Investment Comment

Markets' credit-related dyspepsia was eased to some extent by the remedial and urgent capital-raising activities of banks. The purchases of sub-prime mortgage debt by some high-profile buyers and the success of a clutch of new bond issues also buoyed investors' hopes that credit market conditions might have stabilized. Mars agreed to buy Wrigley, for example, in a deal financed by more than $10 billion of debt, seemingly faithful to the words of the chewing gum company's old advertising slogan: "Wrigley's aids digestion".

However, investors' concerns about the implications of the credit crisis persist. According to ratings agency Fitch, financial institutions have now written down more than 80% of the subprime-related losses they are estimated to have suffered to date; but, with the outlook for defaults among companies and individuals worsening amid fading global growth, and with banks' capital positions (notwithstanding recent fundraising) in places appearing inadequate, the financial sector remains vulnerable as a whole to further losses. With 'inter-bank' lending rates still elevated and mortgage rates moving well above base rates, the risk to economies from scarcer and more costly credit is evident.

If, as the International Monetary Fund argued in April, the world economy has suffered (as a result of the crisis in credit markets) 'the largest shock since the Great Depression', it is perhaps remarkable that headline measures of economic wellbeing have not been gloomier; no major economy has yet entered recession (being defined strictly as two consecutive quarters of 'negative growth'). Remarkable, too, is the occurrence of a secondary shock, in the form of rising inflation, as the global economy weakens; slowing economic activity, particularly in the United States, has served traditionally to relieve inflation pressures.

Comparisons made by some commentators of today's economic backdrop with the 'stagflation' of the 1970s, characterized by the concurrence of weak activity and high inflation, seem far-fetched, but economies have slowed and pricing pressures around the world have increased. The Economist newspaper suggests that two-thirds of the world's population now suffers inflation of greater than 10%, a level that will lessen consumers' spending power and limit the options of monetary policymakers.

The cost of oil has become a particular focus of attention, with the announcement in May by American Airlines, the world's biggest airline, of a significant reduction in the number of flights it proposes to offer within the U.S. illustrating the obvious pressures that higher energy costs are applying to businesses. With a barrel of crude rising in price on 6th June by more than it had cost in 1998, and with global expenditure on oil having risen to 7% of GDP (a level not seen since 1980), the scope for the oil price both 2to oblige higher interest rates and to set a quasi form of monetary policy (by reducing consumers' and companies' spending power) is obvious.

Perturbed by the twin threats from tighter credit markets and inflation, equity markets surrendered the gains they had made in the weeks following the rescue of U.S. investment bank Bear Stearns in March to record disappointing returns for the second quarter as a whole. The markets of Continental Europe returned -3.7% in dollar terms (for a return of -12.0% over six months), North America closed the quarter with a return of -1.0% (-9.9% over the first half ) and the UK fell by 0.8% (-11.2% over the half year). Elsewhere, Japan achieved a rare quarter of share price growth with a (yen-diminished) return of +2.5% (to cut investors' losses for the first half of the year to 5.5%), the markets of Asia ex Japan rose by 1.7% (-11.4% over six months), and emerging markets fell collectively by 0.8% (to take the half-year return to -11.6%).

In bond markets, similarly, investors' growing fears about inflation and their interpretation that rising prices will force the hands of the central banks to raise interest rates proved decisive as government bond prices fell. The JP Morgan Global Government Bond Index returned -4.4% to reduce its gain over the six-month period to 4.8%.

Reports on the U.S. economy have tended to paint a picture of a slowdown rather than of more calamitous conditions. House prices fell by more in the year to the end of April than in any year since the 1930s (notwithstanding the deflation which typified that decade) but, to date, the slowing of consumer spending growth, the relenting of manufacturing activity and rise in unemployment have been consistent with slowing growth rather than recession. It is probable that the economy has received a fillip from the tax rebates paid to consumers in recent weeks, although surveys found that consumers planned to spend only between 20% and 40% of their rebates. According to the 'HowISpentMyStimulus' website, one individual recorded that he had spent his check on securing bail from a Pennsylvanian jail and another that he was considering using his check to take legal action against President Bush in relation to the 2003 invasion of Iraq.

