The problems associated with the American mortgage market escalated during the third quarter of 2007 and caused a profound change in interest rate expectations.  In the United States, both prime rates and federal fund rates were reduced by ½% in order to head off anticipated recessionary influences within the economy, whilst in the UK the anticipated upward move in interest rates was put on hold.  Underlying inflation in the UK remains a potential problem looking forward but recent data have, if anything, been a little softer and a number of reports indicate that the UK housing market is now beginning to slow.  Additionally comments by a number of high street retailers have confirmed that trading became more difficult over the summer, perhaps exacerbated by the poor weather.  We thus anticipate a further small cut in American interest rates before the end of the year and for UK rates to remain at around current levels for the time being.

Currency markets were a little more volatile and the Dollar continued to lose ground over the period against the Euro.  We anticipate some further Dollar weakness but also believe that given the change of interest rates expectations in the UK, Sterling will tend to weaken as well against a trade-weighted background.

Global oil markets continued their upward march hitting new highs during the third quarter.  Despite comments from OPEC regarding the lack of sustainability of oil over $80 a barrel, demand continues at a high level and as we approach the winter season in the developed world, it is hard to see any catalyst which will bring the oil price down significantly.  Hard commodity prices, too, were a feature during the quarter and it now appears that following the cessation of sales by one or two central banks the price of gold will continue to move ahead.  Growth in China again appears to be picking up so it may be feasible once again to suggest that demand for industrial metals such as copper, zinc and nickel will continue to remain firm in the short term.  A feature in world wide bond markets was the widening of credit spreads, or the additional yield demanded by investors to invest in corporate bonds rather than sovereign issues or those backed by supra-national authorities.  In the UK, the Gilt market made a little progress as expectations of further interest rate rises were put on hold by the problems experienced in the banking market.

As we believe that inflation is by no means dead in the UK it is our view that the yield on longer dated fixed interest stocks remain relatively unattractive at present and we would recommend having little exposure towards this area.  We continue to remain underweight in bond markets generally but continue to monitor opportunities in the Index Linked market, although currently, the terms on offer are unattractive.

Turning to global markets, the economic recovery in Japan continues to stutter and the Yen remains weak.  Investors continue to remain risk averse and although a weak Yen will continue to be a benefit for Japan’s exporting industries, global investors appear to have become somewhat more negative towards Japan recently.  We continue to believe that over the long term prospects in the Japanese market are sound but these may take a little longer to materialise than we previously envisaged.  It has been pleasing to note the excellent performance recently from a number of the Pacific Rim markets, a number of which have hit all time highs.  Growth prospects across the region are very good and although ratings in these markets have risen recently this does appear justified by the outlook for profit growth.  This could possibly be derailed by another sharp rise in the global oil price but overall we feel prospects for this part of the world are still most attractive.

In the United States, it is becoming more probable that as a result of falling prices in the American housing market and some change in investor sentiment, growth rates may now slow a little in the medium term.  However, the Federal Reserve has been most accommodating in its interest rate policy in seeking to head off recessionary influences and it would appear unwise to “fight the Fed” too aggressively. 

It had been our previous expectation that equity markets in the UK would mark time over the summer and, looking at the overall indices, there has been only a relatively gentle decline over the last three months.  This does however, mask some exceptional volatility experienced particularly during August.  It now appears that interest rates may remain on hold for the rest of the year, rather than gently rising as we had previously anticipated but we feel it is now prudent to adopt a slightly more cautious approach towards equity markets for the short to medium term.  The impact of the crisis in the banking sector, the probability of a slowing housing market and less consumer activity on the high street may tend to inhibit equities somewhat.  It will also undoubtedly become more difficult to raise finance for the merger and acquisition activity which has been a notable driver of markets over the past three or four years. 

In Euroland, the German equity market has performed considerably better than that of the UK and it remains our belief that growth prospects here are encouraging.  The French economy is still in a transition phase following the recent presidential election whilst economies such as Ireland and Spain, which have benefited strongly from rising house prices, may suffer slackening growth rates as housing finance becomes more difficult to obtain.

Turning to our investment themes, we have made relatively few changes and continue to reiterate our enthusiasm for commodity related stocks and note the resilience against a more difficult trading background of the global luxury goods sector, where overall trading levels continue to remain firm.  On a more macro level, we continue to remain overweight in equities against fixed interest although as has been mentioned, we do now sound a slight note of caution for the markets in the short term.

Overall, it has been perhaps surprising that equity markets in the UK have remained relatively stable given that the quarter has seen the first run on a clearing bank for nearly 140 years.  The current ratings on the UK equity market are not demanding and there is still some evidence of dividend growth coming through.  However, the real economy has become more dependent on earnings from financial services and consumer confidence has tended in the past to be very much anchored on expectations regarding house prices.

The outlook for both of these variables has been more cloudy of late and although we may see some further progress from markets we are generally tending to hold slightly higher levels of cash in our portfolios than hitherto.  On a global perspective, the performance from the Pacific Rim markets has been most encouraging and overall capital flows do appear to be more directed towards these areas.  Nevertheless, one of the main drivers of equity markets since 2003 has been merger and acquisition activity and it is to be expected that following the shock to the financial system in the summer criteria for lending will be necessarily tightened.  Speculative acquisition activity will thus be less prevalent and this may inhibit overall growth in markets globally.



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