Portugal became the third euro zone country to seek a rescue from the EU as the nation’s fiscal situation and political crisis pushed borrowing costs to record levels. Bloomberg reported the rescue sought may be worth as much as EUR 75 billion. This comes as no surprise as the markets have long priced in this possibility. Portugal faces bond redemptions totalling EUR 9 billion due by 15-June. The trigger came as PM Jose Socrates resigned on 23-March after parliament rejected his proposed budget cuts. We continue to see the debt situation in the periphery as untenable. The taxpayers and public are bearing the brunt of the debt load. Ultimately, a debt restructuring may be inevitable. The question is soon or later. Trade them if you wish but we are avoiding the bonds of Portugal, Ireland and Greece. Spain and Italy are in much better shape and markets are giving their bonds the benefit of the doubt as spreads against German bunds fell recently. Interestingly, the announcement had limited impact on the EUR which went on to top 1.43 handle.

The ECB hikes, BOE holds. On Thursday, the European Central Bank (ECB) raised interest rates by 25 basis points to 1.25% for the first time since July 2008, while in a separate meeting the Bank of England (BOE) left rates at a record low 0.5%. The contrast cannot be more stark given the inflation rate in the UK is 4.4% - double the target – while “only” 2.6% in the euro-zone. Unlike the ECB which pushed ahead nonchalantly with a well-flagged rate hike even as Portugal became the third euro-country to seek a bailout, the BOE continued to judge the UK economic recovery too shaky to withstand higher rates. The ECB might have been emboldened by the market view that Portugal is likely to be the last to seek aid and that Spain has decoupled from the crisis. The fall in Spain’s bond yields over the past month reinforces the view that the market is optimistic that Spain is moving in the right direction to address its fiscal problems. Still, we are not convinced that the risks have entirely gone away. With the EUR at a 14-month high, unemployment rate stuck at 20% and a combined public-private debt load in excess of 3 times GDP, watch out for aftershocks!

The FOMC minutes of its March 15 meeting revealed a tension amongst Fed policymakers over the path of monetary policy beyond the completion of USD600 billion of bond purchase programme or QE2 in June. The hawks, most notably Plossner, Fisher and Kocherlakota, argued that the Fed should move to a less accommodative stance given the strength of the economy whilst the doves led by NY Fed Prez William Dudley noted that the recovery remains tenuous and argued that loose policies are needed beyond 2011. The implied probability of a rate hike from current target Fed Fund rate of 0.25% from the futures market remain below 50% by the end of the year. At the heart of the debate are differences in opinion over how much core inflation is rising and where the natural rate of unemployment lies in this current cycle. It seems the Fed’s central tendency is 5.5% and with current unemployment rate at 8.8%, the central bank has room for loose policies. But the hawks argue that it should be as high as 7.5% and that current policy stance could be unnecessarily loose spurring inflationary pressures ahead. While this may sound academic, the fact that the debate failed to recognise the potential secondary effect of higher food and energy prices on overall inflation is for us critical. We feel that there is a real risk that the Fed may end up behind the curve.

Once again, China showed its penchant to raise rates on a public holiday. On 4-April, the last of the 3-day “Tomb Sweeping” holiday, the PBOC boosted its benchmark one-year lending rate and deposit rate for the second time in 2011, by 0.25 point each to 6.31% and 3.25% respectively. Even though we have been expecting another rate hike this quarter, the timing was a bit surprising and could signal that the inflation rate for March may be much higher than 5% or even above 5.5%. But truly, we think it underscores policymakers resolve to get ahead of the curve to defuse signs of overheating. That said the job is not done yet as the deposit rates remain well below the CPI. We expect another 2 rounds of 0.25 points hike by end of summer and also open market operations by the PBOC to drain liquidity. By then, we expect CPI would have moderated below 4% to more or less in line with deposit rates. We are beginning to see the end of the underperformance of Chinese stocks and would advocate adding on weakness for those still unexposed.

Japan suffered the biggest aftershock on Thursday night since the 11-March earthquake. The 7.1 magnitude temblor near the site of last month’s quake sent the operator of the stricken Fukushima nuclear plant to evacuate workers. Fortunately, there have been no signs of changes in radiation levels or damage to the reactors. Again, this laid bare the emperor’s new clothes. As one commentator puts it, the nuclear technology we have today to generate power is “half baked” because we have been smart on how to start a nuclear reaction but less so in stopping it. And because we can only contain the process and not stop it, the nuclear fuel remains highly radioactive and has to be stored away for decades. Should we continue to allow ourselves be served “half-baked” dishes? We reckon this is a major setback for the nuclear power industry with significant impact for decades. In the near term, oil, gas and coal will be well supported.

After days of tense negotiations and partisan bickering, US Congress leaders reached a last minute accord to slash USD 38 billion from federal spending this year to head off a shutdown of the government. Expect more of this partisan brinksmanship in the coming months with a renewed vigour from the members of the conservative new House majority.

EQUITY

The MSCI World is within spitting distance of its recent 52-week high in mid-February. The current uptrend remains firmly intact supported by fundamentals and valuations. However, with the strong rebound after the earthquake in Japan, the markets are beginning to be technically stretched making it vulnerable to pullbacks in the near term. Further rises in oil price which topped USD113 bbl in New York at the end of the week could potentially spoil the party. In a month where the global carnage and disaster struck, the swift rebound in the markets smacks of market complacency even if you can make a case that the risks thrown by these concerns are transitory. We would like to take a more cautious approach as we do not discount a weaker second quarter due to softer US consumption and higher oil prices. A repeat of 2Q10? Also, we are beginning to mull a reversal of the DM vs. EM trade in favour of EM.