The U.S. economy has been propelled for a generation by the relentless spending of U.S. households, but consumers' wallets may finally close as the benefits of tax rebates fade and as falling house prices, reduced access to credit, higher fuel and food costs and a weakening labor market take their collective toll. The 'forward-looking' elements of consumer confidence surveys are already at their weakest levels since 1973. Sales of sports utility vehicles have fallen sharply and, in a graphic response to consumers' increasing frugality, General Motors announced in June that it may sell the iconic, 'gas-guzzling' Hummer business and that it plans to complete development of the 'Volt' electric car by the end of 2010.

The Federal Reserve cut the headline rate of interest to 2% at the end of April in response to the perceived risks to U.S. economic growth. Latterly, however, it has appeared torn between its dual responsibilities to promote growth and to maintain price stability, resolving seemingly that inflation should be the greater of its preoccupations amid dramatic rises in energy prices. With the inflation-adjusted interest rate standing below zero and consumers' long-term inflation expectations having risen to a 13-year high, the U.S. central bank is likely to maintain its 'hawkish' rhetoric,whatever its actions on interest rates.

Notwithstanding the current inverse relationship between the dollar and the price of oil, the currency's protracted weakness (in which the central bank had appeared to acquiesce in the interests of U.S. trade) has not appeared to fan the flames of inflation as markedly as might have been expected. However, Chairman Bernanke announced in June that the Federal Reserve had lost patience with the decline of the dollar. Mindful also of the requirement to maintain investor confidence in U.S. assets, policymakers would welcome the diminished threat to inflation implied by a healthier dollar.

Aside from obdurately strong retail sales data in May (at odds with more recent evidence such as a profits warning from retailer Marks & Spencer), reports have depicted a clear slowing in the rate of growth in the UK economy. The housing market has weakened considerably, with prices falling more over the year to May than in any year since the property slump of the early 1990s and with transaction levels decreasing markedly; consumer confidence has declined significantly against a backdrop of rising food and fuel prices and much tighter credit conditions; and manufacturing activity has slowed sharply.

A slowing economy, fast-rising fuel prices and increasingly militant trade unions have elicited (exaggerated) comparisons with the state of the country in the 1970s. The prime minister, despite 'feeling the hurt' of the electorate as it contends with the worsening economic backdrop, stirred memories of an even earlier era, given that his popularity rating fell below that of Neville Chamberlain when Germany invaded Norway in 1940. The astonishing volte-face over the abolition of the 10p tax rate seems merely to have hastened 'prudence' to her grave.

Mervyn King, Governor of the Bank of England, warned in May that the UK economy was leaving the 'nice' (non-inflationary, constant expansion) decade behind and that the 'squeeze on households' (from rising prices) would 'arguably be an even more significant restraint on consumer spending this year than the credit crunch'. Despite UK supermarket chain Asda's launch of a two-pence sausage, statistics have shown an escalation in price rises across the economy, with consumer price inflation reaching 3.3% in May and producer price inflation at its highest level for a quarter of a century.

As the Bank of England seeks to tackle rising prices, it will be concerned, not simply by the acceleration in inflation rates, but by the further increase in consumers' inflation expectations (now at 4.3% for the next year) and by signs of higher wage settlements in the private sector (most notably the two-year settlement of 14% reached by Shell tanker drivers). Given the Bank's conviction that the economy must slow sharply to contain these inflation pressures, it is likely to draw some comfort from the cooling of activity, but it will need to be dexterous to deal successfully with the twin challenges of slowing growth and rising prices.

Given the assertion by some commentators that the Bank of England's task is reminiscent of that which it faced in the 1970s, it is perhaps fitting that Governor King opened the Bank's own 'Multi-Colored Swap Shop' (in its previous incarnation, a 1970s UK children's television program) in April in the form of its new Special Liquidity Scheme. The scheme, which allows UK banks to swap mortgage-backed securities and other forms of debt for UK Treasury bills, should serve to improve liquidity in the UK banking system and thereby close the (pronounced) gap between monetary policy rates and effective borrowing rates for businesses and households. It should help the Bank also to separate its responses to the respective growth and inflation challenges it faces.

