February 2008 Newsetter...click here for full PDF version

US market update
Fear of recession in the US was the source of most of this month’s woes in global stock markets. Yet the US suffered least among all the major developed markets. The S&P 500 dropped just over 6%, compared with the over 10% of other major markets. The US economic picture grew progressively gloomier over the month. House prices fell, inflation hit 4.1% for the whole of 2007, but slowed marginally in December. Retail sales dropped 0.4%. Economic growth in the final quarter of the year was just 0.6%, weaker than expected and a considerable fall on the third quarter figure of 4.9%.  The IMF said it was pessimistic on the outlook for the US economy. The Federal Reserve then took the bull by the horns and slashed rates twice in nine days - the first by 0.75% and the second by 0.5%. It clearly marked the Fed’s priority as shoring up growth rather than curbing inflation. President George Bush also announced an economic stimulus package, with $150bn of tax rebates to be implemented by the summer. The markets were initially jittery that these aggressive moves by the Government and Federal Reserve showed the economic picture were deteriorating more quickly than expected. But, having digested the news, they slowly began to move up, albeit with significant volatility.

Q: Why is making...…a decision on interest rates so difficult?
A: On 22 January, Mervyn King warned that 2008 could be a tough year for the UK economy. He forecast a slowdown as consumers tighten their belts and reduce their spending. This fuelled expectations of interest rate cuts, but his tone hinted otherwise. Fuel prices and energy bills are high and King predicted “a period of above-target inflation”. This leaves the Bank of England caught between a rock and hard place. If rates are eased, it could fuel inflation – but if rates stay on hold, this risks suppressing economic growth even further.

The impact of falling house prices
The housing market started to fall in the last quarter of 2007. There is now gloom among commentators looking into 2008 with many predicting an unravelling of the unprecedented multi-year boom in house prices. But while the housing market generates a lot of headlines, how important is its continued growth for the health of the economy? The traditional argument has been that strong house prices generate a ‘wealth effect’, which gives people the confidence to spend money. Many homeowners have used this to their advantage by taking on additional borrowing or used equity release to help fund that spending. Research group Defaqto estimates that the equity release market will be worth around £1.7bn in 2008. However, the big worry now is that if house prices fall too far, those that have taken on the extra debt could find themselves in negative equity. This matters because those people will then stop spending – and this will knock profits in the corporate sector. If corporate profits begin to fade, jobs will be cut, which means people will have less money and spending will fall further – and so on in a potential downward spiral. However, the UK economy is far from there yet. Some people are undoubtedly sitting on too much debt and will run into difficulties, but the corporate sector remains healthy and unemployment is low. Retail spending has proved remarkably resilient and interest rates still remain at historically low levels. Of course, a decline in house prices is good news for some people – notably first time buyers, those moving to a bigger house or those buying a second home. They will have smaller debt repayments and more money to spend. Even a significant fall of 10% would only take houses prices back to where they were 12 months ago. So it’s not time to start panicking yet.

UK market update
January was a month of two halves. It began with the markets fretting over retail sales figures as Marks & Spencer’s and other big retailers reported weak Christmas trading. It ended with apocalyptic losses from a French rogue trader and huge emergency rate cuts from the Fed. By the end of the month, the FTSE 100 had dropped 9% and markets were factoring in a prolonged recession in the US and UK. Retail sales were down in December compared to 1% growth in November. PC World, SCS Upholstery and Homebase all performed badly and the figures from Marks and Spencer’s were a shock, but the gloom on the high street was not universal. Tesco, WM Morrison and Waitrose bucked the trend showing growth in revenues. The markets really started to suffer in the middle of the month. Over just three days the UK saw its biggest one day drop since 9/11 and its biggest one day rise since 2003. Initially the volatility was attributed to mounting fears of a recession in the US, but then it emerged that a rogue trader had lost French bank SocGen €4.9bn (£3.6bn) and the unravelling of positions had significantly destabilised markets. There was recovery on the back of aggressive rate cutting by the US Federal Reserve, but the Bank of England made it clear it would not follow due to inflation concerns. The Bank made no change to rates at the start of January.

