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After the mid-week volatility in equity markets, some degree of stability has returned to the market thus re-assuring investors who are positioned for gains in risk assets. Indeed, at the end of the month, the gains in many equity markets remain impressive. Policymakers have helped reduce systemic risk in the financial system and investors can focus more on the traditional concerns of economic data flow and earnings potential.

In the FX market, volatility in the majors is low and looks technically range-bound for now. Sterling is holding up well and is acting as a barometer of investor risk and is less affected by data flow, the UK fiscal burden and the potential capital needs of the UK banking sector.

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Sharp declines in the Chinese equity market and investor worries of a tightening in Chinese bank lending upset the recovery in risk assets. The oil price has eased and in the FX market, the EURUSD exchange rate pulled back to the 1.40 level. Interestingly, sterling has held up well and the yen is fairly steady.

You will recall that I highlighted research from analysts at BNP Paribas at the start of the month which warned of a sharp pullback in the Chinese equity market. There are certainly bubble-type elements to the behaviour of the market here. In addition, Chinese money supply growth has been exceptionally rapid, reflecting FX reserve growth, hot money inflows and strong lending. All of this poses challenges for the conduct of Chinese policymakers and global investors will be monitoring this carefully. The Chinese equity market has tended to lead developments in global equity markets.

However, European equity markets have opened in positive territory this morning but real money investors looking to increase exposure are likely to be cautious for the time being.

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Yesterday's batch of US economic data was mixed with house prices reporting a recovery but consumer confidence easing back. Confidence by definition is an intangible element but for economy-watchers, the monthly numbers reflect important feedback on perceptions of net wealth and job security. In this regard, developments in the jobs market are crucial and the upcoming US jobs data that is reported in early August will be important for assessing whether the increase in the unemployment rate is close to peaking. If it is, then the markets, being forward-looking in nature, will likely start to price in a normalisation of the Fed's monetary policy.

There are certainly signs of stabilisation in the real economy but consumer demand is just moving sideways rather than recovering. My guess is that employers are still cautious and I note that hours worked are at a low point. As a result, I think unemployment will remain an economic problem for a while yet.

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Volumes are light in both the equity and currency markets and can make for a typical summer of listless and range-bound trading. But I wonder if there is a risk of being lulled into a false sense of security. Equity markets are grinding higher and any pullbacks have tended to be short-lived. My guess is that the macro theme of economic stabilisation is sufficient to maintain a long-bias in equities for now.

In the currency market, the US dollar is looking like it is on the ropes at the moment. The US dollar index (DXY on Bloomberg) is below the 80 level and is testing previous lows. Purely from a technical picture, things don't look great. Reserve accumulation either by China or other Asian central banks continues at a significant rate and overnight there was intervention by some Asian central banks to prevent appreciation in their currencies.The Reserve Bank of Australia made hawkish comments on monetary policy overnight and the market is now pricing in a rate hike by the end of the year.

At the margin, fresh reserve accumulation is now more likely to go into the euro rather than the dollar. They have enough dollar eggs in one basket. The euro is now testing previous highs and I would not be surprised to see a decisive break-out through the top of the range which could see the EURUSD exchange rate move into a new 1.45-1.50 range. Likewise, dollar weakness could see the GBPUSD exchange rate move from 1.65 to 1.70.

Otherwise not a great deal else to report this morning and the main data focus will be on the the CBI distributive trades survey for signs of recovery in the UK retail sector. In the US, there is fresh data on house prices and consumer confidence. A recovery in house prices is an essential ingredient in helping to rebuild consumer confidence but at best the US housing market is only just starting to stabilise.

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The rally in equity markets continues with setbacks proving modest so far. I mentioned in my blog last week Goldman's upgrade of their forecast to 1050 for the S&P index and I tend to agree with them. This recovery in so-called risky assets has been underpinned by economic data in the US and UK which has indicated some degree of stabilisation in the real economy though the jury is still out as to the strength and durability of any recovery.

In addition, there has been much talk that the major central banks might be exiting their policy of 'printing money'. Indeed, there is now growing speculation of who might be the first to raise short-term interest rates though any such move has to be regarded as only the first stage in a normalisation process. However, long-term interest rates are edging up.  

This week, the US Treasury has to sell over USD100 billion of bonds to fund its deficit. Given that China is America's largest creditor, I suspect that the Strategic Economic Dialogue between the US and China today will highlight American efforts to re-assure China that it intends pursue policies to stabilise the deficit and the dollar. However, the dollar is on the ropes particularly against the European and emerging market currencies. Slippage in the dollar is pushing commodity prices higher and commodity-based currencies have experienced a strong recovery in recent weeks. Should American efforts to talk the dollar up appear unconvincing then the next few weeks might prove interesting in the currency market. Sterling might be a beneficiary of all of this despite fresh worries regarding banks' exposure to commercial real estate losses and ongoing problems related to the UK's budget position.