Germany's fastest quarterly expansion for 12 years helped the European economy to record strong growth in the first three months of the year, but surveys have suggested that, like the constitutional aspirations of Europe's politicians following rejection of the Lisbon Treaty by the Irish electorate, economic activity took a knock during the second quarter. The effects of the global credit crunch, a strong euro, and rising food and energy prices appear to be inhibiting economic activity on the Continent.

The European Central Bank celebrated its tenth anniversary in June with inflation concerns still predominant in its communiqués and financial markets pricing in the significant chance of a rate rise. Despite the ECB's recognition of growing risks to the financial stability of the eurozone, the central bank raised rates at the beginning of July (to 4.25%) to ease the growing threat of inflation. With consumer price inflation of 4.0% being only fractionally lower than the prevailing interest rate, the central bank's caution is reasonable.

Like its European counterpart, the Japanese economy grew robustly during the first quarter, but it appears to have slowed since. No sooner had the new governor of the Bank of Japan, Masaaki Shirakawa, settled into his post, than he had set about downgrading economic growth forecasts and renouncing his predecessor's faith in a virtuous cycle of rising wages and growing consumption.

With inflation now firmly in positive territory in Japan, owing to rising fuel prices and, among other things, to spaghetti (which the Japanese like to eat with seaweed and cod's roe), the Bank of Japan may be tempted to raise interest rates over-zealously to maintain price stability; but, following two decades of economic malaise, Japan seems to require less impetuous central banking. In Shirakawa, at least, the country appears to have a man proficient in monetary policy. When asked in an interview shortly after taking his position what his main hobby was, Shirakawa replied that it was 'central banking'. Mervyn King, at the Bank of England, by contrast, prefers to spend his spare time supporting Aston Villa Football Club or playing tennis; and Ben Bernanke, at the Federal Reserve, is an accomplished saxophonist and follower of the Boston Red Sox.

With wages and real estate prices rising, consumption may yet grow stronger in Japan, but the country still relies heavily on its exports to sustain economic expansion. Slower global growth and soaring energy prices have been discouraging, but relations with China (Japan's largest trading partner) continue to improve promisingly. Rapprochement was aided by Chinese President Hu Jintao's gifts of two giant pandas and a ping-pong match with his Japanese counterpart during his visit in May.

In the Asia-Pacific region, the cyclone in Burma and the earthquake in the Sichuan region of China were large-scale human tragedies; but inflation became the principal economic priority for politicians and central bankers. Until recently, Asian policymakers had regarded rising food and energy prices as being caused by 'supply-side' shocks. They were content to use price controls, subsidies and export bans (and, in the case of the Philippines, the threat of life imprisonment for hoarding rice) to tackle what they perceived to be ephemeral problems. Latterly, however, policymakers have taken more rational steps to tackle pricing pressures: withdrawing subsidies, tightening monetary policy and contemplating allowing their currencies to rise. Most notably, China raised the price of gasoline by 17% towards the end of June.

With interest rates almost universally negative in real terms across the region, and with budget surpluses being eroded fast by subsidy costs, Asian countries were pouring fuel almost literally on to inflation fires in their attempts to shield their economies from the effects of global price rises. While it is encouraging that Asian policymakers are beginning to tackle inflation trends more rationally, their challenge will be to contain pricing pressures without derailing economic growth.

Bond markets take encouragement typically from the type of gathering gloom about global economic prospects that was evident during the second quarter; they took their cue instead from investors' growing concerns about inflation. With central banks seemingly hamstrung by the necessity to tackle rising prices, and investors anticipating that interest rates will have to rise, bond yields rose. The yield on the two-year U.S. Treasury climbed from 2.38% to 2.90% in just two days in June in anticipation of tighter monetary policy; and, to reflect the heightened demand for inflation protection, the gap between yields on index-linked government bonds and conventional sovereign debt widened over the quarter.

As long as investors' fears about inflation (and about the rising price of oil in particular) continue, fixed-interest markets are likely to struggle to make headway; the major government bond markets are pricing in the likelihood of further rate rises towards the end of the year as central banks seek to bring inflation under control. However, as yields rise, opportunities may become more attractive to buy bonds as a 'hedge' against worsening economic conditions. Bond yields might fall again if monetary policymakers are successful in taming inflation and can turn their attention to growth-promoting cuts in interest rates

In corporate bond markets, shareholders' pain has been to some extent bondholders' gain; dividend cuts and rights issues are positive for fixed-interest investors and the recapitalization of balance sheets may provide selective opportunities for investment in the debt of financial institutions in particular. Investment-grade bond prices appear still to be over-compensating for the risks to global economic growth, but high-yield bonds remain vulnerable to rising default rates amid worsening economic conditions.

