Investment comment

Central banks continued to cut interest rates aggressively (effectively to zero in both the U.S. and Japan) in the final months of 2008 and to adopt a plethora of additional 'unorthodox' measures to try to ease conditions in financial markets and to revive economic activity. They increased their reserves significantly to provide liquidity to private sector borrowers (in some cases lending directly to companies) and they intensified their purchases of government bonds and commercial paper in attempts to drive down the effective costs of borrowing.

Governments, too, continued to try to stabilise the financial system and to lessen the seriousness of the economic downturn. They introduced a raft of tax cuts and spending plans during the final quarter and acted in places to avert panic among bank depositors and shareholders by bailing out failing financial institutions. Most notably, the U.S. government (in sharp contrast to its decision just weeks earlier to allow Lehman Brothers to collapse) stepped in to rescue Citigroup. The bank had famously been encouraged by its chief executive to 'get up and dance while the music [was] still playing' but, in answer to the question raised originally by the American author Hunter S. Thompson (and reprised in the Killers' recent hit record), 'Are we human, or are we dancer?', it showed itself to be more the former than the latter.

The efforts of monetary and political authorities around the world have appeared to stabilize, but not to 'normalize', conditions in credit markets, underscoring perhaps the inherent contradiction between a globalized financial system and the disparate and localized nature of attempts to regulate it. Furthermore, while the world has stepped away collectively from the 'abyss' of financial-market disintegration, the labors of central bankers and politicians have seemed increasingly unlikely to avert an economic slump. World trade has contracted suddenly, consumption has flagged, industrial output has weakened precipitously and employment markets have deteriorated quickly.

Compounding the challenges to global investors of dysfunctional credit markets and weakening economic conditions have been startling shifts in the values of the world's major currencies. The U.S. dollar has appreciated particularly strongly, its potency being arguably the barometer of strains in financial markets; the yen has also been markedly strong while sterling has been strikingly weak. Seen through the prism of foreign-exchange movements, the experiences of investors in the world's major economic regions have been vastly different therefore from one another.

In government bond markets, yields fell spectacularly as concerns about the outlook for global economic growth and the specter of deflation trumped potential anxiety about the engorgement of government balance sheets; interest rates on three-month U.S. Treasury bills actually fell to negative levels for the first time since 1940, with investors effectively paying for the privilege of owning short-dated U.S. government debt. The JPM Global Government Bond Index returned 9.7% over the quarter in dollar terms (a 12- month return of +12.0%). In corporate bond markets, 'spreads' (the additional yield premium over equivalent government issues) widened further during the fourth quarter amid persistent aversion to 'risk'.

Despite a year-end rally in equity markets, returns from the major regions were universally negative over the quarter in local-currency terms and the pronounced strength of the U.S. dollar generally had a negative influence on the fortunes of U.S. investors. In Continental Europe, dollar investors experienced a quarterly return of -22.7% (-46.1% over the year), in contrast with the (euro) return of -16.9% to local investors over the final three months. U.S. investors received a three-month return of -26.3% from UK equities (-48.3% over 2008 as a whole), despite the UK equity market having fallen by 'just' 8.7% in sterling terms over the final quarter. Pacific ex Japan equities delivered a dollar return of -24.9% over the quarter (-50.0% over the year) and emerging markets delivered collectively a return of -27.6% (-53.2% over 12 months). U.S. equities themselves registered a return of -23.1% (-37.8% over the year).

In contrast with the attrition of U.S. dollar strength on returns elsewhere, Japanese equity returns to the U.S.-based investor were boosted by the strength of the yen (returns of -9.0% over the quarter and -29.1% over the year comparing with yen returns of -22.3% and -42.5% respectively).

The U.S. economy, according to the National Bureau of Economic Research, entered recession as long ago as December 2007, and estimates suggest that it may be contracting currently at an annualized rate of more than 5%. Government spending and vigorous export activity have prevented a steeper rate of decline, but elsewhere weakness has been pervasive. The housing market has continued to deteriorate, manufacturing activity has fallen to its lowest level since 1982, and unemployment is rising fast (with more jobs lost in November than in any month since 1974). Not even Wal-Mart's selling of $7 vacuum cleaners has been sufficient to prevent either retail sales or consumer confidence from falling.