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Yesterday's UK retail sales figures posted a strong gain in the month very much as I expected. After the steep declines in spending last year, there are signs of stabilisation on the part of the consumer but it would be premature I think to believe we are on the brink of a sustainable recovery.

This morning the UK is the first of G7 economies to report economic growth numbers for the second quarter. I will be looking for an indication of a rebuild in inventories which will continue as demand optimism improves. Andrew Sentance upset the gilt markets after comments he made in an interview with Bloomberg. Mr Sentance is a member of the MPC and he claims that the Bank of England (BoE) could end its purchases of gilts next month. Gilt yields are higher as a result. There is a risk that the BoE may start becoming more hawkish on interest rates and I would not be surprised if we started to hear comments from BoE officials that interest rates could go up or normalise earlier than expected. In principle, all of this should help underpin sterling, though the poor fiscal backdrop remains a key concern.

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This morning's retail sales data for the UK economy provides important clues for the state of the consumer. Recent data has been disappointing but I wonder whether spending might be stabilising. In the US, I have highlighted in my blog that retail spending is no longer declining but moving sideways. After falling off a cliff last year, the consumer in the US is now at the bottom of the cliff. So it has to be sideways or up from now on. The same applies in the UK I think. Whether it is the impact of the car scrappage scheme, sales discounts or consumers spending because of low yields on bank deposits, I would not be surprised to see better-than-expected data. A continuing slump in spending looks less likely in my view.

In the currency market, sterling is holding up well especially against the dollar. An apparent pause in the Bank of England's quantitative easing programme is also helping sterling. A move to 1.70 in sterling/dollar is undemanding in my view. As I have mentioned before, sterling is also a barometer of investor risk. At the moment, a preference for risk on the part of investors is still intact and equity markets are holding up reasonably well.

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Mr Bernanke's congressional testimony yesterday was very much as featured in the Wall Street Journal article I highlighted in Tuesday's blog. Why anyone would be surprised that the Fed would want to keep their policy options open beats me especially as Mr Bernanke rightly expressed concern over the level of unemployment. Even the growth optimists at the Fed, and there aren't many, see little relief in the unemployment rate. This is why I think the Fed will keep rates lower for longer. At the very least, the Fed would have to see clear signs that the unemployment rate was peaking, never mind signs of sustainable trend rates of growth in the G3 before exiting the current policy stance. The Fed has historically acted as a global monetary policeman and US interest levels tend to set the benchmark for global rates.

In the UK, I read in some morning commentary that FX traders expressed surprise at the record blow-out in government borrowing. They obviously don't read the newspapers. Of more relevance in the short term will be the MPC minutes today. Like the Fed, I think the Bank of England will keep their options open as the UK economy is not yet out of the woods with regard to the prospects for growth.

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Goldman's central macro forecast for Q3 is sub-trend economic growth in the G3, low inflation and low interest rates, and strong emerging markets growth. Goldman believes that the balance of economic news "has been better" (despite little evidence that US final demand is improving) and that recent earnings results have shown "resilient margins" and "better guidance". Goldman's strategy team is upbeat about the prospects for equities and even though the S&P is now at the top end of its three month trading range (the S&P closed at 951 last night), it is raising its year-end target for the S&P to 1060.

In spite of my own more bearish views on the global macro economy, I have nevertheless advised in recent weeks that the equity market could grind higher over the summer given the relative underweight positions of real money investors as well as a variety of sentiment and positioning indicators that pointed to equities tending to go up rather than down. So I won't quarrel with Goldman's new S&P target. If they are right, then in the currency markets this points to an unwind of net long yen speculative positions which are now the highest amongst the G10 currencies. Sterling, as a barometer of global investor risk, might prove resilient in this environment despite worries about the UK's longer-term fiscal situation.

Also the latest Merrill Lynch Fund Manager Survey contains a number of contrarian signals which suggest some upside for equities. When I worked at Merrills many years ago, I always regarded the monthly survey as a good guide to what real money investors were thinking given the spread of the sample survey. I had a lot to do with the currency part of the survey and found that investor responses to the survey often provided good contrarian calls on the direction of surveys. I note in the most recent survey that investors regard the euro and the yen as the most overvalued currencies. But back to equities. The Merrill Lynch survey highlights that real money is still underweight equities in terms of asset allocation and that cash holdings are still relatively high (i.e., there is still plenty of cash that can be put to work in the market). So we shall see.