When General Electric announced its results for the first quarter of the year at the beginning of the U.S. equity market's 'reporting season', the portents for the market as a whole were discouraging; despite deriving more than half its sales from outside the U.S., GE's results failed to reflect the benefits of a weaker dollar and the strength of some of its overseas markets. However, the overall U.S. market picture was not so bleak. While financial corporations reported sharply lower profits, strength in the resources sector meant that corporate profits were in aggregate higher than in the first quarter of 2007.

As the U.S. economy slows, profit margins are almost certain to fall; productivity improvements and the muted growth of wages may protect earnings to some extent, but the outlook is challenging.Financial and consumer-related companies are likely to find the going particularly rough, with asset values falling and credit conditions detrimental, and the financial sector's recourse to shareholders for additional funding seems far from over.

Excepting GE's difficulties, the industrial sectors of the economy have enjoyed the strength of overseas demand and the impetus provided by a weak dollar, but the combination of fast-rising raw material prices, higher borrowing costs and policymakers intent on 'talking up' the dollar may be injurious to U.S. industry in the months ahead. In such an environment, investors should find relative security in companies whose earnings are comparatively 'defensive' and whose balance sheets are strong.

The UK stock market fell by 'just' 1.5% over the first quarter (in total return terms), with strength in the ever-larger resources sector (oil and gas +17.6%; mining +17.0%) counteracting the pronounced weakness of the financial sector (banks falling in aggregate by 20.8%). The colonization of the UK equity market by overseas resource companies continues apace. Ferrexpo, a Ukrainian iron ore producer, followed the recent arrival of two Kazakh mining companies by joining the FTSE-100 Index during the second quarter and Fresnillo, a Mexican silver miner, is likely to join in September. The mining sector is six times larger now as a constituent of the UK stock market than it was eight years ago. Together, the oil and gas sector and the mining sector represent one third of the FTSE All-Share Index and the level of the UK equity market as a whole depends to a significant extent therefore on the fortunes of resources companies.

Conditions in the banking sector have deteriorated perceptibly in recent months and banks' share prices have fallen precipitously amid rising bad debts and undignified fundraising activities. The failure of Bradford and Bingley's original rights issue was a particular debacle, with management seemingly oblivious to the true state of the bank's balance sheet and underwriters unwilling to honor their commitments. Unease about the outlook for banks now rests not so much on the prospect of asset write-downs (which are likely to continue), but on whether, as the economy deteriorates and the housing market in particular weakens, banks have sufficient capital to provide a buffer against their bad loans. A cautious approach to investment in the financial sector remains imperative.

The fall in European companies' first-quarter earnings, like that witnessed in the U.S., was attributable entirely to weakness in the financial sector. Earnings growth, excluding financial stocks, was positive and, with the beleaguered banking sector representing a much greater part of the European market than of the U.S. (17% versus 6%), that was no mean feat. However, the smattering of profit warnings across a range of industries during the second quarter, and the increased rate at which companies (among them BMW and its aptly-named chief executive, Norbert Reithofer) have been taking charges to reflect rising bad debt levels, suggest that the effects of the global credit crunch, an appreciating currency, and rising food and energy prices have been having an adverse impact on European companies in recent weeks.

As the economic backdrop becomes more demanding, investors are likely to rediscover the intrinsic qualities of Europe's larger companies. Large-cap stocks have underperformed their small-and mid-cap counterparts significantly over the last six years, chiefly because private equity firms have favored the use of 'cheap' debt to buy the latter. In an environment of more expensive and less abundant credit, there will be greater allure in large, well-managed companies with strong cash flows that prevent their being beholden to banks and to less obliging credit markets.

The Japanese stock market was alone among the major markets in posting a positive return over the second quarter. Overseas investors apparently were significant buyers of Japanese equities during the quarter, buoyed perhaps by the promise of greater domestic pricing power, perhaps by the conviction that Japan's banking system will remain relatively unscathed by the global credit crisis, and perhaps by companies' propensity to increase dividends (up 14% compared with last year) and to carry out share buy-backs (up 15% on last year).

