Quarterly Investment Report - Qtr ending June 2005

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.

Whether our view on future events proves to be well founded or not, it is probably fair to say that the industry consensus would be that over the next couple of years we are looking at single digit returns from all/any asset class.

One factor does seem however to dominate the world economic scene, namely China. The sleeping giant has now well and truly roused itself and the West is quaking – not surprising with unit labour costs on mainland China at only 5% of what they are in the States, how can the developed countries compete? The answer in many instances is that they can’t. Whilst not specifically Sino-related, take a look at General Motors and MG Rover and imagine that happening with greater and greater frequency. GM, like many other western companies have reserves that they can draw upon, but how long will they last – Standard & Poors don’t think that long, they’ve just downgraded GM stock to “junk” status!

We had been expecting another hike in interest rates in the current cycle. However, the situation appears to have changed now. The retail sector slump and the collapse in consumer spending have happened at a rapid and somewhat unexpected rate. Indeed, the British Retail Consortium was one of the first organisations to start pleading for a rate cut some months ago. A cut seemed less likely then - but things have certainly changed.

The Bank of England left rates unchanged at its June meeting, against a background of weak manufacturing and consumer data. Another indication of the minds of policy makers was given last Wednesday, when the Bank of England released its quarterly inflation report. The UK central bank said that the growth outlook had weakened slightly because of the consumer spending slump, but, significantly the governor Mervyn King said that he expected a resurgence in spending because house prices had steadied and the jobs market was strong. The report also said that inflation was expected to stay close to the bank's 2% target over the next 2 years. This is a change of view. In the previous inflation report issued 3 months ago, the Bank said it expected the CPI rate to be in excess of 2% at the end of its 2-year forecast horizon. The report can be interpreted as less hawkish than previous statements.

Calls for an actual cut in interest rates accelerated after the government unveiled a slump in manufacturing activity on May 9th. UK factory production fell 1.6% in March, compared with a consensus view for a 0.1% gain - and that wasn't even taking into account the collapse of Rover. The fall was the largest seen in 3 years. The slump was actually so bad that there was speculation this could impact first quarter economic growth. A miserly 0.6% growth is the expected result - if it was below this then the picture would be truly grim. Immediately following the manufacturing data, yields on UK interest-rate futures slid to a 3-month low, an indication that the market was pricing in an interest rate cut this year. The retail sector has also added to the gloom. When Dixons issued its trading update last week, chief executive John Clare painted a gloomy picture of future prospects. Sure, the market was relieved that there wasn't a profits warnings and the shares rallied, but his comments on the sector outlook were nothing short of cataclysmic - well, if you believed the newspapers, that is. The Independent reported the story as indicating that Clare saw the retail sector heading for a meltdown to rival the consumer slowdown of the early nineties. This, we believe, is a distortion of what Clare actually said. He said that trading may get worse - and we agree with him – but using the word "meltdown" was not exactly being fair. This news accelerated the call for an interest rate cut. Indeed, Thursday's edition of The Times lead with the headline "Interest Rate Cut Signalled After Slump on High Street." The justification? The fact that Mervyn King said that the speed of the slowdown had taken the MPC by surprise.

We do not believe another rate rise is now on the cards. This is a shift in position for us, but we are not convinced that there will be a rate cut soon either. The economic environment is very mixed and a neutral stance on rates will probably now be taken by the MPC going forward.

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

Sterling
Negative: Possible peak in UK market interest rates.
Positive: US$ will have to fall to correct US trade deficit. Weak German economy.
Our view: That the £ will strengthen against the US$ and the Yen and will remain broadly static against the Euro.

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

Fixed interest
Negative: Rising UK government borrowing. Rising US interest rates. Falling Gilt and US Treasury prices.
Positive: Possible peak in UK market interest rates. Loss of 10% reclaimable tax credit to PEPs and ISAs on dividends. Static US inflation.
Our view: Sell Gilts. Hold quality stock (BBB credit ratings and above) and junk bonds (CCC ratings). Buy 2nd line fixed interest securities such as Preference shares. Buy bonds rated B to BB, but be very selective.

Equities
Negative: High levels of consumer debt. Loss of 10% reclaimable tax credit to PEPs and ISAs on dividends. Significant downturn in consumer spending. Rising bankruptcies and repossessions.
Positive: Expected UK GDP growth in 2005 in the region of 2.5%.
Our view: Sell cyclical stock. Hold defensive stocks.

Index-linked
Negative: Negative: Relatively low UK inflation rates. Interest rates expected to rise to curtail credit boom. Rising interest rates will begin to curtail inflation 1 year hence. Possible peak in UK inflation.
Positive:
Our view: Sell index-linked gilts. Hold 2nd line index-linked securities.

Commodities
Negative: 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.
Our view: Hold commodities.

Gold and Silver
Gold
Negative: Denominated in US dollars.
Positive: World economic uncertainty. Weakening reserve currency (US$).
Our view: Hold Gold.
Silver
Negative:
Positive: Increasing demand given increasing applications for the metal. Just off an all time low relative to Gold.
Our view: Hold Silver

Property
Residential
Negative: Falling prices in many UK areas. Historically high UK property values to earnings ratio. Weakening demand in many parts of the UK. Penal UK Stamp Duties. High levels of consumer debt. Rising repossessions. Fall in the number of mortgage approvals.
Positive: Anticipated influx of EU workers into the UK. Possible peak in UK market interest rates. 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. Boost to housing market expected with advent of new pensions legislation in April 2006.
Our view: Sell residential property, possibly go back into the market in early 2006.
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.
Positive: Possible peak in UK market interest rates. Expected UK GDP growth in 2005 in the region of 2.5%. Stronger tenant demand in certain areas/sectors (offices).
Our view: Sell commercial property.