Europe Update
January started with a drip-drip of bad news from the banks, before concluding with a risk management catastrophe from French bank SocGen when rogue trader Jérôme Kerviel racked up €4.9bn (£3.6bn) in losses. It was a testament to how much the banks had fallen already that the news ‘only’ knocked the SocGen share price by 27% and it was recovering by the end of the month as bid rumours circulated. The FTSE Eurofirst index 300 index fell, reflecting a poor performance from the French and German markets, but also a better performance from the Irish market, which also fell but by far less. However this relatively decent performance is more a reflection of previous weakness than current strength. Although stock markets were buoyed by news of rate cuts in the US, European Central Bank president Jean-Claude Trichet talked down the probability of Europe following suit, saying inflation remained a greater worry. Rates were left on hold at 4%. He was proved right as figures released at the end of the month showed Eurozone inflation at 3.2%. But economic growth in the region is slowing markedly: Business confidence figures across the Eurozone were their lowest since the start of 2006 (Source: Eurostat). The Eurozone is less exposed to tumbling house prices, but many analysts still believe a recession in the region is possible.

Japan market update
Japan’s Nikkei index followed global markets down in January as the spectre of a recession in the US loomed. Although Japan has been largely insulated from the sub-prime debacle, the US remains a key export market. Japanese exports are already under threat from the strengthening yen and with a lacklustre domestic economy, they had been the main driver of economic growth. The Bank of Japan finally reduced its estimates for growth for the fiscal year 2007, having clung to its 1.8% estimate in the face of negative data. Bank of Japan governor Toshikiko Fukui admitted that growth would be nearer to 1% on the back of a prolonged decline in housing investment. The domestic economy showed no signs of picking up and analysts believe that even this is starting to look optimistic. However, Fukui dispelled any immediate hopes of an interest rate cut. He made it clear that the next move was more likely to be up than down. This conclusion was supported by figures showing inflation at a 10-year high, up from 0.4% to 0.8%, almost entirely driven by higher energy prices. The Nikkei fell 10% over the month, in line with most of the other major markets but disguising huge volatility.

What is a portfolio?
A portfolio is the collective term for the total of all your investments, which might include a range of asset classes, such as equities, bonds, property and/or cash. Its success is dependent on the way it performs, although one investor’s definition of performance may differ from another as we all have a different outlook. Hence, there is no catch-all solution to fit everyone’s investment needs. A good portfolio should generate decent returns while keeping within your risk profile. This is done by selecting an appropriate mixture of different assets, bearing in mind not just risk but also your age, your needs, your timelines and your financial position.

Comparing ISAs and pensions
With life expectancy increasing, financial planning becomes all the more important. If you’re thinking of saving for retirement, then you might consider a pension is the best way to ensure you have enough to live on when you’re older. However, there are alternative ways of achieving your goals, such as using Individual Savings Account (ISA) allowances. One of the main differences between a pension and an ISA is in the way they are taxed. Your pension payments will qualify for tax rebates up to your highest rate, while the income you take later on will be taxed. With an ISA, the money you contribute will have already been subject to tax, but then withdrawals you make are tax free. It’s useful to be aware that if you’re over 65, your pension income counts towards your personal tax-free allowance, while your ISA withdrawals do not. According to some commentators, the differences between a pension and an ISA mean that a typical higher rate taxpayer – saving a similar annual amount into both an ISA and a pension plan over their working life – is likely to find that by the time they reach retirement age the pension fund would be larger. This is important as it can influence the size of annuity that can be bought. However, the annuity income is likely to be taxable, unlike ISA withdrawals. But then withdrawing money from an ISA may mean you are eroding your capital, which can eventually run out. Other pension benefits include the fact that employers can pay into a company or stakeholder pension scheme, and the contribution limits for pensions are much higher than for ISAs. Nevertheless, an ISA is much more flexible. With a pension, you have to wait until you are aged 50 to make withdrawals (which is expected to rise to 55 by 2010), whereas an ISA can be accessed quite easily. With longer life expectancies, as well as some high profile issues concerning the way in which a minority of pension funds have been managed, many investors’ retirement sums are not quite as large as expected. As a result, some people are now looking to boost their pension funds by topping up their company pension, or by using additional investment vehicles. One solution could be to use both an ISA and a pension plan to ensure that your retirement income is as healthy as possible.

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