Investment Comment
Second Quarter 2008

Given financial institutions' mounting inventories of credit related losses, and amid increasing paranoia about the scale and location of further such losses, banks have grown yet more jealous of their diminishing stores of capital. Tangible lending rates (both between banks and to their ultimate borrowers), as opposed to central bank interest rates, have remained elevated, with mortgage rates in the US and UK actually rising; and cash-strapped borrowers have been forced to sell (often higher-quality) assets to meet banks' heightened calls for collateral.

Credit market disorder has brought about ever more noteworthy casualties: from the 165,000 customers no longer deemed good prospects by UK credit card operator Egg, to a clutch of highly-borrowed hedge funds and, latterly, Bear Stearns, the US investment bank, which endured the Great Depression but which was brought down in March by overwhelming exposure to latter-day financial instruments. Perhaps the most unlikely casualties have been the 'monoline' insurers, traditionally underwriters of municipal bonds, whose relatively recent expansion into mortgage bond insurance now threatens their bankruptcy.

The unrelentingly bad news emanating from dysfunctional global credit markets (and from the erstwhile enthusiasts of those markets) has underscored the increasing scope of events in those markets to impinge on 'real' economic activity. Rates of growth are slowing already in the major economic regions and, most notably, US consumer retrenchment appears to be under way in the face of deteriorating credit, housing and labour markets.

Meanwhile, rates of inflation have continued to climb almost ubiquitously, driven principally by the rising costs of food and fuel. Commodity prices slipped towards the end of the quarter, but not before new thresholds had been crossed, with gold surpassing $1,000 per troy ounce for the first time and oil breaching the $100-a-barrel mark. Food prices, too, have increased markedly, threatening thereby not simply to exacerbate inflation, but also to provoke social unrest in developing economies. Global rice prices, for example, rose by 30% on 27th March alone and have doubled since the start of the year.

In bond markets, financial and economic strains have been particularly evident, with the concurrence of widening spreads on corporate bonds (the additional yield over government issues) and ultra-low rates on short-term US treasury bills pointing visibly both to the eschewing of credit risk by investors and to increasing anxiety about the fortunes of the global economy. The FTA Government All Stocks Index achieved a muted total return of +1.4% in the first quarter but, with government bonds more widely treated like safety-deposit boxes by nervous investors (particularly in the US) and with sterling weak against other leading currencies (especially the yen), the JPM Global Government Bond Index (ex UK) delivered a return of +10.3% to the UK investor.

The major equity markets were unanimously weak as investors reassessed their earlier expectations that corporate earnings would remain strong in 2008 and concluded that the crisis in credit markets was likely to be more damaging to corporate activity than previously thought. The UK market fell by 9.9% in total return terms and world markets (ex UK) posted a return to the sterling investor of -8.5%, with emerging market indices recording a collective loss of 10.8%, the Asia-Pacific region falling by 10.3% and North America by 9.2%, and Europe ex UK and Japan losing 7.4% and 7.2% respectively.

Perceptions have mounted that the US economy has entered recession. Whether or not the economy has actually begun to contract, economic data (aside from a buoyant export sector) has been almost unequivocally negative. The housing market has continued to deteriorate, with mortgage foreclosures rising to their highest level in 22 years amid tightening lending standards. Surveys have indicated the slowing of manufacturing and service activity, consumer confidence has been falling fast and the labour market is reported to have weakened significantly during the opening months of the year.

US policymakers have become appreciably more aggressive in seeking to stave off the risks posed by defective credit markets and a weakening economy. The Federal Reserve responded to the spate of bad economic news with a series of deep cuts in interest rates (taking the Federal Funds Rate from 4.25% at the start of the year to 2.25% in March). It also implemented a succession of more strident measures to buttress banks' balance sheets and to restore confidence in credit markets, including offering to take $200 billion of mortgage-related instruments from financial institutions ('primary dealers' as well as banks) as collateral for (more liquid) Treasury stock. To provide further support to the ailing economy, electorally-minded politicians waved speedily through Congress a fiscal stimulus package that will entail cheques of up to $600 per person being sent to 117 million Americans in the coming weeks.

The Federal Reserve has begun to refer more explicitly to the growing threat of inflation in the economy, a threat that had appeared at the beginning of the year to be the 'elephant in the room' during its (credit-focused) deliberations over monetary policy. With lower central bank rates failing currently to be reflected in reduced borrowing costs to businesses and households, rising prices appear not yet to have seeped into the rising inflation expectations that would restrain the Federal Reserve's rate-cutting instincts. However, inflation is one of a number of threats posed to US monetary policymakers.

