Changing growth expectations and asset markets

The most telling investment story for asset classes is the continued increase in the stock market and the changing expectation in the bond market. These stories are closely tied together and show the difficulties of adjusting to a swiftly changing economic landscape in the first half of 2007.

The stock market can be characterized by three phases. Phase one, the gains until the China sell-off. Market expectations changed with the perception that assets were actually riskier than expected and that growth may be slowing. Phase two was the the recovery of the equity markets based on the idea that assets were not looking at a change in risk and that fact that housing problems may not spillover to the rest of the economy. The third phase is the period of consolidation during June. Growth may be positive but moderate. The risk of inflation may be diminished.

Bond markets have sold off on the economic rally. With the probability of a recession diminished and the chance for higher inflation and no reduction of interest rates by the Fed. the market saw some of the worst performance in years. The last half of June, however, saw a bond rally. The surprise has been a decline in inflation and moderate growth.