U.S. authorities have acted determinedly to try to ease conditions in both financial markets and economies; the outlook for the latter rests to a great extent on the improvement of the former. Congress finally passed the Troubled Asset Relief Program at the end of October, although not before the bail-out plan had grown to 450 pages in length and been ambushed by $50 billion of vote-winning tax breaks. Increasingly, however, the U.S. authorities have moved away from the notion of buying tainted assets from financial institutions to the 'European' approach of injecting capital into banks.

The precariousness of the three large U.S. carmakers (Chrysler, Ford and General Motors), which appeared to be destined for what has been termed 'Carmageddon', is symbolic of the challenges facing President-elect Barrack Obama. With the budget deficit for 2009 already forecast to reach as much as $1 trillion (owing in part to Obama's plans to undertake the largest infrastructure investment program in the U.S. for half a century), the new president will be limited in his ability to protect the interests of car-centric Detroit, let alone all troubled corners of the United States.

The Federal Reserve cut rates to a range between zero and 0.25% in December and introduced a mélange of other measures to demonstrate that monetary policy does not cease when rate cuts are exhausted. With consumer prices falling fast, deflation appears to have become a near-term preoccupation of the U.S. central bank but, with the monetary printing presses now thundering, it seems unlikely that it will remain so over the longer term.

For now, the manifest strength of the dollar is pernicious for U.S. policy-makers seeking to scotch the threat of falling prices. Amid the 'deleveraging' of the U.S. financial system, the dollar has resembled a homing pigeon returning to roost, its flight 'home' bringing about its scarcity elsewhere in the world. Should credit markets begin to operate in more conventional fashion and should the growing scale of U.S. public sector debt appear incongruous with the payment of paltry rates of interest to the funders of that debt, the U.S. currency could weaken from prevailing levels. However, there can be little conviction about near-term changes in the values of the world's major currencies.

The UK economy was reported to have shrunk in the third quarter of 2008 for the first time in 16 years. Austerity and thrift appear to be coming back into fashion fast, with Powys Council (in Wales) announcing plans to switch off two-thirds of its street lights and designs for the 2012 Olympic media centre being scaled back from an £80 million structure to an array of trailers: so much for the Labour government's promise of 'an end to boom and bust'.

Aside from the government's own mimicry of the private sector's borrowing and spending activities of recent years, the economy has been bereft of support from its key constituents. With credit proving scarce and the housing market ailing, consumer confidence is brittle and the demise of 99-year-old retailer Woolworths (as well as the downfall of a mounting number of other stores) has illustrated how difficult conditions have become in retailing. Even with the pounding inflicted on the UK's currency (sterling ended 2008 at its lowest trade-weighted level since 1975), reports suggested that never had the manufacturing sector deteriorated as fast as during the three months to November, while business confidence had fallen to its lowest level since the industrial 'shakeout' of the early 1980s.

Gandhi's Indian restaurant in Kennington, South London, may prove to be more 'recession-proof ' than some occupants of the UK High Street; it provided the take-out food over which Chancellor Darling's banking rescue plan was agreed in October. The plan, which entailed the creation of a £50 billion fund to buy UK banks' shares (and the eventual taking of controlling stakes by the government in Royal Bank of Scotland and HBOS), received some acclaim, but it remains to be seen how the UK banking sector recovers from the serious wounds it suffered during 2008. In a survey compiled by the World Economic Forum in the spring of 2008 (before the severity of the banking crisis had become clear), confidence in the UK's banking system had fallen so quickly that the British system was ranked 44th in the world (compared with first in 2006), below El Salvador and Botswana.

The government has set out its stall unequivocally: despite the prospect of falling tax receipts (to be aggravated by the seemingly ineffectual cut of 2.5% in the rate of value added tax), it plans to raise public spending extensively. 'Prudence' has been dumped unceremoniously in the pursuit of a Keynesian solution to the UK's economic woes. With the budget deficit forecast to widen to as much as 10% of GDP (according to less optimistic estimates than those of the Treasury), and with gilt sales set to reach unprecedented levels over the next four years, the government is gambling on its ability to sustain investors' confidence. John Maynard Keynes himself wrote that it was better for governments to 'build pyramids and dig holes' than to leave workers idle; but the government should rue the fact that, like pyramids, its finances are (already) built on sand.

The Bank of England was stirred into action by what it saw to be 'the very marked deterioration in the outlook for economic activity at home and abroad'. Not since the Bank was created in 1694 has the base rate been lower than the 2% to which it was reduced in December (and, in January, the rate was cut to 1.5%). There is doubt, however, about the efficacy of lower central bank rates given that lack of transmission of lower rates via the banking system remains the key impediment to the maintenance of 'normal' credit conditions. Without extending greater loan guarantees to the banks or nationalizing the banking system more widely, the government may be unable to prevent banks from simply exploiting lower rates to boost their capital.