In terms of the more immediate market focus, all eyes are on Mr Bernanke's Congressional testimony today. An article in today's WSJ (click here) gives the main gist of what Mr Bernanke's thinking is. In the article, he says that the Fed has plenty of options for ‘exiting’ the current stance on monetary policy but he expects this exit to be someway off. This echoes the view of the Fed's Lockhart in comments last night who does not see a strong recovery in the medium term and is particularly concerned about the upcoming schedule of commercial real estate financings and the adverse impact that might have on US regional banks (click here for more). Mr Bernanke will be cautiously upbeat though as he would not want to dent confidence but if he signals that an accommodative monetary policy is likely to remain in place for a while yet, I think this will be well received in the equity market and could help support the US dollar.

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Asian markets were generally positive overnight thus bolstering the positive move towards equity markets that we have seen in recent weeks. In addition, there is news that CIT is getting a reprieve and avoiding bankruptcy for now though it may simply be a case of simply postponing the day of reckoning with the taxpayer eventually picking up the pieces. Also this week, we will get further earnings reports from US companies with 28% of the S&P index reporting. This time it will be corporates rather than financials and the upbeat reports from banks last week should not be interpreted as being reflective of what's happening in the corporate world. However, the S&P index did seem a little tired towards the end of last week and the index did not have the strength to take out the June high of 956. So this week's price action will be interesting. For what it's worth, our FX equity indicator, euro/yen, is still sending a positive signal for equities.

In a week in which the economic data flow is generally light, the main focus will be on Mr Bernanke's congressional testimony on Tuesday and Wednesday. I expect Mr Bernanke to echo generally the upbeat view on the economy (for 2010 anyway) that was evident in last week's FOMC minutes. However, the fact is that while many measures of underlying demand in the economy have stopped falling off a cliff, demand is still at the bottom of the cliff and, at best, moving sideways rather than staging any notable recovery (click here).

Last week's US retail sales numbers were weak and US consumers are still faced with a weak housing market, difficult labour market conditions and declining wage growth. Even the Fed expects little relief in the unemployment situation. So consumers are saving more and repaying debt i.e., de-leveraging. In the background, the parlous condition of many state finances (e.g., California) points to spending cutbacks and job losses. I can't see how the Fed can consider raising interest rates anytime soon and though there will be plenty of questions about ‘exit strategies’, I think Mr Bernanke would be sensible to keep his policy options open.

In the UK, the main focus will be on the Bank of England (BoE) MPC minutes on Wednesday and the retail sales data on Thursday. There was some surprise in the markets at the last BoE policy meeting when there was no change in quantitative easing (QE). The markets feel that QE isn't working and point to the higher level of gilt yields since the programme started as well as the absence of any pick-up in bank lending. The feeling in the market is that the BoE will expand QE at its August meeting from the current level of £125 billion but I think the minutes will make for interesting reading and I wonder whether there are one or two members on the MPC who would rather put the programme on hold.

As far as the currency market is concerned, things have been realtively quiet but I am encouraged by the resilience of sterling which I think can hold its own against the dollar. If equities can avoid a dump then currencies like the yen can give back some of their recent gains which look overdone in my view. For the euro/dollar rate, the June high of 1.4338 could end up being re-tested but like many in the market I think that a stronger euro will not help the eurozone economies recover.

ECU SUMMER RECEPTION - EDITED SPEECHES NOW AVAILABLE

For those of you that were unable to come to ECU's Summer Reception on 9th July at the Royal Geographical Society, or for those of you that were there but would like to read the text from the speeches given, the edited transcript is available here. The transcript comprises the views of Charles Manduca, Philip Manduca, George Magnus and Robin Griffiths on the current economic situation and where it is likely to head over the next six to eighteen months.

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Yesterday, the International Monetary Fund released its annual report on the UK economy (click here). The IMF concludes:

1. there are "tentative signs that economic activity is stabilising"
2. but that the recovery is "likely to be slow and subdued"
3. inflation is set to "remain low for an extended period of time"
4. more has to be done to re-capitalise UK banks
5. fiscal policy is a key challenge requiring corrective policies to put the debt/GDP ratio and budget deficit back on track

Some press reports this morning have, I think, exaggerated comments by IMF officials by claiming that the IMF is warning the UK Government about a potential run on the pound (click here for an example). For sure, there may be scenarios in which the fiscal arithmetic and lack of credible policy measures starts to scare foreign investors. However, that has not happened yet. Gilt auctions have not failed and the pound has been relatively steady on a trade-weighted basis since the start of the year. But there is no doubt that, given that all the major economies face similar problems over fiscal policy in the aftermath of the financial crisis, investors will be assessing on a relative basis which countries are acting fastest to put fiscal policy right. But no need to panic just yet.

