GEORGE TCHETVERTAKOV<br /><strong>HEAD OF MARKET RESEARCH, ALPARI UK</strong><br /><br />FINANCIAL markets continue to remain in a state of flux as conflicting indicators and persistently unpredictable macro events sway sentiment. The frothy risk-rally in equities, commodities and FX that started in March hit a wall of doubt in mid-May leading to a sense of overextension amongst investors as well as speculators. The sudden boost in confidence was born in the financial sector on the back of returning profitability amongst financials, helped primarily by record levels of stimulus. <br /><br />Since May, however, range-bound consolidation has occurred along with increasing variance in macro data flow &ndash; several monthly economic indicators have fluctuated spectacularly; suggesting a burgeoning recovery one month, only to shock market participants with a reversal the next. It is highly likely that the widespread uncertainty prevalent among governments, businesses and individuals has led to a failure to re-establish confidence &ndash; whether it be spending decisions on an individual level, investment preferences within businesses or policy frameworks amongst government policymakers. <br /><br />It is also likely that the shock value of the financial crisis created a sense of disbelief that a strong recovery could take place. The psychological effect from the crisis is likely to be as important as the financial ramifications because, although the tangible impact has been that of falling asset prices and higher unemployment, the impact is only now starting to be felt. As if the global economy had suffered a concussion, market participants are struggling for clarity and are reluctant to take risks while waiting for a recovery. The risk-rally from March lows was unable to be sustained partly because of the fear that economic conditions cannot recover that quickly. <br /><br />All sectors of the G20 economies have felt this dragging effect. Consumers who continue to have stable incomes are choosing to cut spending and/or borrowing; house prices remain under pressure as both buyers and sellers refrain from entering the market, waiting for prices to stabilise. <br /><br /><strong>CUTTING INVENTORIES</strong><br />Businesses are doing the same &ndash; cutting investment, inventories and staff as a way to survive until economic conditions improve. Paradoxically, collectively waiting for better times is preventing those very conditions from occurring &ndash; this is due to the psychological effect of unprecedented asset price falls as well as media coverage that focused on worst-case scenarios. The priority is clearly to save for your own benefit rather than spend for the benefit of aggregate demand, which although understandable is also worrying for quick recovery theorists. The same scenario occurred in Japan in the 1990s where saving rates rose so high that deflationary effects persisted for a decade. <br /><br />Asset prices have reflected macro uncertainty via range bound trade since May; equities, commodities and FX have all been unable to break higher because of ongoing insecurity about the validity of the recovery. The ongoing second quarter earnings season in the US has threatened to change this because, while the first quarter performance was primarily about financials, investors are now hoping for a broad improvement in performance across all sectors as confirmation that normality could return in the near future. <br /><br />Since firms started to report in early July, US, UK and European equities have rallied close to 10 per cent. Investors and consumers alike are probably going to continue questioning any rapid recovery story &ndash; the only difference now is that indications of expansion rather than slowing contraction stand to drive confidence higher.