The eurozone economy has entered recession officially and recent data has supported expectations that 2009 will be one of the most challenging years in Europe's economies since the Second World War. Paralysis in credit markets has taken its toll on the activities of businesses and consumers (notwithstanding central bank governor Trichet's assertion that there has been no credit crunch in the eurozone) and the buoyant euro appears to have exacerbated exporters' travails, with industrial orders reported recently to have fallen at their fastest ever rate. Volvo's sales of heavy trucks were reported to have collapsed by an astounding 99.7% in the year to the end of September, with the company receiving just 115 heavy truck orders in Europe during the third quarter (compared with 41,970 orders during the equivalent period in 2007).

The European Central Bank has begun to react to the eurozone's economic challenges by cutting its headline interest rate by 1.75% to 2.5% and via a range of other steps. However, its actions have appeared to lag those of its major counterparts around the world and it must surely regret having raised rates at the beginning of the summer as the eurozone stood on the brink of recession. ECB policy-makers argue that deflation is not possible in the eurozone given 'rigidities' in the region's price-setting mechanisms, but their fixation with anchoring price expectations seems still to imperil the more important task of easing fragile financial-market and economic conditions on the Continent.

In Japan, the economy was declared to have entered 'keiki koutai' (recession), with prime minister Taro Aso declaring that 'a storm that comes once in 100 years is raging'. Consumer confidence and household spending have declined sharply and Japanese exports have fallen faster than at any time on record, with the soaring yen an important factor in slowing trade (as well as in, apparently, the cancellation of an exhibition tour by sumo wrestlers to London scheduled for later this year). There is an unfortunate irony that Japan's reward for its relative discretion towards the growth of credit in its financial system is a strong currency, which has served only to accentuate the vulnerability of its economic constitution. With consumers reluctant to spend, the economy is lopsided in its reliance upon exports and capital spending for its wellbeing.

Japanese authorities, like their European peers, have been slow to react to deteriorating economic conditions, albeit that the Bank of Japan cut interest rates from 0.5% to 0.1% during the final quarter of 2008. The country's policy-makers seem sometimes to resemble characters in a western film (in which the ammunition-short cowboys are surrounded), but the recent announcement by central bankers that they will purchase commercial paper and government bonds gives hope that they wish to resist being typecast in the role.

In the Asia-Pacific region, rates of economic growth have slowed distinctly. In China, in particular, the economy has expanded at a much more measured pace in recent months than previously, with industrial production growth falling to its lowest level in a decade and two-thirds of the country's toy manufacturers reported to have closed in 2008 amid a decline in overall export volumes. Accompanying the slowdown has been a pronounced fall in inflation (from almost 9% to less than 3%), which has broadened the scope of authorities to take ameliorative action.

China has contributed about a quarter of the growth in global GDP in recent years and its fate is critical therefore to that of Asia and to the world as a whole. It is unclear whether or not a slower rate of activity in China will persist, but the Chinese authorities are well placed to try to stimulate their economy should they desire to do so. Recently announced plans to spend enormous sums on infrastructure are affordable given that China's debt-to-GDP ratio stands at just 20%, and the raft of interest-rate cuts made by the central bank during the fourth quarter should be transmitted effectively to borrowers, given the state-controlled nature of Chinese banks.

Asia's economic success has been founded upon the vitality of the region's manufacturing industries and upon the funneling of export profits into investment. As the economies of Asia's trading partners slow, Asian trade-reliance will be costly and it is unlikely that the region's economies will grow much in aggregate during 2009. Against this backdrop, authorities will surely be motivated to try to boost domestic demand to give Asia greater autonomy in its economic destiny.

Governments and investors in government bond markets appeared to scratch each other's backs during the final quarter of 2008. For investors, sovereign bonds provided a 'safe haven' to which to retreat from uncertainty in other asset markets; for governments, unbridled demand for their debt led to sharply lower financing costs. By the end of the year, the U.S. government, for example, was able to borrow for 30 years at a cost of little more than 2.5% per annum.

In the near term, lower bond yields are the corollary of concerns about the global economic outlook and deflation, and they have been underwritten too by the increasingly 'quantitative' nature of global monetary policy (with central banks indicating their intention to buy long-dated government bonds). Concerns about prospective large increases in the issuance of government bonds have, for the time being, been eclipsed.