Domestic investors have remained steadfastly on the sidelines of their domestic equity market and it is noteworthy, for example, that the country's public pension fund (the largest in the world at $1,500 billion) holds only 11% of its assets in Japanese equities. With returns on equity still well below those in other major markets, the diffidence of Japanese investors is forgivable but, with inflation expectations mounting, shares are likely to grow more appealing compared with (low-yielding) cash and bonds, Investment Comment Third Quarter 2008 particularly if economic expansion is sustained by improvements in wages and real estate prices.

The stock markets of the Asia-Pacific region weakened further during the second quarter, with investors unable to overcome their concerns about the effects of mounting inflation on economic activity and corporate profits. If policymakers are correct that rising prices have occurred as a consequence of a short-lived supply-side shock, it is conceivable that bond, equity and currency markets will be supported by the greater scope of central banks to promote economic growth; but such a benign outcome is far from assured.

The recent lifting of price controls by a clutch of Asian governments should encourage the 'rational' resolution of inflation challenges but, until the impact of pricing pressures upon Asian monetary policy and economic growth prospects becomes clearer, Asia's stock markets may struggle to make significant headway. In the near term, the region's businesses may be hampered in their attempts to preserve profit margins by rising wage, energy and commodity costs and by the slowing of key export markets in the U.S. and Europe. However, economic growth in the region should remain robust and Asian companies remain attractive to the long-term investor given their exposure to growing domestic consumption.

Investors have faced two (arguably paradoxical) challenges during the first half of 2008: a deflationary crisis in global credit markets and the inflationary thrust of soaring food and energy prices around the world. Neither challenge has been 'resolved', and the implications of each are likely to set the tone of financial markets during the second half of the year.

The 'becalmed' era in credit markets has ended in resounding fashion, but the effects of changes in credit conditions remain unpredictable. In the financial sector, balance sheets are still fragile (and vulnerable to further falls in U.S. house prices) and 'inter-bank' borrowing rates remain elevated. Elsewhere, the effective costs of borrowing for businesses and consumers have stayed considerably higher than central bank interest rates.

Even once credit conditions have 'normalized', there are likely to be significant changes in credit markets, which bring about not so much the 'resolution' of prevailing challenges as the imposition of a new order. The increased regulation of credit markets and the commercial necessity for banks to lend more 'conventionally' than hitherto should put paid to the reckless lending practices carried out in recent years. The extent to which less abundant and more expensive credit will affect economic activity and corporate earnings is uncertain, but scarcer and higher-cost debt seems unlikely yet to have taken its full toll on the fortunes of households and businesses.

Mounting inflation threatens to complicate an already challenging situation by constraining consumers' spending power, eroding corporate profit margins and encumbering the operations of the world's central banks. Pricing pressures should abate as economies slow, and monetary policymakers in the developed world will draw comfort from the moderate growth of wages in their economies to date, but there is a risk nevertheless that commodity and food price 'shocks' will provoke more generalized rises in prices and wage demands.

The challenges will not be straightforward to resolve. By historical standards, interest rates are low in real terms around the world, but central banks will be unable to tackle inflation by raising rates with impunity for fear of choking the demand that distinguishes economic slowdown from full-blown recession. Amid the combination of slowing economic growth and rising prices, there are further risks to the wellbeing of economies, among them 'resource nationalism' (as governments act to safeguard their commodity supplies), the greater deployment of protectionist policies that may restrain the growth of trade, and, in general, the imposition of 'more government', which will frustrate companies' profit-making ambitions.

There is every prospect of a period of sluggish economic activity as the end of the 'cheap money' era coincides with an escalation in the global prices of energy and food; indeed that is precisely what some central bankers have said they consider necessary to scotch the inflation threat. However, the long-suffering investor should persevere. Threats (particularly in the financial sector, where the healing process from credit-induced wounds seems far from over) are obvious but, as sentiment in markets deteriorates, changes in economic and financial landscapes are likely to present attractive opportunities for investment.

"How poor are they that have not patience!
What wound did ever heal but by degrees?"
William Shakespeare, 'Othello'