Elsewhere, the equity markets have had a good run this week but I wonder whether some degree of risk aversion might come back into the market. There are plenty of factors from the Jakarta bombings through to fresh worries in financials (CIT bankruptcy, exposure of US regional banks to the commercial real estate market etc, swine flu deaths). Technically, the early June high of 956 is in focus but should profit taking occur then I think 880-900 provides good support for now. There are earnings results from Citi, BoA and GE today but I think that the earnings estimates can be beaten.

Finally Prof Roubini, famous for his (correct) forecasts on the financial crisis says he is not revising his view. He says the US economy is in "the 19th month of a severe recession" and he sees "shallow, below-par and below-trend recovery where growth will average about 1% in the next couple of years" (click here for his statement).

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Equity markets made gains for the third straight day with stocks up around 3% yesterday but volumes remained low which warns that sentiment could prove fickle. The S&P index closed at 932, above the 925 level that I had suggested the market could go to in the short term. Sentiment was aided by economic data (CPI, industrial production, the NY Fed index) that were interpreted as being ‘better than expected’. However, I note that US industrial production actually fell at an annualised rate of 11.6% in Q2 so we should not get too carried away. Goldman's economics team in their morning note say that many measures of spare capacity in the US economy are at or near record highs and they think it could take 3 to 5 years to eliminate this spare capacity. In the meantime, core inflation will likely decline over the short to medium-term. The FOMC minutes published yesterday evening contained an upgrade to the Fed's GDP forecasts for 2010 but the minutes contained nothing to suggest that the Fed was about to extend its bond purchasing scheme.

Elsewhere, the latest GDP numbers for China have been released and they showed that China grew by 7.9% in Q2. Growth of just above 8% is likely for the whole year. Chinese industrial production numbers were also quite strong growing at 10.7% in the 12 months to June. Interestingly, China's FX reserves topped $2 trillion for the first time and there is some indication that there may have been ‘hot money’ inflows of around $60-70 billion in Q2. This makes it difficult for Chinese policymakers to control money supply which is growing at a double-digit rate but there will be more ‘fine-tuning’ in the central bank’s monetary policy operations as it tries to soak up liquidity. The rise in FX reserves also implies that there has been little diversification out of the dollar and the dollar accounts for about 65% of China's FX reserves. Other capital flow data suggests that China is still buying US debt. Foreigners hold 28% of US debt but the US is issuing about $2 trillion of debt this year compared to just above $700 billion in 2008. The fate of the dollar depends on foreigners continuing to fund the US budget deficit and today's US TIC capital flow data will make for interesting reading.

However, it is worth noting that there has already been a considerable adjustment in US imbalances with both the trade deficit shrinking and the private sector offsetting an expansion in the government's budget deficit. The private sector is saving more and reducing its deficit. Professor Krugman makes some interesting points about the importance of looking at what is happening in the surplus/deficits of the private sector and government (click here). Also of interest in this morning's financial press is Anatole Kaletsky's piece in The Times about potential fiscal dangers in the pipeline (click here). The dangers of exploding government deficits was highlighted by Fitch, the credit rating agency, revising New Zealand's long-term sovereign debt rating to negative. New Zealand also has a current account deficit that amounts to 8.5% of GDP. The news put downward pressure on the NZ dollar amd makes financing of the deficit more challenging.

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Yesterday's release of the latest UK CPI inflation data revealed a drop in the inflation rate below the 2% target for the first time since September 2007, the approximate start of the credit crisis and the demise of Northern Rock. Food price inflation fell to 5.5% from 8.4% and the cut in the VAT rate last December is continuing to impact on the CPI data. The Bank of England's Monetary Policy Committee (MPC) needs to be mindful of the risks of deflation and in my view it is deflation rather than inflation which is the key risk in the current environment. The MPC needs to keep its policy options open and at the very least this means an extended period of low interest rates. More immediately it means that it is quite likely that the MPC will extend its quantitative easing programme at its August meeting. Today's UK unemployment data is unlikely to provide much relief and the underlying trend is for the unemployment rate to rise. I don't see  the unemployment rate peaking until next year.

In spite of all of that, market sentiment is positive and this is being reflected in the equity markets. Optimism is a fragile concept though, particularly as trading volumes are below normal at the moment. However, the market took comfort from Goldman's results yesterday and an upbeat forecast from Intel. Yesterday's US retail sales data didn't contain too many ‘green shoots’ and the headline number was flattered by a 5% increase in petrol prices (the US retail sales data is not inflation adjusted).Strip out petrol and auto sales and retail sales fell 0.2% making for the fourth monthly decline (click here for more). Overnight, Asian equity markets were generally higher and the Bank of Japan at its regular policy meeting kept targeted interest rates unchanged at 0.1% and extended its credit programme to the end of the year.