With bond yields so low, governments can 'afford' more easily to widen their budget deficits, but they may not be able to afford to take their lenders for granted. Government bond auctions in Germany, Belgium and Japan have either suffered shortfalls or been cancelled, and in Spain the government had to increase the coupon on one issue to ensure its success. Bond yields can fall even as governments indulge in spending sprees; in Japan, given the propensity of financial institutions to hold increasing amounts of government debt in the 1990s, yields kept falling even as the government moved from running a budget surplus to running persistent deficits of 7-8% of GDP. However, investors will need to be cautious about the major governments' abilities to fund their fiscal ambitions without having to pay higher rates of interest to their benefactors (and therefore about the prospect of rising bond yields in future).

Investors should be guarded also about the inflation implications of governments' largesse. Bond markets have turned tail on their earlier fears about inflation, with bond yields falling in the U.S. to levels that imply deflation for five years (the only precedent for which is the Great Depression). In the near term, the slowing pace of global economic activity and the deleveraging activities of financial institutions should preclude the resurgence of significant pricing pressures and provide support for sovereign debt. However, the scope of governments to create unlimited amounts of money in pursuit of their goals could well kindle higher inflation and represents therefore a longer-term danger to government bond investors.

In corporate bond markets, financial-sector deleveraging may serve to keep yield 'spreads' wide but, with premia on investmentgrade issues over government bonds having widened from about 1% to about 5% over the last two years (taking them to their highest levels since the 1930s), there are some attractive opportunities among higher-quality corporate issues. Such large premia denote the expectation of remarkably high default levels (and low 'recovery' rates should companies falter), but a diversified approach which seeks to harness the debt of companies with strong cash flows and sound balance sheets should prove fruitful.

The North American equity market suffered its worst year in 2008 since 1931 and the final quarter was particularly volatile. During October and November alone, the S&P 500 Index moved by more than 5% (up and down) on 14 days, more than the combined number of days on which it had done so since 1987. As investors crave a more even keel on which to sail, they might take comfort that, over the last 80 years, the U.S. equity market has gained an average of 8.9% per annum during Democratic presidencies (compared with 0.4% during Republican incumbencies).

The factors that have caused volatility in equity markets (broadly dysfunction in credit markets and deteriorating economic conditions) persist however and, in 2009, share prices are likely to remain volatile as investors continue to evaluate them. With 'cyclically-adjusted' U.S. equity valuations having dipped below their long-run average for the first time since 1991, investors appear to be compensated more obviously for the risks inherent in stock-market investment. With the S&P 500 dividend yield having risen decisively above that of 10-year U.S. Treasuries for the first time in almost 30 years, investors might be drawn reasonably to the (selective) attributes of equities rather than of government bonds.

The scope for disappointment in relation to earnings and dividends is manifest and it will be imperative to take a stock-specific (rather than an index-based) approach in the months ahead. Stable and strong earnings, cash flows and dividends should be prized qualities, and investors will need to be mindful of the implications of dollar strength hitherto; 40% of the earnings of the largest 25 U.S. companies derive from overseas.

2009 is likely to be another challenging year for the UK stock market, with corporate profits expected to fall in aggregate. Dividend payments are likely to be cut savagely in some areas (particularly among financial companies), but dollar strength should offset much of the financial sector's temperance given that a third of the dividends of UK companies are paid in dollars. Furthermore, with the proportion of UK companies' income paid out as dividends being roughly 40%, there should be some cushion for investors against deteriorating earnings.

As in North America, it will be imperative to be discerning in choosing candidates in which to invest. The availability and cost of credit will be important determinants of companies' fortunes, and balance sheet strength would seem to be the prerequisite of sound investment. As government spending and gilt issuance swell, the risk of a loss of faith in UK assets should not be overlooked; threats of higher inflation and a falling currency may prove too daunting for some overseas investors. However, with the valuation of the UK equity market standing at its lowest level for 25 years, the longterm investor should be provided with attractive opportunities to buy well-chosen equities.

With one notable exception, European equity market weakness was unrelenting during the fourth quarter. The exception was Volkswagen* which, in sharp contrast with the fortunes of the large U.S. car manufacturers, became briefly the most valuable company in the world. A 'squeeze' on short-sellers of the stock amid an increase by Porsche of its stake in the company led to VW's share price rising by 337% in two days. Aside from the pandemonium in Germany's capital markets, European equity markets closed 2008 down 42.6% in local currency terms.