FIXED INCOME

Policy normalisation in the DM may come earlier than expected. We remain underweight global bonds and underweight duration. Where we are more neutral is in EM hard and local currency debt where the rate hike cycle has reached an advanced stage.

FOREIGN EXCHANGE

The carry trade is strong. The JPY and USD are the global funding currencies as investors do not expect rate hikes in these two economies any time soon. The JPY should remain ranged at 83-87 as the forces of repatriation and intervention play out over the next months. But given Japan has the weakest economic profile within the DM majors, we expect the JPY to gravitate towards 90 making it a strong carry trade currency. EUR continues to be supported by a hawkish ECB but the euro is overbought technically.

• In the US, the key non-farm payroll survey published on Friday confirmed an improvement in the US labour market. Net job creation in March came in above expectations at 216k (consensus: 190k) and February’s figures were revised upwards. The more indicative private sector job creation numbers were up sharply for the second month running at 230k and the unemployment rate dropped by 0.1 point to a 2-year low of 8.8%. Also, noteworthy is that the bulk of the jobs came from services (199k) while manufacturing slowed slightly. These strong figures corroborate the robust readings in the ISM manufacturing and non-manufacturing indexes of late. We feel the mix of strong economic momentum with still accommodative policies supports our tactical overweight stance in US equities. 
• In China, manufacturing growth accelerated for the first time in 4 months easing concerns that China’s tightening policy may lead to a hard landing. The Purchasing Managers’ Index (PMI) rose to 53.4 in March, 0.6 point lower than consensus but higher than February’s 52.2. This is evident that government policies are at least gaining some traction. But with consumer inflation still topping the government’s 4% target in the first 2 months, we see no change in PBOC’s tightening stance as inflationary pressures remain high with prices of commodities still moving up, especially energy. There is a higher than even chance that interest rates will be raised again this quarter. 
• Speaking of commodities, the S&P GSCI index of 24 raw materials continued to climb for the week rising to 725 on Friday which is just a touch below the 2-year intraday high of 731 reached on 7-Mar-11. Food prices are now 15% above the 2008 high. We feel the market is underestimating the risks stemming from climbing commodity and food prices. As food and energy accounts for a much larger share of the consumer baskets in emerging markets (EM) than in the developed markets (DM), headline inflation rates have been rising strongly across the EM over the past few months. This, in turn, has led to EM equities underperforming DM on concerns of policy risks and higher rates.  
• But with ever higher prices, we are now seeing the same headline effect in the DM. Inflation in euro zone unexpectedly rose in March to 2.6%, the fastest in more than 2 years. It looks quite likely that the ECB, whose president had been prepping the markets for it, will raise interest rates by 0.25 point from a record low of 1% on 7-April. According to market watchers, this will be the first time since the 1970s that Europe would lead in a tightening cycle. The EUR had been on a tear since a month ago when the central bank dropped hints of their impending move. How can this be good for Europe we just cannot fathom. The stronger currency and higher rates will further retard the efforts by peripheral countries to rein in their fiscal problems. 
• The failure of the euro zone summit on March 24-25 to resolve a funding issue for a permanent rescue mechanism to be introduced in 2013 strangely had little impact on the EUR. It barely dented the currency recent inexorable ascent. The Brussels gathering did little to help Greece, Ireland and Portugal, the zone’s most troubled economies. Their situation is getting worse—and Europe’s leaders bear much of the blame. No wonder Portugal’s 2-year bond yields briefly surged beyond 10% during the week on its continuing debt woes and credit rating downgrades before trading back to the 8% level. In fact both Portugal and Greece had to suffer ratings downgrade during the week. We believe a restructuring is inevitable for Greece and Ireland and maybe even Portugal and the earlier the better. These economies are on an unsustainable course, but not for lack of effort by their governments. Greece and Ireland have made aggressive budget cuts. Greece is trying hard to free up its rigid economy. Portugal has lagged in scrapping stifling rules, but its fiscal tightening is commendable. In all three places the outlook is darkening in large part because of strict policy prescriptions at the core’s insistence to slash budgets regardless of consequences to growth. And you’d have thought they had learned a thing or two from the Asian Crisis in the late 90s. 
• Finally, while Japan’s nuclear crisis continues to hog the headlines, markets have seemed to regard the situation as contained and localised judging by the speed of the global equity market rebound. We are a bit less sanguine not least because the nuclear situation hasn’t improved but also the impact on global supply chain especially in the auto and IT sectors may be underestimated and underappreciated at this early stage.

EQUITY

• The current uptrend is intact supported by fundamentals and valuations. We believe equities should continue to grind higher over a 12-18 month horizon. But trading would be volatile as markets try to scale the ongoing concerns highlighted above including the MENA revolt and uprising which continued to push oil prices higher.

FIXED INCOME 

• Policy normalisation in the DM may come earlier than expected. We remain underweight global bonds and underweight duration. Where we are more neutral is in EM hard and local currency debt.

FOREIGN EXCHANGE 

• The recent EU summit failed to dent the enthusiasm for the EUR as the market is pricing in at least 75 bps rate hike for EUR by end 2011 following hawkish ECB tone on inflation. The Fed meanwhile is still keeping its USD600 billion quantitative easing intact. Such diverging policy paths should provide support for EUR, which is testing resistance at 1.4282, despite continuing woes in the periphery. Perhaps the EUR may take a breather and retest 1.40 after the any rate decision by the ECB on 7-April. Meanwhile, the JPY should remain ranged at 83-86 as the forces of repatriation and intervention play out over the next months.