I guess the consensus view in the market is marginally pro-risk at the moment but I sense that conviction is low with traders and investors attempting to assess the next macro move going into Q3. In the interim, the current equity rally could extend a little further (I note euro/yen has moved up a little to 131 this morning) and I would not be surprised to see the S&P extend towards the 925 level. However, earnings estimates for Q2 are important. The market has had a good start so far but needs to see earnings beat the 62% level reported for Q1.

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In my last blog I said I was spending a long weekend in God's Country. I thought everyone would know what I meant but my son, who reads my blog, was puzzled and asked what did I mean? I have obviously failed as a parent in communicating our heritage, and our ancestors who fell at Culloden must be rolling in their mass graves (click here and here). My son did observe though that if it is God's Country, God had clearly never been to Glasgow. Fair point.

Anyway back to markets and as Nessa in "Gavin and Stacey" (click here) might say "what's occurring?" Well, in the currency markets, not a lot. In the last five days, sterling/dollar has traded a narrow 1.5982-1.6381 range, euro/dollar has traded 1.3832-1.4073 and the dollar index is flat-lining around the key 80 level. Robin Griffith's favourite FX equity indicator, euro/yen, is around 130 this morning. So not a great deal to report and one investment bank's report I read yesterday described trading conditions as ‘aimless and listless’.

That's not to say that nothing is ‘occurring’. The price of oil fell 10% last week and that is essentially a welcome reduction in tax for consumers and businesses. US Treasury Secretary, Timothy Geithner, says there is a "very strong chance" of economic growth returning "over the next few quarters". The Singapore Government has just revised up its economic growth forecast this year and what happens in Singapore is regarded as an important bellweather of gobal demand. Overnight, Asian equity markets broke a nine-session losing streak with the Nikkei up over 2% as optimism over the prospects for the global economy returned to the markets. However I did note a report from analysts at BNP Paribas who are warning that the Shanghai Comp Index could be in trouble later in July (click here).

In addition, influential banking analyst Meredith Whitney put out a ‘buy’ on Goldman Sachs who are expected to report bumper earnings today (click here). Should earnings reports elsewhere in the banking sector surprise on the upside, equity markets could see fresh gains. The S&P index closed at 901 last night and the important technical level of around 880 is holding so far. A run back up towards 925 cannot be ruled out in the short term.

Otherwise, in the UK, the latest report from RICS reported that buyer enquiries in the housing market have been rising for the past 8 months. Sterling tends to track the RICS price expectations index (as well as mortgage approvals) so this might underpin sterling for now. However, PWC also put out a report which was more downbeat and they say there is a 30% chance that UK house prices won't return to their previous peak until 2020 (click here). There is certainly more anecdotal evidence of increasing transactional activity in the housing market but I think that the unemployment rate needs to peak first before house prices can make a sustainable recovery. And remember that banks are still tight on lending and that will also hamper a potential recovery.

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Last night's Summer Reception, which The ECU Group held at the Royal Geographical Society, highlighted all our concerns about where the economy and the markets will end up. It was entirely proper that the proceedings were held at the RGS where many great explorers have mapped out hostile terrain and spoken of their adventures. Mapping the financial markets seems no less different and as Philip Manduca, our Head of Investment, said in his introductory remarks, it requires intensity of focus on the part of his investment team as well as in-depth analysis together with flair, intuition, collective memory and a touch of good luck. Easy really.

George Magnus, as he outlined last night, continues to think it will be a long haul out of the recession. George was very prescient in spotting early on the seeds of the financial crisis and he helped popularise the work of US economist Hyman Minsky who studied the economics of financial speculation. Minsky's work is enjoying a revival and is required reading for understanding the dynamics of financial regulation. I agree with most of George's analysis as I think balance sheet recessions – which require de-leveraging and debt paydown – take time to put right. Talk of ‘green shoots’ looks misplaced in my view. George has also done a lot of work on demographics and he pointed out the adverse impact that ‘baby boomers’, who are now retiring, will have on spending and savings as well as the claims they make on entitlement programmes. One of George's ‘black swan’ risks looking forward is a breaking-up of European Monetary Union and I note this morning that the IMF is warning of a financial crisis in Central and Eastern Europe.

