Quarterly Investment Report - Qtr ending December 2006

Foreword
Certainly there is never a time where there aren’t positive and negative factors affecting either the global economy, the UK or individual securities for that matter. The art is balancing these “for and against” factors and deciding which is likely to dominate and thus cause downwards or upwards movements in stocks.

Commentary
The MPC raised rates by a quarter of one percent to 5.00% on 9th November.

According to Steven Roach, chief economist at Morgan Stanley, the downturn in the US housing market, with its resultant knock-on effect upon the US construction industry, could knock 2% off US GDP. At the very least, this might trigger a recession scare in the US financial markets which would doubtless have an impact upon world markets.

A three-bed semi detached is still a three-bed semi detached – you don’t get anything more for your money, so, in the UK, where the majority of people buy property to live in, what is the justification for paying higher prices? The report dated 22/11/06 from David Miles of Morgan Stanley (which can be found in this section of our website) makes interesting reading. Mr Miles’ opinion is that the single biggest factor driving up house prices in the past decade has been the expectation of buyers that prices will keep on rising. As well as speculative expectations, the other factors pinpointed by Mr Miles are the rise in people's incomes, the rapid growth of the population and the cheap cost of borrowing due to low interest rates.

The main buyers on the first rung of the property ladder will be first-time owner occupiers or landlords. For many of the former, even the cheapest houses have become unaffordable. For the latter to still be buying with yields running at only 5%, the expectation of further capital gains must be one of the main motivators - for the leveraged residential property investor, gross rental yields relative to mortgage rates have now declined to a virtual parity.

In the attached report, one of the conclusions is that there are likely to be significant falls in real house prices once buyers expectations come down. Whilst the report does not conclude that a drop in UK house prices will necessarily have an impact elsewhere, we would argue against this based upon the view that: (a) much of people’s spending has been fuelled by the availability of cheap remortgage finance against their homes and (b) when people feel wealthy they will spend – if their house prices fall significantly, they will tend to draw back.

The above is against a background of rising personal indebtedness in the UK, bankruptcies, arrangements with creditors and mortgage arrears. The number of bankruptcies in the third quarter was 15,416 and there were 12,228 IVAs, up nearly 120% on the corresponding period a year ago.

It would appear that we are now seeing the first signs of rising housing stocks in parts of the UK where prices are stickiest.

Outlook
As we see it, the following are the major positives and negatives affecting individual asset classes/Sterling:

Sterling
Negative: Rising UK inflation.
Positive: Rising UK interest rates. US$ will have to fall further to correct US trade deficit.
Our view: That the £ will strengthen against the US$ and remain broadly static against other major currencies.

Variable interest
Negative: Rising UK inflation.
Positive: Rising UK interest rates. Safe haven relative to other asset classes. Base rate still above inflation.
Our view: Hold Hold existing deposits. Add to cash through asset disposals. Add

Fixed interest
Negative: Rising UK government borrowing. Rising UK inflation. Rising UK interest rates. Rising US inflation. Falling US Treasury prices.
Positive: UK rate rises may hold at 5% for some time.
Our view: Reduce fixed interest holdings.

Equities
Negative: High levels of consumer debt. Rising bankruptcies and repossessions. Rising raw material costs.
Positive: Expected UK GDP growth in 2007 in the region of 3%.
Our view: Sell cyclical stock. Hold defensive stocks.

Index-linked
Negative: Relatively low UK inflation rates.
Positive: Rising inflation.
Our view: Hold index-linked gilts. Buy 2nd line index-linked securities.

Commodities
Negative: Significant rises have already occurred in commodity prices. China’s consumption of oil and raw materials may reduce. Threat of a world economic downturn.
Positive: Increasing demand of late for raw materials especially in growing economies such as China. Limited refining capacity for oil.
Our view: Hold commodities.

Gold and Silver
Gold
Negative: Denominated in US dollars.
Positive: World economic uncertainty.
Our view: Hold Gold.
Silver
Negative: Declining use in photographic film as digital photography gains popularity. Increased mining of lead, copper and gold on the back of higher prices will lead to an increase in silver production as a by-product. Denominated in US Dollars.
Positive: Increasing demand given increasing applications for the metal in areas such as power generation, water purification applications and biocides. Just off an all time low relative to Gold. Last year was the 14th in a row that demand for silver outstripped supply. Silver ETF perhaps to be launched on the US market.
Our view: Buy Silver, albeit that gaining exposure is difficult.r

Property
Residential
Negative: Negative: Ratio of UK property values to earnings is substantially above its historic trend. Penal UK Stamp Duties. High levels of consumer debt. Rising repossessions and insolvencies. Rising UK interest rates.
Positive: Anticipated influx of EU workers into the UK. More buoyant private rental sector with First Time Buyers being either unable to get onto property ladder or awaiting a fall in prices at bottom end of market.
Our view: Sell residential property.
Commercial
Negative: Penal UK Stamp Duties. Rising Gilt yields. Weakening tenant demand in certain areas/sectors (retail and manufacturing). Analysts predict little capital growth in the immediate turn. Many investors now committing funds to this asset class. Worsening economic background. Rising UK interest rates.
Positive: Expected UK GDP growth in 2007 in the region of 3%. Stronger tenant demand in certain areas/sectors (offices).
Our view: Sell commercial property.