Equity markets worldwide suffered further heavy falls during the third quarter of 2008. Evidence grew of an impending recession in the USA, the UK and Japan and, towards the end of the period, the intensifying crisis in capital markets as a result of the so-called ‘credit crunch’ claimed a number of high profile victims, most notably Lehman Brothers, Washington Mutual and Bradford & Bingley, and compelled mergers from a position of weakness for a further number of well-known financial companies. Central banks continued to provide high levels of extra liquidity to markets but a reluctance by banks globally to lend to each other, fearing a lack of credit-worthiness and counterparty risk, meant that inter-bank interest rates remained stubbornly high.

Currency markets again remained volatile – the major feature being a general strengthening of the dollar against sterling. We continue to expect that sterling will lose further ground against most major currencies in the medium term as we envisage that UK interest rates are set to fall sharply from here and the deficits on the trade and fiscal balances for the UK will widen still further.

In the light of slowing global growth, some heavy falls in commodities were noted. In particular, world oil prices fell sharply from the peaks seen during the summer. We now expect that this trend will continue in the light of a weakening picture of growth from both China and India, whose presence in the markets as major new consumers of oil had been instrumental in the dramatic price rises seen over the past three years. Prices for a range of hard and soft commodities weakened in sympathy with the oil price and it is difficult to see any major catalysts to drive prices sharply higher in the short term. We still favour the idea of a commodity ‘super cycle’ and it is possible that good long-term opportunities to build weightings in commodity related stocks will appear soon.

Bond markets firmed over the period as investors sought the security of sovereign debt and anticipated further falls in global interest rates. As fears of deflation rather than inflation gained the upper hand later in the period, we turned more cautious on index-linked bonds and, going forward, now believe that there is significantly more value in high quality conventional fixed interest securities. We are now more positive on high quality bonds than we have been for several years, as we believe that inflation will fall sharply in 2009 and that interest rates will fall. We will seek opportunities to build weightings in this area in preference to holding cash balances on deposit.

Turning to global markets, sentiment in the Japanese economy turned more gloomy as growth forecasts proved over optimistic. In the medium term, however, the fall in global oil and commodity prices is better news for Japan as a major importer of raw materials, whilst its banking system is now probably more robust than that of most other developed economies. Pacific Rim and Emerging markets suffered particularly badly from the credit contagion spreading out from the United States, whilst growth rates in general have not been significantly pared back. Good long-term investment opportunities are likely to present themselves in these areas over the next few months provided that the pricing trends in commodity markets remain in their current muted state.

In the United States, the high profile casualties in the equity arena and continuing falls in the housing markets continued to dominate investor sentiment. Consumer confidence levels remained at a low ebb and whoever takes over the White House in January 2009 will have a grim economic legacy to inherit. The economy has probably now been in recession for a few months but it is our current view that this downturn will be shallow and, hopefully, relatively short term as reflationary fiscal and monetary measures are implemented to boost financial and consumer markets. We now expect further falls in US interest rates down to 1% for 2009 as inflationary fears recede.

The UK economy is, in our view, still relatively poorly placed to weather a global slowdown given the generally high levels of consumer indebtedness and vulnerability of the key residential property market to further substantial falls. We now expect UK interest rates to fall to 3.5% during 2009 as inflationary pressures abate, but this may not be enough to prevent a recession in the economy which may last throughout 2009 and, perhaps, into the first quarter of 2010. This backdrop may not be particularly favourable for domestically orientated UK equities, but more global companies may well benefit from the further falls in the parity of sterling against most major currencies that we continue to foresee. It is also important to remember that markets also try to anticipate future economic trends and will bottom some time before economic data looks more positive. It has also been the case that bear markets in equities, which, in retrospect, the UK market can be seen to have entered in the early summer of 2007, have rarely been significantly longer than two years in duration. For long-term investors in UK equities significant opportunities may thus emerge over the coming months.

In Euroland, even the hitherto relatively resilient German economy is now showing distinct signs of a slowdown, whilst peripheral economies such as Spain and Ireland are now almost certainly in recession. The euro itself may face mounting pressure as more European economies face a slowdown or cessation in growth which cannot be tackled, unlike the case for the UK, by a depreciation in the domestic currency.

On a global perspective, economic conditions are likely now to get worse before they start to get better. The world's banking system is under significant strain and further casualties are almost certain, perhaps even of hitherto seemingly safe household names. The forced reduction in leverage throughout the hedge fund universe may also prove problematic. However, on a slightly brighter note, the fall in the oil price and the easing of inflationary influences may now allow interest rates to fall in the developed world, and even China has embarked tentatively on a programme of monetary easing. Equity markets are certain to remain highly volatile in the short term but it is at times of fear and tension that the best investment opportunities emerge for patient, long-term investors in solidly-financed, well-managed companies.



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