Robin Griffiths, also on our Investment Committee, thinks that the Asian economies will dominate our economic future with the developed western economies falling behind. Robin is a particular bull of China and India (and their currencies). Robin, however, is bearish on equity markets and looks for a low point by October. He felt that we should not rule out new lows. He mentioned the euro/yen exchange rate as an indicator of equity market moves and highlighted the 130 level as important. Below 130 and you will end up with a weaker equity market. Robin was also a longer-term bear on the US dollar and said that the 80 level on the dollar index (DXY if you have a Bloomberg terminal) is key. We are at 80 this morning and Robin warned of further dollar slippage if this level gives way. He thinks the GBPUSD rate could go to 1.70-1.80.

All very interesting, and chatting with clients afterwards revealed just how much interest there is in many deep-seated issues including the role of China which I think will be very important. Some clients were bullish and optimistic which tempered pessimism on the economy elsewhere. Many agreed that volatility will remain in place for a while but many also thought this would bring tremendous investment opportunities especially in global macro.

Anyway, all food for thought which I will contemplate further over the weekend on my visit to God's Country.

I had the great pleasure to be invited by Goldman Sachs to a dinner last night hosted by Prof Willem Buiter (formerly a member of the Bank of England's Monetary Policy Committee). As always, he made some astute observations on the state of the economy and monetary policy which sparked a lively debate amongst the guests (mainly hedge fund managers). Prof Buiter's comments on UK monetary policy are particularly relevant as today is the regularly scheduled meeting of the Monetary Policy Committee.

The markets expect interest rates to remain unchanged today and look for the Bank of England (BoE) to increase its quantitative easing by £25 billion to the current maximum limit of £150 billion (for an explanation of what quantitative easing is and how it works in the UK click here). It is likely also that the BoE will ask the Treasury for an increase in the current maximum limit.

While lower interest rates in the UK are estimated to have increased borrowers' spending power by £60 billion per annum, most of this has been financed by a £40 billion-plus cut in personal income. In a credit-constrained world in which consumers are repaying debt, the normal impact of lower interest rates in reviving economic activity is muted. While the media have tried to give a positive spin to the IMF's latest economic forecasts ("the recession is over"), a closer look at the forecasts shows that the IMF expects the UK economy to grow by 0.2% next year. Whoopee!

Back to UK monetary policy: Prof Buiter thinks quantitative easing isn't working (click here for his comments). The BoE's purchases of gilt-edged securities are resulting in a cash pile-up at the banks which isn't being recycled into the real economy. In addition, there is a leakage abroad as gilt sales by foreign holders results in cash leaving the UK economy. If you look at all the main measures of money supply and credit growth, they are still trending down. Perhaps the BoE, instead of buying gilts, should purchase private sector securities.

However,Prof Buiter thinks that the banks should be recapitalised by raising tangible common equity from the markets, injections of public sector capital and mandatory debt-to-equity conversions. He thinks (rightly) that liquidity is not the problem. A shortage of capital and the threat of insolvency is the problem. Capital needs to be boosted and toxic assets removed. Banks' leverage (which is still too high) needs to be reduced. Without any of this, the UK is likely to face a prolonged situation in which credit remains tight, thus impeding and hindering a sustainable economic recovery for some time.

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US equity markets are at two-month lows and overnight saw the Nikkei drop for its sixth consecutive session. The S&P index broke the important 888 technical level which highlights the risk of further declines. The S&P index is now below its 50-day and 200-day moving averages and below the opening level of 2009 (903). The Q2 earnings season starts today (Alcoa) and investors will be monitoring this closely to see whether earnings estimates are justified. I think they are not so I am expecting disappointment. Stockmarket valuations are close to the historic average (based on the PE/10 metric) but there is a high probability that valuations could move lower before this move down is over (click here for the analysis). So, investors should be wary of more slippage in equity markets over the near-term.

Following an unexpected 3.0% decline in Japanese machinery orders, the Japanese yen moved to a five-week high against the US dollar and there were reports of Japanese selling in GBPJPY with cable (GBPUSD) below the 1.61 level. I note on my chart that the 100-day moving average in the GBPUSD exchange rate is at 1.5924 which might provide support as sterling would start to look very ‘oversold’ down there. But much depends on the stockmarkets as investors do regard sterling as a barometer of global investment risk.

The EURUSD at 1.39 is still tracking movements in the oil price (currently at $62) and the CFTC is said to be considering tighter regulations on oil trading. I prefer to trade the FX market with a bias towards long dollar positions at the moment. G8 is unlikely to come up with anything dramatic concerning ‘reform’ of the international monetary system, though the debate about the dollar's long-term future as the world's leading reserve currency is likely to remain a hot topic for some time.

As far as G8 is concerned, the Chinese President has left the summit to deal with unrest in the Xinjiang region. The German Finance Minister is concerned that companies are struggling to roll-over debts while Laura Tyson, an economic adviser to President Obama, says a second fiscal stimulus package should be considered. I agree and note that Goldman's economics team look for the next package to total $250 billion for 2010-2012. The fact is that the US economy is struggling to return to trend rates of growth and the consumer simply doesn't have enough fire-power to take the economy out of recession.

