We have been a little surprised by the resilience of the UK equity market over the past few months but a key driver of performance recently has been the high level of merger and acquisition activity. BPB and Exel within the FTSE 100 Index have received bids from abroad and Boots and Alliance Unichem have very recently announced merger proposals. A number of other large companies including O2, BOC, Lloyds TSB, Standard Chartered and Marks & Spencer have at one time or another been the subject of bid rumours. Companies have also continued with programmes of stock repurchases – the so-called “de-equitisation” strategy - which we have touched upon in recent quarterly reviews and which has had the effect of buoying the equity market further.

Our scepticism concerning the Treasury’s over-ambitious growth targets for the UK economy has been vindicated this quarter as the Chancellor has downgraded the ambitious 3% - 3½% target set out last year to a more muted 2%. The UK economy expanded at its lowest rate for twelve years in the second quarter of 2005, whilst a number of commentators, including principally the IMF, warned of a build-up of inflationary pressures and falling consumer confidence in the UK. Current inflation is running at a level of 2.4% per annum and we expect it is set to move up to 3.0% as the effects of rising oil prices and a lower level of sterling impinge more strongly. The UK manufacturing sector may, for example, enjoy something of a boost if sterling weakens further as anticipated.

The yield differential between the US and the Euroland has widened this year and this would seem to be a trend that is set to continue into the first part of next year. However, we are monitoring the position closely as we expect the Federal Reserve to reach the end of its current cycle of monetary tightening early in the New Year, whilst the ECB may look to raise interest rates at a similar time. This could have the effect of reversing the current yield trends and could potentially disrupt recent currency patterns as well.

The US housing market, the main growth driver, continues to advance in quite a dramatic fashion but there seems little justification for current values and we would advocate particular caution in this respect. There has been a major shift in attitude towards the real estate market over the last few years and residential investment accounts for a far bigger share of the economy than in the past. This has aided employment growth but household balance sheets are now looking significantly more precarious. It seems that housing may be overvalued by as much as 25% and the US savings rate, as a percentage of disposable income, has fallen from around 10% to nil between 1975 and 2005.

It has been noticeable that the UK retail arena has been particularly weak over the summer and we expect this trend to continue. Consumers, we believe, will continue to pay down unsecured debt and the housing market will stay relatively subdued at least until next spring. Against this background, we feel that the equity market having enjoyed a reasonable year, and underpinned by stronger than expected dividend growth and takeover activity, will find it a little difficult to make significant progress by the year end when confronted by the headwinds of falling economic growth and gently rising inflation.

Turning to our current investment themes, we believe that the pace of growth in China is flattening a little although demand for many commodities, including principally copper and oil, remains at high levels. Other industrial markets such as steel are also appearing to be turning up once more. We also see continued good results from companies involved in the sale and distribution of so-called “luxury goods”, where end markets tap into the increasing wealth, of commodity rich countries, in the Middle East and also Russia. Commercial property markets have continued to be very active over the summer and with a potential change in the tax structure for quoted UK companies on track for 2006 we see further upside in this area of the market too. These themes, we believe, have some way further to go.

On currencies, the Chinese authorities have announced a revaluation in their currency and a relaxation of the bands in which the currency is set to trade against a number of major currencies. We anticipate further strengthening of the Chinese currency and this should boost the exchange rates of most other Far Eastern currencies and in particular the yen against sterling and the euro. For sterling-based investors, this has implications for investment policy in these markets and we continue to favour Pacific Rim economies where growth rates remain robust.

The best performing major market over the quarter has been Japan where at long last we feel the market move has real substance behind it. The re-election of Prime Minister Koizumi means that reform of the Japanese financial system including the Post Office will continue unimpeded and there has been evidence of both increasing merger and acquisition activity in the domestic Japanese market as well as the perceived willingness of Japanese companies to increase dividend payments to shareholders. All these factors bode well for Japan in the future.

Whilst US growth may be set to disappoint next year, the Euroland growth rate is at least due to rise. Euroland equities have been and indeed may continue to outperform US equities particularly as the US current account deficit is expected to remain a major concern.

Overall, we feel that the UK equity market is currently fairly, if not fully, valued but that after a good move in 2005 so far, a short period of consolidation is likely. Overseas markets, such as Japan and the Pacific Rim have further attractions. Despite the prospects for falling interest rates, we feel that conventional fixed interest gilt markets offer little value, particularly against a background of rising inflation in the UK. We remain heavily underweight in this area. Our bias in equity markets is still heavily against consumer and retail related areas in favour of resources and sectors benefiting from a perceived lower level of sterling exchange rates.



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