The central bank faces challenges in seeking to retain control of both the pricing and supply of money in the financial system. Lower interest rates may, far from reducing borrowing costs, risk triggering higher costs of borrowing as the corollary of heightened inflation fears and a loss of confidence in the (already fragile) dollar; indeed, while the Federal Reserve has been cutting interest rates, mortgage rates actually have been rising. In any event, with the capital of US banks under pressure following large-scale write-downs, it is doubtful how stimulative headline rate cuts can be in encouraging financial institutions to lend as they did the last time interest rates were cut aggressively (between 2001 and 2003).

The UK economy, like its US counterpart, appears to have been hampered by the woes of global credit markets and by the slowing of its housing market. As in America, house prices appear to have fallen during the first quarter (albeit at a much slower rate) and credit conditions have tightened significantly. Mervyn King, Governor of the Bank of England, acknowledged the gloomier milieu when he warned UK households that a 'genuine reduction in (their) living standards' was inevitable. In contrast to the US, however, UK policymakers have shown, out of a combination of choice and necessity, a much more cautious approach in their interventions to stem impending economic weakness.

Whereas the chairman of the Federal Reserve has made clear his intention that the US central bank will take whatever steps are required to try to alleviate the pressures in financial markets, the puritan Mr King has argued that the Bank of England should not try to reverse the re-pricing of risk by markets. The Bank's Monetary Policy Committee has appeared more fretful recently about the potential for falling asset prices to prompt a damaging tightening of credit conditions, but its quarter-point cut in interest rates in February was the full extent of its rate cutting during the first quarter. If inflation is the elephant which US central bankers are loathe to recognise, rising prices (and particularly the fear that expectations of higher inflation will incite higher wage settlements) remain the bugbear of UK policymakers, and the MPC has been careful to keep its guard raised against inflation in the UK.

It is doubtful whether the Chancellor of the Exchequer's benign reading of the public finances in his Budget speech in March will have assuaged the Bank of England's apprehensions about either growth or inflation. As the UK economy slows, the thrust that might have been provided by heightened fiscal stimulus will be unavailable to a government whose prior profligacy has largely exhausted the potential for lower taxes or higher public spending; and as the parlous state of the public finances weighs on sterling, the more likely it will be that higher import prices will excite higher overall inflation.

In Europe, the central bank has maintained its steadfast resistance to interest rate cuts, voicing not simply its concern about sustained inflation threats on the Continent, but also its conviction that the eurozone economies are broadly 'sound'. The European Central Bank's anti-inflation zeal was presumably heightened by the belligerence of trade unions seeking 'juicy' wage rises during the first quarter of the year, and by some of the settlements reached.

If the financial markets are to be believed, the ECB will be forced to capitulate on its interest-rate position and lower rates several times during 2008 against a backdrop of fading growth. However, European economic indicators are sufficiently mixed that the likelihood of looser monetary policy is questionable. While Europe faces significant headwinds from a rising currency, rising commodity prices and a tightening of credit conditions (as pronounced as in the US), export volumes have remained robust and measures of business confidence have been improving in much of the region.

The failure of the political factions in Japan to agree upon a successor to now-retired Bank of Japan governor Fukui (and the void which now exists at the helm of Japanese monetary policy therefore) is disturbingly typical of the failure of the Japanese authorities to engineer a sustained solution to the challenges of their economy. At a time of crisis in financial markets, it would seem more important than ever for central banks to make decisive policy decisions and to communicate effectively with market participants. Alas, on both fronts in Japan, there are doubts about the current efficacy of monetary policy.

Governor Fukui's legacy represents all too neatly the continuing mire in which Japan's economy finds itself and the failure of monetary policy initiatives to tackle the persistent threat of deflation. Core inflation, at 0.8%, now stands at its highest level in a decade but, with the positive inflation reading being attributable entirely to rising energy prices, and with the yen resurgent, wage growth illusive, and Japan's export dependency making it vulnerable to economic weakness elsewhere in the world, monetary policy remains challenging.

In stark contrast with the situation in Japan, inflation seems increasingly to be the bête noire of policymakers in the Asia Pacific region. Food prices, in particular, have continued to rise strongly across the region, eliciting a raft of varying policy responses from governments and central banks. In China, where the worst snowstorms in 50 years aggravated pricing pressures during the first quarter, the authorities have fallen back on their collectivist impulse by implementing a series of caps on the prices of basic necessities and raising the reserve requirements of the commercial banks. Simultaneously, a number of Asian governments have favoured the use of subsidies to alleviate the pressure on consumers from rising food and energy prices; in Indonesia this year, for example, the government's fuel subsidy bill is anticipated to rise to a level roughly equivalent to 4% of the country's gross domestic product.

At present, Asian economies are growing sufficiently strongly and public finances are robust enough that measures to curb inflation (or its impact on consumers) need not be ruinous either to economic growth or to regional budget surpluses. However, there is a risk that rising food and energy prices in Asia will either precipitate social unrest or lead to policy actions that worsen the outlook for domestic economies. Increasingly, it seems likely that Asian policymakers will be compelled to revalue their currencies to reduce import costs rather than perpetuate their existing measures to douse the flames of inflation.

