The UK equity market continued to make progress during the last quarter of the year and ended 2005 at a four and a half year high. As we noted in the autumn, a key driver of markets this year has been a markedly higher level of merger and acquisition interest, principally led by European companies making cash offers for quoted UK firms. We see no major sign of this activity diminishing in the early part of 2006 given the abundant availability of credit and historically low levels of interest rates in the developed world. A further supportive factor for markets throughout 2005 was the theme of ‘de-equitisation’, or the significant programmes of stock repurchase that were undertaken by a number of large UK companies. Again, we envisage that this will continue in 2006 and will underpin markets to some extent.

The outlook for interest rates globally in 2006 is a little less clear. In the UK, sentiment has shifted recently towards an expectation of a slight fall in rates by the spring, whilst in the USA, Euroland and Japan the trend appears to be towards a slight upward movement. The movement in opinion in the UK has to some extent been a factor in the decline of sterling relative to most major currencies that we had expected during 2005 and which we expect to gather momentum during 2006. Economic growth appears to be faltering in the UK, productivity growth is stagnant at best, due in part to additional corporate legislation and the high levels of public expenditure brought forward over the past few years. Additionally, the fiscal deficit and trade balance in the UK continues to worsen.

We foresee some fiscal tightening by the Chancellor to address these issues in the short term, combined with an increase in gilt issuance, particularly at the longer end of the market. Although there appears to be a ready appetite from institutional sources such as pension funds and insurance companies for this type of paper, we continue to see little advantage for our clients in locking in low levels of overall return in long-dated fixed interest stock, particularly as we believe that markets are being significantly over-optimistic in discounting a rise in inflation over the medium term. We remain, as we have consistently positioned our funds throughout 2005, significantly underweight in fixed interest securities relative to equities.

Turning to global markets, we moved to a significantly more positive stance on Japan in the late summer in anticipation of a pick-up in economic growth and the re-election of the Koizumi government. Our faith has been amply rewarded by some sparkling performance from the Japanese equity markets in the final quarter of 2005 and we continue to foresee further good growth opportunities in 2006. The US market has had a dull year overall in 2005 and may again find fundamental progress difficult in the early part of 2006 against a background of a stagnating retail property market and the prospect of a further tightening in interest rates. In Euroland, Germany has at last seen a rise in consumer confidence, a trend confirmed by recent data, and there are now good prospects for upgrading economic growth forecasts for 2006. Elsewhere, however, we note the pressures to which the Euro is subject given the substantial fiscal deficits being run by a number of member states. We nevertheless see some upside for markets given current modest valuations and remain positive about the outlook for a number of the Eastern European economies as they further develop their capital markets.

We also retain our enthusiasm for our major investment themes as we enter 2006. The emergence of China as a global economic superpower has come into sharper focus during 2005 and the impact of this evolution continues to be a major factor in equity and commodity markets. We have retained a good exposure towards resources and mining stocks throughout 2005 and see no evidence at present to change our stance. Another theme which we believe has further potential relates to the sourcing and sale of ‘luxury goods’, where, as we have noted before, a number of companies benefit from accessing the wealth being generated by commodity-rich economies in the Middle East and Russia. On the domestic front, commercial property in the UK has experienced strong demand throughout 2005. The Chancellor announced in his pre-Budget statement a proposed change in the taxation of quoted property companies, and the emergence of direct investment in the City and West End office and retail markets by Middle East interests continues to reinforce our confidence in this asset class.

We have been a little surprised by the resilience of the UK consumer during the latter part of 2005 against a background of high levels of indebtedness and the prospect of rising levels of taxation. The domestic housing market, contrary to a number of predictions, appeared to bottom out during the autumn and now seems to be trending a little higher once again. We nevertheless retain a cautious stance towards domestically related stocks and, given our belief that sterling will come under further pressure during 2006, again seek to focus our portfolios on stocks able to benefit from a weaker pound. Resources, mining and aerospace-related equities thus retain their attraction.

Overall, therefore, we envisage a broadly encouraging picture for markets for the New Year. Plentiful finance for takeover and merger activity, continued growth from China and the Pacific Rim economies and the renaissance of Japan are all positive factors. Global oil prices, too, appear to be rather more stable at levels some way below the peaks reached in the autumn. On the other hand, for the UK in particular, the consumer still appears somewhat over-extended and we retain our caution on inflation and the possibility of higher taxes.



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