the following affiliated, registered investment advisers: Aberdeen Asset Management Inc, Aberdeen Asset Management Investment Services Ltd, Aberdeen Asset Management Ltd and Aberdeen Asset Management Asia Ltd (collectively, the “Aberdeen Advisers”). Each of the Aberdeen Advisers is wholly owned by Aberdeen Asset Management PLC. “Aberdeen” is a U.S. registered service mark of Aberdeen Asset Management PLC.

This outlook is for information purposes only and should not be considered as an offer, or solicitation, to deal in any of the investments mentioned herein. AAM does not warrant the accuracy, adequacy or completeness of the information and materials contained in this document and expressly disclaims liability for errors or omissions in such informationand materials. Any opinion or estimate contained in this document is made on a general basis and is not to be relied on by the reader as advice. Neither AAM nor any of its agents have given any consideration to nor have they made any investigation of the investment objectives, financial situation or particular need of the reader, any specific person or group of persons. Accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the reader, any person or group of persons acting on any information, opinion or estimate contained in this document.

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