Bond markets depicted clearly the economic and financial market strains with which investors contended during the first quarter of the year. Widening corporate bond spreads and falling yields on US treasuries were the obvious symptoms of 'deleveraging' in the global financial system and of the general preference of investors for security over risk. The flight to 'quality' which, for example, saw the yield on one-month US Treasury bills fall below half a percent, also reflected investors' conviction that, despite escalating headline inflation, central banks would be committed to stabilising global financial markets via lower interest rates.

Shorter-dated government bonds may continue to find support both from central banks' benevolence in monetary policy and, by default, from the shunning of riskier assets by investors. However, (low-yielding) government debt appears to be generally expensive on a longer-term view and its 'safe haven' status may face challenges. The prospect of recession appears already to be reflected in government bond prices, inflation (which in the US exceeds the treasury yield available at most maturities) threatens to eradicate real returns, and enlarged fiscal deficits on both sides of the Atlantic portend greater bond issuance (which may cause prices to fall).

The continued unwinding of leverage in the financial system is likely to keep volatility in corporate bond prices relatively high but, in contrast to government bonds, gloominess about the outlook for the global economy and strains in financial markets have made investment-grade bond prices more attractive. Companies face more arduous economic conditions, but their greater willingness to defend their credit quality (whether by injections of fresh capital or by using the proceeds of asset disposals to reduce debt) provides encouragement to invest in higher-quality corporate debt. With global bond prices falling to levels that imply that one in six investment-grade companies will default on its bond commitments in the next ten years, there should be ample opportunities to invest in well-chosen debt.

There remain significant pitfalls, however, in the sub-investment-grade field, where recompense for the greater sensitivity of lower-rated bonds to slowing economic activity and tighter credit conditions is available only very selectively. Default rates on 'junk' bonds remain extraordinarily low in spite of the crisis in credit markets and a looming US recession. With the number of companies trading at 'distressed' levels (defined in the US as being 10 percentage points above treasuries) up almost 20-fold since last summer, prevailing default rates are incongruous and a discriminatory approach will be required as more challenging conditions impair the fortunes of lower-quality companies.

The US equity market suffered its worst January for a century and closed the first quarter down by almost a tenth in sterling terms. Share prices were driven lower by heightened fears about both the scale of the crisis in credit markets and worsening US economic prospects, as well as by the recognition that earlier expectations for corporate profits had been excessively optimistic. Volatility was high and, notwithstanding Visa's high-profile and successful debut on the stock exchange, the volume of initial public offerings was sharply lower than in previous years.

Although previous bank failures on Wall Street have traditionally preceded stock market rallies, the circumstances to which Bear Sterns succumbed continue to present significant obstacles to corporate interests. Forecasts of US corporate earnings have been revised successively lower, but the residual expectation of a double-digit rise in overall profits in 2008 across the stock market appears misguided. The process by which credit-market induced wounds are healed is unlikely to be quick and, with companies' costs rising and pricing power dwindling, it is highly conceivable that the combined earnings of listed companies will fall in the near term. However, the infirmity of the financial sector should not obscure the healthiness of balance sheets and cash flows in much of the non-financial sector. Conditions in stock markets are likely to remain challenging, but if investors can be fastidious in distinguishing between a company's share price and its value, they will not be bereft of investment opportunities in US equities.

UK equity investors endured similarly torrid conditions to their US counterparts during the first quarter, with substantial daily movements (including the largest one-day points fall in the FTSE 100 index since its formation in 1983) leading to a sharp fall in share prices.

Equities in the UK are trading at their lowest valuation versus gilts for 50 years, with the average earnings yield (earnings per share divided by share price) of 9% being roughly twice the yield available on gilts. The ratio between earnings yields and gilt yields has a patchy record in identifying value in the equity market and its prevailing level may indicate either that gilts are costly or that corporate earnings are set to fall. However, UK equity valuations appear to provide some insulation against the cold drafts emanating from global credit markets and economies.

Corporate profits, which have risen by 177% in the UK over the last five years (in no small part owing to strong earnings growth in the financial sector), will come under pressure from the effects of the credit crisis and a slowing economy. The fortunes of the major banks will be critical to the fate of corporate earnings as a whole in 2008 and the outlook for banking earnings themselves is highly uncertain (in spite of the illusory confidence displayed by the banks in raising their dividends by an average of 10% during the first quarter). For UK companies more generally, the difficulties in the financial sector have lead to sharply higher funding costs, even among companies with strong credit ratings. However, there are mitigating factors in assessing the outlook for the UK's listed companies; the structural growth of emerging economies should remain supportive of the resource sectors that comprise a quarter of the UK stock market's total capitalisation; the absence of a capital expenditure 'binge' during the present economic cycle has safeguarded the overall health of balance sheets; and a weaker pound should be a valuable fillip to UK companies with overseas operations.