Finally, Brad Setser at the Council for Foreign Relations (CFR) has come up with an interesting video/graphic explaining the global financial crisis and it is well worth looking at (click here).

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The Japanese equity market is down for its fifth straight session as worries about the prospects for the global economy dent investor sentiment. The same applies to the other major markets where there is a reappraisal about where the economy is going following the optimism seen in the second quarter. Now, things look a little less certain and recent economic data suggests that the foundations for a durable economic recovery are not so strong. Readers of my blog will know that I am not a true believer in the ‘green shoots’ story and I warned some time ago that the stockmarket rally would falter in the light of economic reality.

The S&P index is now off some 5% from its peak in early to mid-June and market technicians are looking at the 880 level as a key support. If this level breaks, we could see a deeper retracement which would coincide with a steeper retracement in commodity prices together with further gains in the US dollar. Upcoming earnings results are important but earnings estimates are way too optimistic in my view and the absence of pricing power in what is still a deflationary environment will weigh on future profits growth.

Gordon Brown makes a good point that we should not be complacent about deflation as he prepares for the G8 summit. I think that policymakers will have to consider fresh stimulus measures and I think it will be apparent before too long that consumers (in the US and the UK) do not have the firepower to put their economies back on track. Of course, this means a further deterioration in budget deficits but I don’t see any meaningful alternative.

As far as developments in the currency markets are concerned, most of the major currency pairs are still in their recent trading ranges. Sterling has seen some profit-taking in tandem with the slippage in equity markets (and financials). However, the G8 will put the dollar in the limelight and I am not convinced that it is time to write off the dollar just yet.

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The upcoming G8 summit is likely to focus on the prospects for the dollar's role as the leading reserve currency. This is a theme which is unlikely to go away and there will likely to be lots of talk about reform of the international monetary system. However, it is in nobody's interest to see a weaker dollar and I think the G8 understands that so I wouldn't be surprised to see the dollar do well. Certainly, last week's poor US jobs data is denting equity markets as optimism of economic recovery fades.

No surprise to see oil and commodity prices lower this morning. Also, sterling is not doing well. Prof Niall Ferguson thinks there is a one in three chance of a sterling crisis as a result of the UK's budget deficits (click here). In addition, there is talk that the Bank of England will extend its quantitative easing programme.

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Yesterday's US jobs data contained plenty of bad news and put a big questionmark over the ‘green shoot’ thesis that we are through the worst and that economic recovery is around the corner. Hours worked in the private sector fell to a record low. This is a key indicator of what's really going on in the economy. The corporate sector is de-leveraging, cutting costs and shedding labour. Recessions do not end when the number of hours worked declines.

The knock-on effect is that wage income declines (hours worked multiplied by the hourly wage rate) and this is what is happening too (average weekly earnings fell 0.3% in June). Labour has no pricing power and given that labour costs are the major component of total unit costs then deflation, not inflation, is the main worry looking forward. With the unemployment rate edging higher (9.5% currently) and likely to stay high for some time, this has enormous political and social implications. Of course, unemployment is rising in all the major economies and I noticed that Spain's unemployment rate reached over 18% in the recent data release.

So the notion that the recession is over looks very misplaced to me and I think financial markets are in for further disappointment as the economic news rolls in during the rest of the summer. I think deflation remains a real risk and from an equity market perspective, deflationary pressures undermine corporate pricing power as well as corporate profit margins and earnings streams. I notice also that in the US, there were seven bank failures this week making for 52 FDIC-insured institutions that have failed so far this year. It is not surprising that equity markets have started the second half of the year on a jittery note and we could see further downside in equity prices over the short term.

All this suggests to me that the US economy in particular needs further policy stimulus. There has been a lot of talk about ‘exit strategies’ in which central banks drain liquidity and raise interest rates. However, if economic recovery fails to materialise then I think policymakers will simply have to keep interest rates lower for longer and on the fiscal side think about tax cuts and ways of putting money in people's pockets.

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The main focus for the financial markets today is the outcome of the European Central Bank’s (ECB) latest decision on monetary policy as well as the latest monthly reading on the US jobs market. As far as the ECB is concerned, I think it will largely be a non-event. My guess is that interest rates will stay on hold for now as the ECB has, so far, preferred to ease policy through injections of liquidity into the banking system. Last week's subsidy of 1-year money provided on very generous conditions by the ECB is an example of this (for a critical appraisal of the ECB's funding I recommend Professor Buiter's latest thoughts on this and I see little to disagree with in his analysis – click here). Mr Trichet will likely remain non-commital, as he usually is, in terms of what the ECB might do in the months ahead.

