Interest rates once again moved higher in both the UK and Euroland during the second quarter of 2007, whilst US interest rates remained on hold.  Our view remains that rates are likely to stay at around the current level in the US for the near term but that further rate rises in both the UK and Euroland are to be anticipated during the coming quarter.  Interest rate expectations in the UK have shifted recently and, in order to rein back inflationary influences, rates may now have to move to 6% during this year.  The housing market remains reasonably buoyant, although there are now indications from the high street that consumers are, selectively, beginning to cut back on expenditure.  Recent data also indicate that in order to maintain current expenditure patterns consumers are starting to dip into their savings, as the savings ratio has fallen to its lowest level since 1960.  In America, the Federal Reserve has continued to express its concern over inflation although recent data have been softer and some serious concerns remain in parts of the American housing market. 

Currency markets have been relatively stable over the quarter although the dollar has begun to lose ground against most major currencies.  We anticipate this trend will continue for a while but believe that when markets foresee a peak in the UK interest rate cycle, sterling will begin to weaken again on a purchasing power parity basis. 

Global oil markets remained firm, and with demand rising in the summer in the United States and continued uncertainty in certain major producing countries such as Nigeria, it is hard to envisage any easing in the global oil price in the near term.  Hard commodity prices, too, have continued on an upward trend and there appears to be no slackening in the pace of demand from China for a number of base metals.  However, given the rises that we have seen in the past few years, it will be unreasonable to expect further dramatic rises in the near term.

Bond markets have experienced another poor quarter worldwide as interest rates have risen.  Concern has been expressed about the quality of a number of junk bonds issues yielding relatively small premiums to gilt-edged securities or treasury bonds.  These concerns have tended to focus on the “sub prime” mortgage market offerings in the United States and it remains our view that yields offered in a large number of corporate bond markets, both in the UK and elsewhere, are relatively unattractive and we continue to advocate an underweight stance in the bond markets generally and see little upside in the short term.

In terms of global markets, economic recovery in Japan has faltered a little recently and interest rates have remained on hold.  The equity market has risen a little but overall domestic investors appear to be risk averse and maintain very substantial cash balances.  However, the recent Tankan Survey was encouraging and we continue to believe that the long-term prospects for Japanese markets remain sound.  The yen has continued to be weak against both sterling and the euro, and it is possible that a sharp correction in this recent trend could prove destabilising to global markets.  Most other Pacific Rim economies continue to exhibit good growth and their markets have responded accordingly.  Especially good progress has been seen recently in South Korea and Hong Kong, despite a background of rising oil prices.  Valuations for these markets have moved sharply up in the past three to six months and a pause for consolidation may be in order, although longer-term valuations, given the growth of the underlying economies, remain attractive.  

Despite many high-profile reports of the gloom in the American housing market and the pressure to which the US consumer is currently subject, growth in the US economy remains at long-term trend levels.  The Federal Reserve has made soothing noises concerning the plight of distressed borrowers and is maintaining a policy of keeping interest rates on hold for the time being.  If there is to be any major dislocation in capital markets for the rest of 2007, it is probable that further bad news from this area proves to be the catalyst.  We continue to closely watch for any further developments in this regard.

Overall, returns from global equity markets have been positive but relatively unexciting in the UK and parts of Europe, although Pacific Rim markets have performed somewhat better.  Given the pattern of gently rising interest rates, equity markets may tend to mark time over the summer, in a traditional pattern, before picking up momentum in the autumn.   Despite more difficult credit conditions, there has been no noticeable slackening of merger and takeover activity in global markets, although overall lending criteria for acquisitions appear to have tightened and particular importance is now being attached to security of cashflow from companies being acquired.  Turning to Euroland, the German economy continues to enjoy superior growth to most of its trading partners; however, the recent convincing election results in France may engender a more market-orientated approach to the domestic economy and possible boost to economic growth in the future.  Strains within the varying economies in the so-called Eurobloc appear to have abated a little recently but signs of tension are present beneath the surface, as was evident in the difficulty of obtaining agreement on the new Constitutional Treaty.  

Turning to our investment themes, we have made relatively few changes and overall our asset allocation approach continues to be orientated towards equities and away from fixed interest.  We do anticipate more volatile trading conditions for the rest of the summer and we have raised liquidity a little on days when markets have been particularly strong.  Within the equity arena, our enthusiasm for companies involved in the sourcing and supply of luxury goods remains unabated, and we continue to investigate further opportunities to research and build holdings in companies involved in a wide range of security products and services. 

Despite a continuing flow of poor news from the American housing market and global bond markets, equity markets have remained fairly sanguine over prospects for the rest of the year.  We anticipate some further volatility over the summer and we maintain a watchful stance on our overall weightings, but we take some comfort from the fact that company balance sheets remain generally very sound; traditional valuations for major markets remain, by historical standards, not particularly demanding; and where there has been merger and takeover activity, it has been noticeable that it has been financed mainly by cash and not paper.  This is a very different backdrop from that experienced back in 1999.  Nevertheless, global bond markets and in particular the market for “less than top quality” paper is looking increasingly nervous and, as we have previously stated, it is in this area that any catalyst for a setback in equity markets may be found - we continue to monitor the situation here most carefully.



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