Equity markets endured turbulent trading conditions during the first quarter of 2008 as a result of intensifying fears of a US economic recession and continued tensions in global credit markets. For three major global equity indices – the S&P 500 in the US, the Pan European FTSE Euro First 300 and the UK’s FTSE 100 – the returns were the worst since the third quarter of 2002. Nevertheless, major central banks made a concerted effort to provide liquidity to troubled credit markets and substantial cuts were seen in US interest rates. Rising inflationary pressures in both the UK and Europe inhibited similar sharp falls in rates but global markets are currently anticipating a downward trend in UK interest rates over the year. 

Currency markets remained volatile and the most notable features were a strengthening of the euro and yen against the dollar and sterling. Overall levels of debt within the UK economy remain a major problem and a deficit on both the fiscal and trade balances continue to worry overseas holders of sterling, who we anticipate will remain sellers of the currency for the foreseeable future.

The prices of both hard and soft commodities moved sharply ahead during the first quarter  although some profit-taking was noted at the end of the period. It is likely that some of these spiralling prices were not entirely market related but were the result of speculation by hedge funds; it is therefore possible that some of these short-term price rises will unwind during the second quarter of 2008. However, we do believe that we are still in a ‘super cycle’ for commodities and that periodic sell-offs are very much a pattern in the bigger picture. The strategic needs of both China and India for commodities, given their rapidly advancing industrialisation programs, will continue to provide firm demand for a large variety of commodities for the foreseeable future.

Bond markets experienced credit spreads at a high level compared with the past two or three years and the UK gilt market made further progress as investors anticipated a continuing series of interest rate cuts in the UK throughout 2008.

Looking at global markets, the Japanese economy continues to grow in a rather fitful fashion; overall expectations for growth have been downgraded recently. As a major energy importer, the Japanese economy suffers from rising oil and commodity prices whilst a rising yen against most major currencies has inhibited the competitiveness of its major exporting industries. In the long term, we do believe that the residual strength of the Japanese economy will come through but for the time being investors remain risk-averse and the flow of funds may tend to be out of equities for a little while longer. On the other hand, Pacific Rim markets, where levels of growth are still relatively robust, do now appear to offer substantial value after some sharp falls in the first quarter, mirroring the experience of major industrialised markets.   Global instability in terms of political unrest or sharply rising oil and commodities prices could derail this growth pattern, but on balance we view the set-back in these markets as an attractive opportunity to increase exposure.

In the United States, equity markets gave ground during the quarter, although there was some pick up in the financial areas late on as the swift reaction to the collapse of Bear Stearns indicated that the Federal Reserve was prepared to act quickly and decisively to maintain order within financial markets. House prices in the United States fell substantially and it is
not clear at what level they will bottom out. This had a particularly adverse effect on consumer confidence in the United States and may impinge on levels of consumer expenditure. It is now entirely possible that the US has entered a mild recession but the proactive stance of the Federal Reserve in aggressively cutting interest rates should feed through later in the year to bolster both industrial and consumer spending.

In the UK, a major feature of the early part of the year was a substantial weakening of sterling against most major currencies as concerns grew about slowing growth rates and levels of consumer indebtedness. This will have the effect, over time, of making our exporting industries more competitive against their global peers but does have the short-term disadvantage of importing inflation into the economy through the rising prices of commodities such as oil and base metals. This imported inflation inhibits the ability of the Bank of England and the monetary authorities to reduce interest rates to cope with slowing growth. We do, however, feel that rates will come down a little during 2008 and for the equity market we note that the corporate sector generally is relatively well financed and earnings expectations in terms of market multiples are very modest for this stage in the cycle. We anticipate some pick-up in merger and acquisition activity given the fall in share prices over the first three months of the year as companies with robust balance sheets seek to pick off less well-placed brethren in a somewhat opportunistic fashion.

In Euroland, the German economy has remained quite resilient in the face of slowing economic conditions and the unstable credit markets. Conditions in Ireland and Spain, however, and particularly in the housing markets, have deteriorated sharply and both countries are now suffering from the inflexibility of the euro to accommodate differing growth rates within Euroland.

On a global perspective, the growth trends in the Pacific Rim economies, China and developing countries such as Brazil remain robust and we believe that any recessionary influences in the developed world – particularly the UK and US – will be relatively shallow in nature. We anticipate that the so-called Sovereign Wealth Funds – the funds of governments of oil-rich countries and the Far East – will continue to assume an important role in capital markets, although it is to be expected that a degree of transparency will be sought in their investment criteria. Debt-financed activity, a major feature of the past few years, will be particularly difficult to carry through given the current credit conditions so we would anticipate a renewal of equity financed acquisitions, perhaps through rights issues, to keep the merger and acquisition momentum moving. Despite the poor start that equities have made in 2008 and the possibility that economic growth may slow, we believe that interest rate cuts will prove accommodating for equity markets and the overall tone of markets will tend to improve as the year progresses.



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