The US jobs data tends to set the tone for the financial markets at the start of the month. Yesterday's Automatic Data Processing (ADP) numbers, which report job losses in the private sector, reported job losses in June of 473k. The pace of job cuts is certainly easing as total job losses in the second quarter amounted to 492k compared to 691k in the first quarter. We will probably see a similar picture for the broader nonfarm sector reported today but I think the unemployment rate will continue to edge up possibly breaking the 10% level. The underlying dynamics of the US labor market remain poor and David Rosenberg makes some very salient points and provides some very interesting charts (click here).

Here in the UK, yesterday's PMI data did report an increase to 47.04 from 45.39, but the fact is it was still below the ‘recession/recovery’ level of 50 for the 15th month in a row. Nevertheless, the numbers are slightly better for the UK than the eurozone which might reflect previous sterling weakness, a more pro-active interest rate policy from the Bank of England and an earlier run-down in the UK's inventory cycle. However, while the picture looks less grim there are still concerns about unemployment, the housing market (rising repossessions) and a fiscal situation that looks dire. The Guardian this morning (click here) claims that the UK's transport system faces a £30 billion spending gap which means delays in projects like Crossrail. Bad news for commuters and travellers. We will likely hear more of the same as the government is forced to cut back spending to tackle the budget deficit.

Well, the first half of the year is over. Investors’ best bets over that period would have been to have been invested in high yield credit which reported gains of nearly 35% (Europe) and 23% (US). Oil was up 57% with gold up just 5%. If you invested in emerging market equities, you saw gains of 34% but only 2% in the S&P. The FTSE100 index was down 4% but up 9% in dollar terms (which just shows the importance of getting the exchange right). Indeed, despite all the gloom and doom about sterling at the beginning of the year (remember Jim Rogers?), sterling has actually been a good performer on the exchanges.

What will the second half of the year look like? I think high yield credit has had a good run as corporate bond yields have normalised and spreads narrowed. It will be more difficult to extract a similar performance, and gains for the rest of the year will likely be muted. There is still plenty of cash on the sidelines (though less than there has been). Equity markets need to see hard evidence of economic recovery to justify earnings estimates. Current valuations are not necessarily cheap and there are still challenging headwinds in the economy that could make for a bumpy ride. Some influential commentators think the stockmarket is on thin ice from a technical perspective and point to 8300 in the Dow Jones as being an important level to watch out for on the downside (click here for more on this).

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Readers with a knowledge of UK politics in the 1950s will remember Harold MacMillan's line about economic conditions at the time: "most of our people have never had it so good". Yesterday's UK GDP data reported the worst quarterly performance for economic growth since 1958. Maybe we've never had it so bad (well, at least since the 1930s, which was really, really bad). Whether, the first quarter actually marks the low point in the economy remains to be seen but my guess is that any recovery will prove difficult. UK consumers, like their American counterparts, took full advantage of the boom in credit and used the sharp increase in house prices to extract equity. All of that is going into reverse.

But as we have all discovered, using your house as a glorified cash machine was not a good idea. Getting out of the mess – which will require consumers to save more and repay debt – will weigh on the economy for some time. Adding in the restructuring of the banking sector and tight credit conditions, this still leaves a high degree of vulnerability for the economy. Public finances are in a particular mess and the budget deficit is on an unsustainable path; I have seen estimates from some commentators that argue it will take a minimum tax package of £70 billion just to stabilise the UK's public sector finances.

In spite of all of that, global stockmarkets have just turned in their best quarterly performance in 20 years. Whether a similar performance can be turned in for the third quarter is a tough call. Investors will need hard evidence that the major economies are improving enough to justify earnings estimates. There is still the possibility of shocks to the banking sector should the property market (commercial and residential) fail to recover thus creating negative feedback loops between the banks and property. In addition, and bearing in mind that 25% of the S&P index is accounted for by energy and materials stocks, a lot depends on whether China can act as a locomotive for the global economy. Chinese imports of refined copper reached record levels in May but there is a risk that inventories might soon reach levels that dissipate demand. This could result in some slippage in commodity prices.

Economic data yesterday was not helpful. US consumer confidence dipped to 49.3 in June from 54.9 in the previous month. Historically, US recessions have never ended when consumer confidence has been this low. Measures of jobs ‘hard to get’ also went up and suggest little relief in the US jobs market. Overnight, Japan's Tankan survey did improve but fell short of market forecasts. Capital spending by Japanese manufacturers was noticeably weak. I believe that Japan needs a weaker yen and not a stronger yen, coupled with further stimulus measures.

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