Germany

Sunday’s elections provided no clear winner. This is short term bad news for the DAX, but the correction should be moderate.
Both Chancellor Gerhard Schroeder (SPD) and CDU leader Angela Merkel have claimed victory. A grand coalition (SPD/CDU/CSU parties) is the most likely outcome but it will take weeks, or even months, to find out. Four things are clear:

• First, further reforms are on hold for the foreseeable future.

• Second, the German economy is gaining momentum.

• Third, corporate profits will benefit from euro depreciation and earlier reforms.

• Fourth, the DAX is cheap.

Bottom line: Despite/because of likely political turbulence in the next few months, the DAX looks interesting.

Fed up?

The Fed is likely to raise rates today and leave its policy statement broadly unchanged.
Hurricane Katrina has complicated the Fed’s policy decisions: economic data will be distorted, and growth and inflation outlooks are more uncertain. The FOMC could justify pausing this month, but it will likely proceed with another measured hike. Buoyant housing, strong bank lending growth and firm equity prices suggest that financial conditions remain easy. Meanwhile, the Fed is still concerned that high energy prices could pass through into core inflation. This argues for repeating that policy remains accommodative and more measured rate hikes lie ahead. That does not rule out a pause in November, but a full-blown end to the rate cycle will require firm evidence of a sustained growth slowdown.

Slower consumer spending due to declining confidence and rising unemployment claims would cause the Fed to back off.
The gap between the growth in retail sales and weekly earnings has reached a level historically associated with mean reversion. A decline in this measure typically coincides with a peak in short-term interest rates. The dismal performance of consumer discretionary stocks is already warning that consumers may take a break from spending. Spending will probably slow, but there may not be an abrupt decline.

A less aggressive Fed and fresh U.S. fiscal stimulus will underpin equities in the near term. Ironically, non-U.S. stock markets will be the biggest beneficiaries.
Prior to hurricane Katrina we were becoming increasingly concerned that rising energy prices and Fed tightening would soon jeopardise equity market strength in the U.S. and elsewhere. However, while the U.S. economy is set to slow, the risk of excessive Fed tightening in the near term has markedly diminished, raising the odds of a soft landing. Against such a backdrop, the gradual pickup underway in other key areas of the global economy will continue, which will permit non-U.S. equities to trend higher. Bottom line: A more favorable U.S. policy environment is bullish for global stocks in the short run.

Japan

Japanese equity valuations are more attractive than at anytime in the recent past, although they are still high on several measures.
Prime Minister Koizumi’s resounding victory in conjunction with the gradual recovery of the economy bode well for equities in the months ahead. But does the Japanese market offer good value for global investors? The 12-month forward P/E is 16, close to its historical low. Relative to domestic 10-year bond yields, stocks look appealing, which should induce asset allocators to raise equity exposure as the economic recovery gains strength. Less favourably, the forward P/E is slightly above the U.S. level, despite the U.S.’s superior long-term potential GDP growth. Other measures paint a more compelling valuation story for Japanese stocks.

And finally…….

Bush family holiday.

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.