Investment Update – October 2006

What has been happening in the last six months?

Over the last six months the equity markets gave positive returns, the FTSE 100 gained 1.6%, the US S&P 500 rose by 4.1%, and European markets rose by 3.9%. However, this disguises a period of negative and volatile returns in May and June since which time there has been a steady recovery. Although May and June seemed a somewhat worrying period, in essence it was caused by a number of funds reducing their risk in response to some signs of slowing in world economies. One can only assume that this caught them by surprise and led to a decision to make their portfolios less risky. From our perspective, the most interesting aspect of this chapter was not the market reaction and volatility per se but rather the fact that after a period of very strong and sustained economic growth, there were some signs that economies were growing less rapidly.

Having been through a period of strong economic growth it is unsurprising that this has created some inflationary pressures. Indeed inflation dominated the news in this period after a number of years where quite frankly inflation has been of no worry whatsoever. The inflation has been caused by a steep rise in oil prices and many other raw materials such as metals and to some extent soft commodities. Some of this was due to “natural causes”, i.e. weather conditions damaging crops and the hurricanes in the US. But much of it was due to an excess of demand over supply and in particular the strong incremental demand coming from emerging economies such as India and China. As a result of this, central banks have responded predictably by steadily increasing interest rates to moderate growth and therefore head off any potential upsurge in inflation. Whenever this happens it always leaves central banks in a difficult position, in that they have to balance the need to curb inflation against the desire to keep the economy growing. If they raise interest rates too much, they run the risk of causing a major slow down, but raise them too little and inflation could really take hold. In the US it appears that rate rises have certainly had the desired effect and this is typified in the dramatic slow down in the housing market where there are high levels of unsold properties and the share prices of companies connected to US house building have fallen steeply. It would be unsurprising if this translated into a slowdown in US consumption as consumers feel less confident about life. Inevitably, there will be some fears that this will get out of hand and lead to recession and as the US is the largest economy, this would have a knock on effect on other economies too.

It is worth pointing out, that the UK is somewhat in contrast to the US economy as the housing market has defied the predictions of many Bears by remaining buoyant and house prices in many areas are rising once more. This is despite a policy of interest rate rises similar to that in the US.

It was thought that high levels of personal debt would cause the housing market to slow and consumption to soften but demand has remained surprisingly strong. The fact that we have experienced a period of higher household cost, ie utility bills etc. makes this all the more remarkable. As an aside, perhaps one reason for this stronger economy is that the UK is a

growing economy – by that we mean in population terms. Immigration is significant and inevitably will have an impact on the economy as large numbers of people enter the UK and obtain employment and become active members of the economy. This naturally increases demand for housing consumption and other goods and services. To conclude, stock markets have done reasonably well in the context of an environment of heightened inflation fears, higher interest rates and some signs of a slowdown in the world’s major economy. It is worth mentioning that this has not been a particularly good background for government bonds because government bonds don’t like rising interest rates and inflation fears! However, high yield and corporate bonds have been pretty resilient because they have focused more on the buoyancy of company profits and the ability of companies to service and pay back debt rather than interest rates and inflation.

What about the future? Although the media is currently full of stories about the slow down in US

housing and the possibility of a recession in the US, and the impact this might have on other economies, we believe this is unlikely or indeed if it happens, is unlikely to persist. The reason for this is that there are already signs of a softening of oil prices and commodity prices thereby removing one of the prime causes of inflationary pressure. In turn, this will allow the US authority to not only stop raising interest rates but indeed to think about cutting them. Logically this should lead to a stabilisation or recovery in those parts of the US economy that have been hurting. That is not to say that a recession is out of the question and indeed it is quite normal for markets to get very heated about some of the negatives which emerge when an economy slows down. We would not be surprised if day-to-day conditions may be uncomfortable for the next six months but inevitably the market will begin to look at the US economy in 2007 and beyond, rather than what is happening now.

Historically, we have been able to characterise the UK and the US with a similar outlook. However, as we mentioned earlier, the UK has not experienced any of the softness seen in the US and it would seem likely that not only are we facing more interest rises in the UK but also that UK interest rates would remain higher for longer. This is something for investors to consider in terms of the investments they make and their relative exposure to different economies rather than something that will dictate the overall level of markets around the world.

Overall, we still see a lot of factors that support stockmarkets notwithstanding we could potentially see a volatile period over the next six months. One of the things that are prevalent, not just in a number of markets, is the amount of money that has been put into private equity as an asset class. Private equity makes its money by buying companies mainly from the listed markets.

This money has to be spent by private equity and provides a good underpinning to markets. Indeed mergers and acquisitions activity generally remains pretty buoyant and this gives us a degree of confidence notwithstanding the fact, like many things in life, this sort of activity can be quite fickle and is driven by prevailing market conditions. Turning to bonds, we feel that with US growth moderating and interest rates possibly near a peak in general, this heralds a more benign environment for bonds. Again, the exception here is the UK and to a lesser extent Europe, where growth remains robust and we are probably someway off the peak in interest rates. But overall, we still see value in markets and sufficient opportunities for investors to profit from investing across a range of sectors and markets.

ARTEMIS INVESTOR FOCUS OCTOBER 2006

Richard Smith
www.thefinancezone.co.uk
0845 226 9106

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