The contours of Europe's stock markets are substantially the same as those in 2008, and it will be essential for investors to beware the continuing implications of economic and financial-market woes; rights issues, dividend cuts and debt-for-equity swaps, for example, can erode quickly the case for investment in particular companies (as well as investors' capital). However, as in the other major regions, share price falls to date (which, in Europe, equate to the discounting of about a 40% decline in corporate profits) render valuations selectively attractive. Against a difficult backdrop, a bias to larger companies, robust balance sheets, strong cash flows and diversified business models is appropriate.

If Japan is said to have suffered a 'lost decade' economically, it has suffered a lost quarter of a century in stock-market terms, having fallen in the fourth quarter to a level it last reached in 1982. Shares are trading at about a fifth of their peak levels, with excess capacity, a strong yen and fading overseas demand proving to be an injurious mix for an economy already vulnerable, following the bursting of its earlier asset bubble, to the threats of economic stagnation and deflation.

* Please refer to important information below

The yen's resurgence has been a particular concern for policy-makers and investors alike, with impairment of Japan's export industries (to which the economy and stock market are significantly exposed) being probable during 2009. Toyota, for example, warned in December that the stronger yen and falling global demand would lead to its first loss in more than 70 years. In this context, there are obvious obstacles to successful investment in Japanese equities. However, with 500 of the 1,700 companies listed on the Topix index reported during the fourth quarter to have been trading below the value of the cash on their balance sheets, discriminating investors may identify opportunities to invest in high-quality companies amid the general gloom that hangs over Japan's stock market.

Equity investors in the Asia-Pacific region have experienced their most traumatic year since the Asian crisis of the late 1990s. That crisis was specific to Asia, but stock-market falls in 2008 were symptomatic of a broader systemic threat and, with Asian economies integrated more fully in the global economy than a decade ago, the region has suffered widely from the contagion of defective credit markets and slowing economic activity around the world.

Critically, however, while Asia will experience a slowdown as conditions in its major export markets deteriorate, it should be spared the extent of the structural problems (such as excessive debt) that may dampen growth elsewhere for several years. Over the last decade, the region's banks have grown stronger, foreign-exchange reserves have swelled and the prudent management of public finances permits significant fiscal stimulus now. The industrialization and urbanization of Asian economies should support domestically driven growth and shore up the case for investment in Asian equities for many years to come.

Extreme uncertainty continues to pervade the investment landscape. Conditions in credit markets, whose dysfunction has been the greatest cause of investors' anxiety over the last year and a half, have stabilized, but they remain harsh. In addition, the effects of a deteriorating economic environment and the seemingly incomplete process of deleveraging in the global financial system seem certain to cause continued volatility in financial markets during the year ahead.

With financial sector paralysis apparently avoided, and with fiscal and monetary policy having been loosened considerably, the world economy should avoid outright depression, but the slowdown now in progress may be nonetheless deep and protracted. Much will depend on the unfolding consequences of stresses in the financial system for 'real' economies, and the fate of the emerging regions of the world will be important too. Developing countries have accounted for about three-quarters of global growth over the last 18 months but, while their large reserves and strong budgets should stand them in good stead, capital flight from their economies has wounded them in recent weeks.

The economic and political impact of the events of 2008 is likely to resonate for years to come, and investors, while being encouraged by the concerted efforts of policy-makers, should be mindful of the risks to which attempts to restore more favorable conditions in credit markets and economies will give rise. Among key risks are corrosion in the creditworthiness of high-rolling governments, greater protectionism in global trade (witness President Sarkozy of France's worrying remark that "laissez-faire, c'est fini!") and, ultimately, resurgent inflation. Geopolitical risks persist too, most obviously in the Middle East.

Forced selling by 'over-leveraged' asset holders has contributed significantly to volatility in financial markets (and to investors' discomfort). However, such selling continues to afford opportunities to the long-term saver because its distressed nature detaches the price of an asset from its value. Investors should be well-equipped to harness those opportunities in the months ahead if they can differentiate between the weakness of assets and the weakness of the owners of those assets. A stock-specific approach will be imperative and, given the effects of changes in credit market conditions on the pricing of issuers' debt and equity, so too will be a flexible approach to investment in the different parts of a company's capital structure.

"The cure for this ill is not to sit still,

Or frowst with a book by the fire;

But to take a large hoe and a shovel also,

And dig till you gently perspire."

Rudyard Kipling, Just So Stories,

'How the Camel got his Hump' (1902)