Equity markets rose very strongly in the third quarter of 2009, as central banks continued to provide abundant liquidity to financial markets. The FTSE 100 Index in the UK enjoyed its best quarterly performance since inception in 1984 and outpaced the rally seen by markets in Europe and the United States. The policy of ‘quantitative easing’ was continued in both the United States and the UK but it is likely that the majority of funds allocated for this purpose have now been spent and questions must start to arise in the near future as to how markets will fare without this substantial degree of support.

It has become clear that the Bank of England is attempting to engineer a controlled depreciation of Sterling from current levels and, indeed, indications to this effect caused a relatively sharp fall in the currency towards the end of the period. It remains our view that, given the substantial debt burden that the UK economy is currently experiencing, together with the major fiscal imbalances that have been created through rising unemployment and falling tax receipts, the downward pressure on Sterling will continue. We continue to envisage no major change in interest rate policy for the foreseeable future and expect rates to remain at 0.5% someway into 2010.

Fixed interest markets remained under a cloud as equity markets rallied strongly. However, it was noticeable there was a pick up in interest in index-linked stocks later in the period as fears of a rise in inflation in the medium term gathered some momentum. It is our view that inflation could well rear its head somewhat sooner than most analysts expect and that the UK economy is probably the most exposed to these inflationary influences of all the major developed nations. We therefore remain cautious of fixed interest markets, except for stocks of short duration, and are warming to the longer term attractions of index linked securities as a potential portfolio hedge against this inflationary threat. Additionally, there is likely to be a necessary and significant degree of government issuance over the next few years and, as noted above, the quantitative easing policy is likely to come to an end in a few months time.

In the United States, further signs appeared of stability in the key residential property market as interest rates remained at historically very low levels. This recovery was sustained during the late summer through an increase in property sales, although it was clear that a number of these sales were of re-possessed properties. There is still a substantial amount of liquidity available in money market funds earning virtually no interest, although there has been some shift into fixed interest collective vehicles. It remains a major question as to whether we will see a dip in economic recovery in the next few months but, if the current economic momentum remains in place, it is likely that we will see continued movement of funds from cash into higher risk equities, particularly by investors with an income requirement. We remain, therefore, favourably disposed towards adding to holdings in the US equity market and this view is reinforced by our somewhat pessimistic view on Sterling.

The UK housing market, too, showed some signs of a recovery during the late summer particularly in London and the South East. This is despite the relentless pessimism of a number of economic commentators, who believe that residential values still have a long way to fall. However, some thawing of mortgage requirements by lenders has been noted, particularly led by HSBC, and it may well be that the recovery, first seen selectively in London and the South East, will spread a little more widely during the coming 6-12 months. Stability in the housing market is a pre-requisite for returning consumer confidence in the UK; this is likely to be severely tested during the next 12 months as it is likely that, whatever the outcome of the General Election in 2010, both direct and indirect taxes are set to rise across the board.

In Continental Europe, the dominant German economy has seen a sharp turn around in both confidence and output and for Euroland as a whole it is likely that the recession ended sometime over the summer. However, the unemployment picture in economies such as Spain and Greece has proved particularly burdensome to their respective governments as they have been unable to de-value their way out of their current economic problems.

The ‘healing’ process that was clearly necessary following the major trauma suffered by capital markets in the wake of the collapse of Lehman last September has been surprisingly rapid. It is now clear that a major depression on the scale of the 1930's has been avoided, however it appears somewhat unlikely that the sharp rebound in economic activity seen since the late spring will continue at the rate of the past few months and that a slower path to recovery will be seen throughout 2010 and 2011. For this reason, we feel that equity markets may have got a little ahead of themselves and that a pause for breath following the exceptional rallies of the late summer and autumn could now be appropriate. However, there are substantial cash balances waiting for investment opportunities and it is likely that these balances will be supportive for markets were a correction to take place.

Despite the fact that the UK was one of the better performing markets in the last quarter we feel that there are substantial headwinds in the UK economy ahead of us and that it may be that markets in the Far East and the United States prove somewhat better overall performers for Sterling based investors over the medium term. We reiterate our long held view that equities are our preferred asset class of choice and our view has been reinforced recently by a noticeable pick up in merger and acquisition activity on a global basis. The most obvious manifestation of this in the UK was the approach by Kraft for Cadbury. There will also possibly be a continued demand for fresh equity by indebted companies and it is likely that the financial area will be leading the way.

We remain cautiously optimistic about prospects for markets for the coming quarter and beyond but it would be unreasonable to expect, as we have noted, anything like the spectacular returns enjoyed during the third quarter of this year. However, as long as interest rates remain at their current low levels and economic confidence, particularly in the Far East, continues to grow, we can still see some attractive opportunities in stocks orientated towards the growth areas of the world. We retain a negative bias towards purely UK orientated stocks, especially in the retailing and discretionary expenditure areas of the market, given the undoubted headwinds that will be experienced by the UK consumer during the coming year. We are also concerned about prospects for a number of companies that are exposed to UK government expenditure, with the upcoming public spending round expected to be highly challenging.



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