Now close to three years after the last peak of euphoria and the intervening credit crisis, risk for investors is no four-letter fantasy but is instead a reality cross check. Weak U.S. employment numbers and other releases have already raised political temperature for markets in 2010 by, well ahead of the traditional post Labor Day focus during U.S. election years. As well as political considerations are expanding in Asia (such as cooling asset pressures in China) and Europe(such as deficit reduction). Arguably since late 2007 there has for investors been yin/yang over expansion/recession. Now, the focus on short term developments needs to evolve to corporate requirements for the long run. We expect equities to be in the trading ranges established in 2010 to date Hi- Low (S&P 500 1217-1022; MSCI World 1228-1033) ranges until more clarity emerges, likely around mid 2011. The breadth of recent bond rallies from sovereign debt to junk contrasts with potential cash flow pressures if deflation or economic weakness were to spread. Assumptions of nimble behavior in current fixed income represent risk even if the Federal Reserve has signaled via its August 10, 2010 statement maintaining a large $2.3 trillion balance sheet and low rates. Even with faster Asian growth, we are skeptical about the notion of faster corporate revenue growth without corporate leadership. We do not expect equity valuation expansion in major markets like the S&P 500. In some markets like India, P/E ratios appear high versus inflation pressures on the central bank. One source of bifurcation in favor of quality for the investor today lies in differentiating in favor of companies re-investing for the future and stressing stable ROE over those stretching for amplitude. Within a quality overlay, we favor information technology and energy as well as in healthcare, anticipating further restructuring. Gold remains our favored hedge against uncertainty. Yen levels remain of concern to us as a potential unrecognized global risk factor.

Notwithstanding the summer of 2010 brouhaha, for investments, the Sword of Damocles is likely not Greek restructuring and Europe. Instead, the challenge of rotational change may lie in Asia and the Americas, particularly the United States. The earnings reports emerging in recent weeks now include those from the United States, other parts of the Americas, Europe and Asia. The similarities lie not just in accentuated bifurcation that continues among and between industries. Globally, cost cutting has been yielding substantial earnings recovery gains but also in reputedly stable areas, like consumer staples, pressure and disappointments have not been offset by aspiration potential in emerging regions or basic needs in advanced economies. Stripped to its essence, the cycle that ended in 2000 marked the culmination of concept driven growth expectations boosting markets, especially in technology, media and telecommunications ( TMT ). The next cycle that ended in 2007 had as essence risk premium reduction whether viewed from the perspective of sovereign and junk bond yield spreads or viewed from the perspective of rising performance of low quality equity and its relative valuation gain. A less commented upon aspect of the Japan debacle of the 1990s is the consistency in its subsequent performance. Recovery at the company level was determined by the quality of operations and not all succeeded, for instance in its until then global beating consumer electronics and automobile businesses. Japanese Government Bond yields declined and short rates were held at minuscule levels. However, even as earnings recovered, equity valuation in Japan did not and still has not recovered substantively versus prior expectations and stock bond risk premium analysis. Aggregate dividend yields in Japan have increased from among globally the lowest to now middle of the road levels. The global markets of today remain mixed in low government yields and equity leadership. We re-assert that while there has been global and U.S. overlap in low quality led recovery into the first portion of April 2009 to May 2010 of this cycle, quality of delivery is likely to be the enduring feature for countries, industries and companies alike for investors to favor.

Turbulence is likely to continue in global capital markets based on developments at the thirty thousand feet, at the mountain top and ground level in the form of monetary policy, bank stress tests and earnings releases. Inherently contradictory to good management and seamless recovery remains the pining for easy monetary policy to continue while long government bond yields also remain close to lows in the U.S. dollar, the Euro and the Yen. At the thirty thousand feet level, currently is broad based bifurcation. In fast growing Asia, pushback from the populace is growing over inflation, with central banks responding. Unlike the pre May 2010 markets taking robustness for granted, the July semi-annual Fed Monetary Policy report started with reference to unusual conditions. Even as industrial countries overall keep rates low, an array of central banks with differing economic milieus has been raising rates. The financial sector as link to the real economy gives a mountain top view of turbulence not dispelled by July 26 reports of Basel accord for 2018, by July 23 releases of stress tests in European banks with wiggle room on sovereign debt that contrasts with stringent Swiss action as far back as 2008 and by property loans that Chinese bank stress tests attempt to proactively contain. In a market looking for substance over sizzle, wiggle room in rescheduling recognition affects the perception of quality of bank reporting and specifically to Europe, for the investor favors Swiss over other bank exposure. Albeit improved into the first half of 2010, at the ground level during uncertain global growth and finance, enthusiasm for beating consensus has been muted during earnings releases as the focus had already by May 2010 moved away from governmental largesse sizzle and to the substance of privately generation of revenue. The deluge now from U.S. based releases is forthwith to be joined by European and Asian releases. More than generalized valuation expansion, these characteristics favor a quality of delivery focus over sharp upswings even in our overweight areas like energy and healthcare and favor growth driven by technological change such as in information technology especially in communications.

Capital markets have lately been incorporating that hot Asia plus cold industrial countries concurrently do not become equal to just right, without a workout that blends two solitudes. A required unfolding of workout is likely to apply to policy delivery and market behavior. On currency, we are encouraged by the euro decline, see need for a lower Yen, recognize incremental steps from China now including yuan products in Hong Kong but see need for integrative action within ASEAN also. At this point of earnings recovery, we maintain unusual value develops below 1050 (S&P 500 at 1071; MSCI World at 1089) but exceeding the 2010 highs (over 1250) is likely prolonged to mid 2011. Back in 2006, lack of differentiation in capital markets over risk quality became important for us. The subsequent process is already close to four years old but incomplete. From unemployment to credit failure to earnings decline and corporate failure much has taken place in workout for industrial countries but sovereign debt vigilante behavior is elevating. In emerging countries, containing the political pressures from rising inflation have also become higher priority issues. By early Q2/2010 with complacency on government largesse, market behavior had moved well ahead of earnings and policy delivery. The sovereign debt and the first tranche of earnings releases after Q2/2010 underscore that workout remains underway. The full flowering of a quality overlay on portfolios is still to bloom. Serial exaggeration, part of capital market lexicon for fifteen years, needs next to diminish for progress. It currently oscillates between expectations for seamless recoveries versus double dip into recession. Better blending is likely to require moderating fast growth with more integration in Asia and boosting growth in industrial countries. For earnings now being released from Korea to Europe and the bulk now in the United States, we see bifurcation within industries likely as important as amongst them, during lower recovery than consensus. For industry at large and in the crucial financials, recurring revenue growth capabilities are likely now to be a crux, in contrast to serial exaggeration and consensus tendencies experienced in the last cycle. Quality differentiation related to operations and balance sheets is likely to be a key theme even within our favored sectors of energy, healthcare and information technology.