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September 1, 2007

Steady as She Goes

By Spear's

As the dust starts to settle over the sub-prime and global credit markets, we are beginning to see a little more clearly the forces behind the extraordinary volatility in world markets this summer. In essence it appears that three key factors combined to exaggerate the problems in one regional asset class (sub-prime mortgages), leading to contagion across the financial system in a way that surprised even the most seasoned market commentators.

The first of these factors is that we now have a financial system where market risk is diversified away from bank lending-books toward multiple risk takers (i.e. hedge funds, private equity etc.) in a way that would have been inconceivable a decade ago. It is an extraordinarily positive innovation that has allowed the world successfully to absorb considerable shocks (oil price rises etc.), but it has one, not altogether unexpected, weakness: it requires accurate, timely and, most importantly, credible pricing mechanisms, so that the various parties can successfully trade between themselves to leverage their asset bases.

As investment structures have become more complex (tranches of debt ‘sliced’ up to achieve tailored credit ratings, for example) and the assets once securitised have themselves tended to be more illiquid, the potential for a breakdown in their smooth and continuous pricing has grown. This is the phenomenon we saw in July and August, and the continued paralysis of the inter- bank market is just one of the consequences we are still experiencing.

Secondly, we have seen three years of falling volatility in equity markets and this has clearly encouraged hedge funds and other active investors to increase leverage across their product bases. This contributed to the volatility ‘spikes’ we saw in January this year and in the second quarter of 2006. However, this time around it was not just equities that saw a surge in volatility: it occurred simultaneously in credit markets, long-dated corporate bonds and foreign exchange. In all three cases this occurred after long (3-5 year) periods of abnormal investment ‘calm’ and historically low volatility. Aggressively-leveraged investors found themselves forcibly selling assets across multiple markets.

Thirdly, the number of ‘absolute return’ investors who are constrained in their volatility and acceptable monthly draw-downs has sharply increased across the fund-management industry. It is clear that many have resorted to lowering asset quality or camouflaging greater ‘long’ (beta) exposure and, of course, increasing borrowings in an attempt to sustain returns. In a market downturn they automatically become forced sellers, in marked contrast to the traditional ‘long only’-funded pension schemes of a decade ago that found themselves as natural ‘buyers on the dips’. In today’s market, if increasing numbers of investors try to offload market risk, the volatility of the overall asset class itself tends to rise.

For longer-term investors the question remains this: have events in the financial world materially damaged conditions in the real world? Initial signs suggest not, and the traditional indicators of ‘investor fear’ are starting to subside: government bond yields have stopped falling, investment grade bond spreads are narrowing once more, and the rally in the ‘carry trade’ currencies (yen, Swiss franc) has begun to reverse, suggesting the end of extreme risk aversion.

It is also encouraging to see that the performance of assets seen as dependent on global growth has also recovered sharply: commodity and energy prices which fell last month have recovered, capital goods related industries (technology in particular) continue to lead performance (with Nasdaq in the US the only major index in positive territory over the quarter), while in Europe the Dax in Germany once again led performance in September.

In addition, markets that are linked to China have been strong and emerging-market credit spreads have stabilised. In other words, there is little sign of lasting damage to the global economy and the global growth story. Indeed, as equity markets were falling in July, the IMF increased its forecast for 2007 global economic growth from 4.9 per cent to 5.2 per cent.

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Unsurprisingly, the risks still lie in the US where the mainstream housing market remains the key issue. In investment terms we will continue to avoid any consumer- or housing-linked US investments and to build into our portfolio an assumption of longer-term dollar weakness. We have been pleased by asset returns which have broadly justified our continued faith in ‘large cap’, global growth stocks, and we are still confident that the last quarter will be equity-positive.

To confirm this view we will be looking for no further material declines in bond yields or surges in credit spread, the end of the aggressive under-performance of global banking and financial stocks, and continued supportive action from global central banks. If these criteria are met then we continue to believe that despite all of the volatility seen over the summer, large global growth stocks are still likely to be the best performing major asset class in 2008. With compelling valuations versus fixed interest, double-digit dividend growth and the strongest cash flow seen in a generation, the global blue-chip-equity rally is not yet over.

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