During the second quarter of 2008 equity markets suffered once again from the fall-out in global credit markets and fears continued to intensify of a further slow-down in economic activity across the globe. Although the central banks remained generally supportive of markets in providing liquidity wherever possible, concerns increased over a general pick-up in levels of inflation, and expectations concerning the direction of interest rates moved from an expectation of a fall towards fears of a small rise. 

Currency markets were again volatile, but overall levels were little changed over the quarter.  We anticipate that the downward trend of sterling against a basket of internationally traded currencies will continue, given the significant overall levels of debt within the UK economy and the deficits on both the trade and fiscal balances, which we believe are set to deteriorate further. 

In commodity markets, it was noticeable that some of the excesses in hard commodities such as gold, zinc and nickel tended to unwind a little during the second quarter. However, the key feature in commodities markets, the oil price, continued to hit new highs. We continue to adhere to our view that we are still in a “super cycle” for commodities and that, while we will see periodic sell-offs, overall the trend in most commodity prices over the medium term is likely to be higher rather than lower. China and India, the main drivers of fundamental demand for a large number of commodities, have, however, been making attempts to damp down inflation within their economies and it is our feeling that these actions may have an impact upon the supply and demand picture for most commodities in the short term.

Bond markets tended to trend lower over the quarter as inflationary expectations across the globe rose. Index-linked markets remained relatively well supported whilst a change of sentiment regarding the direction of UK interest rates acted adversely on the UK gilt market. 

Turning to global markets, the Japanese economy continued to struggle as the green shoots of growth that had been seen recently tended to wilt. Inflation crept back into the Japanese economy after a long period of deflation. This may, unusually, be a more positive sign for Japanese investors and companies to re-deploy their substantial liquid assets in a more productive fashion but the outlook for growth in Japan over the next year is somewhat muted.  We continue to believe that the Japanese economy in the medium term will come through its current difficulties and that growth will be led by its exporting industries, which will benefit from a trend towards a lower yen against most major currencies. Japan will also benefit from its substantial nuclear electricity program which to some extent shields it from rising oil prices on the domestic front. Pacific Rim markets, on the other hand, are now perhaps looking a little more vulnerable than they have for some time given the very sharp rise in oil prices and a pick-up in inflation rates across the region. These two factors may now impinge on growth rates generally and we would be reluctant to increase exposure to this area till we see some evidence of both these trends turning down.

In the United States, the fall in equity markets gathered pace as the quarter progressed and financial sectors continued to come under pressure. Housing markets continued to be weak and again it remained unclear as to what level they would bottom out, although there were some tentative signs of stability appearing later in the quarter. Unsurprisingly, consumer confidence levels again plummeted and are now hitting multi-year lows. It is still unclear whether the United States might enter a mild recession later this year as data have been somewhat conflicting, but it is undoubtedly the case that a further slowdown in economic activity is to be expected. It is now also unlikely that rates will drop much below 2% in the current cycle as inflationary concerns have picked up recently.

It remains our view that the UK is not well-placed for a major global economic slowdown given its high debt levels and unfavourable trade and fiscal balances. We expect sterling to continue to decline in the medium term against most major currencies and this will have the effect of pushing the sterling price of imported commodities higher. As we have stated before, this imported inflation inhibits the flexibility of the Bank of England to cut interest rates in order to promote economic activity. Although the UK corporate sector remains generally well-financed, it has been noticeable that heavily indebted companies have been singled out for particularly harsh punishment by the market, given the increasing difficulties there have been in rolling over corporate debt into new structures. We see no sign of this problem abating in the medium term and are actively avoiding placing new funds into companies with high levels of gearing. 

In Euroland, the German economy has remained relatively resilient against a background of general slowdown, but credit conditions in both Ireland and Spain, whose economic growth has been assisted over the medium term by slack monetary policy, have continued to deteriorate and this has impacted severely on the financial and housebuilding sectors in both economies. We again see no signs of this abating and are avoiding both of these markets.

On a global perspective, skies have certainly darkened over the last three months and it is now our view that the credit crunch which started last year is likely to be more protracted than we had hitherto expected. In particular, rising levels of inflation in the developing world will tend to impact the growth rates which we had hoped would provide a counter-balance to the problems seen in the west. We still believe that any recession in both the UK or US, if it materialises, will be relatively shallow in nature and also note the habit of capital markets to try to anticipate a conclusion to adverse conditions. One pointer would be a pick-up in debt-financed activity, which would be a clear indicator of better market conditions, and we continue to monitor this area particularly closely. Overall, it has been a disappointing first half to the year and as yet there are no clear signs of a resolution to the difficult conditions in capital markets. It remains our view, however, that by the autumn some tentative signs of recovery should be apparent and that markets may well then take some encouragement from this at that time.



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