Europe's stock markets were unsettled during the first quarter. They were vulnerable for a time to the repercussions of rogue trading at Société Générale and more so as a whole to the effects of ailing global credit markets and concerns about the economic outlook. Following the decline in share prices, valuations of European equities appear broadly attractive, with cashflow-based measures standing at the lower end of their historic ranges and the market dividend yield being almost 4%.

Earnings growth in Europe, as elsewhere, will almost certainly slow during 2008 as previously high margins and strong revenue growth submit to the more challenging economic backdrop (including surging input costs, significantly higher debt costs and the higher wage claims that are likely to distribute a greater share of profits to employees rather than to shareholders). Nonetheless, while consensus estimates of 7% profits growth this year appear too high, the outlook for European equities is broadly positive. Corporate balance sheets are generally sound, consumers in the region have not taken on debt to the same extent as Anglo-Saxon consumers, and European companies continue to participate profitably in the industrialisation of the developing world.

Japanese equities recorded further losses during the first quarter of the year and foreign investors continued to turn away from a market that has become synonymous with disappointment. With economic growth faltering, corporate profits squeezed by rising input costs, and the political establishment persistently prone to mishap, there has been good cause to recoil from investment in Japan's stock market; but investors may struggle to keep spurning the advances of a market whose falling valuation offers increasing allure.

Asian stock markets will continue to grapple with the slowing of the 'mature' economies, the growing spectre of inflation and the draining of liquidity from the global financial system. However, Asia retains significant attractions to the long-term investor. Profit growth should be underpinned by increasing domestic consumption; and, while Asia is vulnerable to credit-related follies perpetrated elsewhere in the world, its direct exposure to credit market woes should be limited. Asian companies generally enjoy healthy cash balances and the region's banks hold sizeable deposits as surety against loans made. The imposition of further price controls by governments intent on curbing inflation would be undesirable, but the prospect that currencies will be allowed to appreciate to ward off pricing pressures should be positive for sterling and dollar investors.

Financial markets regained some composure towards the end of the first quarter, with investors appearing to believe that a resolution to the crisis in credit markets was drawing nearer. However, the late-quarter rally did not mask the significant challenges that persist. In particular, the credit crisis has deepened since the start of the year, and the US economy is in worse order than generally had been foreseen at the end of 2007.

The actions of the major central banks, especially in the US, appear to have underwritten the solvency of the major commercial banks but, with credit and money markets still failing to function 'normally', there remains considerable uncertainty about the economic and financial-market outlook. Estimates of losses related to the collapse of sub-prime mortgages continue to exceed greatly the level of losses already disclosed and, with tightening credit conditions yet to feed through fully to households and businesses (and with house prices in the US still falling), the contagion of the credit crisis may spread.

There has been dissonance in the approaches of the leading central banks to resolving the crisis, with the Federal Reserve grittier in its response than others, but policymakers may find, regardless of their determination, that they are impotent in slowing in an orderly fashion the 'deleveraging' of the global financial system. The mechanisms by which central bank interest rates are transmitted into tangible, effective lending rates in economies remain jammed. Until banks raise further capital and overcome the paranoia inhibiting more orthodox lending and borrowing practices, financial markets will remain strained and economic activity in much of the developed world is likely to be encumbered.

As long as credit markets remain defective, and particularly as the 'repatriation' of banks' capital engenders the forced selling of assets by some market participants, asset prices generally will remain volatile. However, while recognising the challenges that are faced as a result of deteriorating credit conditions, slowing economic activity in the developed world and rising food and energy prices, investors should not overlook the more positive features of the global investment landscape.

Owing to the response of policymakers, the crisis in credit markets appears increasingly to be one of liquidity rather than solvency and, being confined overwhelmingly to Western European and US financial sectors, the crisis is unlikely to prevent the global economy as a whole from growing respectably in 2008. Inflation is likely to exercise the minds of central bankers in the near term, but the credit crisis, and particularly the imperative for banks to repair their famished balance sheets, should serve to dampen pricing pressures over the longer term.

Parts of the financial sector remain vulnerable to the draining of global liquidity and to the greater regulation (and litigation) that seem certain to restrain their activities henceforth. Beyond the financial sector, however, corporate cash flows and balance sheets are generally healthy and dividend growth remains attractive. Following a period in which the prices of securities have fallen almost regardless of asset quality, good opportunities exist for investors to prosper from investment in the reasonably-valued debt and equity of companies that are well-equipped for the more challenging environment.

''Aye on the shores of darkness there is light,
 And precipices show untrodden green,
 There is a budding morrow in midnight,
 There is a triple sight in blindness keen.''

John Keats, 'To Homer' (1818)