Despite a promising move in UK equity markets in February, when the FTSE 100 index rallied briefly over the 5000 level, concern over trends in global interest rates and a sharp setback in fixed interest markets has impacted equities, with the result that the Dow Jones Industrial Index in the United States has fallen in the quarter and both the FTSE 100 and FTSE All- Share in the UK have risen by only 2.9% and 3% respectively in total return terms. Corporate dividend growth has been a supportive factor in the UK market, however, and it has been noticeable that, as we had foreseen, major companies have continued with extensive programmes to repurchase their own shares.

The swing in the UK to the consensus view that the next move in interest rates will be upwards has led to negative total returns from gilts over the quarter. Looking forward, and reinforcing the comment we made in January, we continue to see little attraction in domestic conventional fixed interest markets. Planned and forecast government expenditure indicates that gilt issuance is set to increase substantially over the medium term and it is hard to see much value for domestic investors in the ultra-long gilts that the Treasury appears keen to offer. As recent empirical studies have pointed out, lending money to the government at a rate of below 5% for any length of time has been a particularly unsuccessful investment strategy for a retail investor. Indexlinked gilts have some longer term attractions, however, and whilst we have been monitoring this sector carefully, we are still hard pressed to find much fundamental value at the moment.

Turning to equities, we had commented in our last review that 2005 might prove to be ‘a year of two halves’. In fact, this comment held good for the first quarter of the year, the equity market having peaked, with admirable symmetry, on February 15th. This date coincided with the beginning of the annual reporting season for most of the major companies, and whilst the overall profit figures and dividends announced were, in general, highly satisfactory, particularly from the banking sector, the market had tended to discount this information ahead of its actual publication and the focus of attention had shifted more onto the prospects for a further rise in interest rates and the outlook for oil prices, which had remained at stubbornly high levels.

The property sector was impacted by the decision in the Budget to re-impose stamp duty on developments in hitherto exempt areas a year ahead of forecast and gave up some performance, having enjoyed an extremely strong year in 2004. However, significant progress has been made in the development of REITs – or Real Estate Investment Trusts – which are more tax efficient structures than the current quoted property companies and which have now, in principle, been approved by the Treasury. Further detail on the taxation schedules for these structures is expected later in the year. The attractions of commercial property as an alternative asset class remain strong and recent data indicate a continuing level of demand for real estate developments in the UK from both domestic institutions and overseas interests, and we look to increase holdings selectively in this area.

We had expected an increased domestic level of restructuring and merger and acquisition activity during the early part of the year as balance sheets in the corporate sector had strengthened considerably. However, this activity was significantly more widespread in the United States than in the UK and Europe. In the UK, takeover activity from private equity interests tended to focus on companies below the level of the FTSE 100 such as British Vita, a manufacturer of speciality foams and chemicals and Woolworths, the high street retailer. One possible reason for the lack of activity in the larger corporate area of the market is that of the pension fund liabilities that an acquirer might inherit from a target company. In the retailing area, it is arguable that both WH Smith and Marks and Spencer were able to resist the advances of potential suitors because of the large continuing long term funding requirements of their current and deferred pensioners. We nevertheless expect further activity as the year progresses, and have recently noted the takeover interest in Allied Domecq, the international spirits company.

Turning to two of our investment ‘themes’ for 2005, we continue to believe in the attraction of the theme of ‘de-equitisation’ – the continued re-purchase of shares by companies themselves to create a more efficient corporate balance sheet structure – which we highlighted in January and which will, we believe, continue throughout the year and prove to be a support to equity markets. Another theme which we had noted in our Investment Outlook recently has been the emergence of China as a dominant economic force in global capital and commodity markets. There has been some debate amongst commentators as to whether the Chinese economic ‘boom’ is beginning to slow down and what the effect that such a slowdown might have on markets. The evidence is somewhat conflicting but it does appear that there has been some slackening of the breakneck pace of growth experienced during 2004. There has, however been little impact so far in terms of a softening in commodity prices and the oil price has remained unseasonably firm despite a rise in quota production from OPEC.

In conclusion, we reaffirm our belief that equities should be the best performing asset class for the year, although we may see some turbulence in the UK during the forthcoming Election campaign and in Europe ahead of the French referendum on the European Constitution scheduled for 29th May. We look forward to commenting further on both of these events in the May edition of our newsletter, ‘A View From The Bridge’.



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