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

The rise of the East
Japan’s reputation as a major economic power is long established – but now other Far Eastern countries are making the jump from "developing" to "developed". In particular, the last two decades have seen China evolve from bystander to economic superpower. China’s development has influenced almost every area of the global economy. Strong demand for its cheaply manufactured products has helped the economy expand rapidly; although the Chinese government has sought to cool down the country’s rampant export-fuelled growth. Elsewhere, an insatiable appetite for raw materials, driven by the rapid development of its infrastructure and booming demand for its exports, has helped to stoke commodity prices. Inflation continues to run at very high levels, fuelled by surging food prices. China’s agricultural capacity have not kept pace with its industrial expansion and, although incomes have grown significantly, food prices are now rising faster than wages – an unwelcome development for China’s middle class. Ultimately, in common with the rest of Asia, China is unlikely to prove immune to the effects of a global slowdown, and this could help to curb growth in the short term. Looking ahead, China’s growing influence on the world economy has led to speculation about its longer-term position in the global pecking order. For now, the US is the economic powerhouse, but China is already a force to be reckoned with.

Keeping it ethical
If you want to invest in the stock market, but are concerned about the activities of some companies, you might want to consider an ethical fund. Many fund providers now offer these, picking stocks based only on ethical, social or environmental criteria, and the area has grown considerably, particularly with the current focus on climate change. The wide choice of options available means you can actively target companies which seek to make a positive difference or which use renewable energy sources and manage waste - or you can simply avoid undesirable companies, such as weapons manufacturers, high polluters or those using animal testing.

Sub-prime and the credit crunch
‘Sub-prime’ describes mortgages granted to home buyers whose credit ratings are less than perfect. This could mean anything – from simply a lower than average credit score through to county court judgements caused by the mismanagement of previous debt. The situations of people classified as "sub-prime" covers quite a range. However, while lenders agree with the loose definition, there is little standardisation in the specific credit scores or situations that differentiate the scales of sub-prime. What is considered high risk for one may therefore be within acceptable limits for another. Part of the problem comes from the way in which institutions fund their mortgage lending. It used to be that a bank would lend against the amount which they held from savers and make their profit from the difference between the interest rate paid and that received. It also meant the bank had a direct interest in default rates as the money they were lending belonged to – and had to be returned to – their own savers. Now, however, institutions bundle up mortgage lending and sell it on to other institutions instead. Like any debt security, the higher the risk of default, the higher the interest paid. So sub-prime does benefit a lender by providing higher income levels. However, risks are high. To help reduce this, some sub-prime and mainstream mortgages are bundled together for sale, thereby spreading that default risk while retaining some of the higher income. Without any uniformity over the scales of sub-prime and with increasingly complex bundles, however, the exposure for any individual lender is very difficult to unravel. In addition, one by-product of bundling up mortgages and selling them on is you remove the direct relationship between money lender and client. This changes the relationship between product provider and client as the provider is not taking on the full default risk directly. Product providers may therefore also accept more risk in order to win the business. The US sub-prime market makes up a bigger percentage of the total than in the UK and as interest rates rose, so did defaults - massively in some areas of the US However, its effects on new lending and on the UK housing market are still to be fully understood. Certainly, without a perfect credit score it is going to be harder for many people – and institutions – to raise funds.

An alternative view
Alternative investments have become much more popular amongst investors in recent years and many mainstream asset managers now routinely offer this type of product. Such alternatives might include hedge funds, property, private equity vehicles, commodities or even antiques, fine wine and classic cars. Each has its own performance characteristics and each can provide different benefits when combined with a more mainstream portfolio. The main reason for including alternative investments is that these performance characteristics are likely to be different to the mainstream asset classes (bonds, equities and cash). Consequently, although some alternatives might be considered higher risk when judged alone, their inclusion in a wider portfolio can actually help to reduce risk by diversifying the portfolio overall. As they tend not to move in line with traditional bond and equity markets, they can be used to defend a portfolio at times of bond or equity market volatility. However, there is no avoiding the fact that such investments are generally high risk. Even the lower risk offerings could prove illiquid in difficult markets and therefore almost impossible to trade. There may also be promotional limitations placed on them if they are not FSA approved. To enjoy the diversification benefits, only adventurous investors will need an allocation above ten or maybe 15% of the total portfolio.

Investing for the future
Sovereign wealth funds have been in the news recently amid rising concern about their activities. But what are they, who is behind them, and why are people worried about them? Sovereign wealth funds are government-controlled investment funds, created by countries with surplus cash for investment. They hit the headlines initially last year when middle eastern funds helped out the investment banks, then more recently following the news that a Chinese fund had accrued almost 1% of UK oil giant BP. Some market watchers have become particularly concerned about the motives behind these purchases; China needs oil in order to fuel its ongoing expansion, and some commentators think China might be building stakes in order to gain influence within the sector. Most sovereign wealth funds also tend to be secretive, a factor that has further fuelled questions about their motivations. In addition, accusations of speculative activity have been levelled against some of their managers, although defendants argue that the managers are simply looking for long-term, stable returns, just like any other investor. Looking ahead, there are moves afoot to persuade sovereign wealth funds to sign up to a code of conduct that would ensure greater disclosure about their assets and investment strategy. It is unlikely that every government involved would be willing to accede to such an agreement; however, until they become more open about their activities, their detractors are likely to remain.

What is a hedge fund?
The term ‘hedge fund’ covers a wide range of investment strategies, from the lower risk, aiming to preserve capital, through to the very high risk, perhaps even using large amounts of debt – gearing – to try and boost returns. They usually have high minimum investment levels and lack the transparency of traditional funds – indeed, many will not reveal how they make their money in case it moves the market and jeopardises their returns. They are also generally unregulated and most are based offshore. For example, a hedge fund manager might aim to produce 'absolute' returns of, say, 10% per year, regardless of whether equity markets go up or down, as opposed to 'relative' returns, where a fund manager aims to outperform a benchmark. They might aim to do this by using a technique called 'shorting' to make money from a stock if its price falls, as well as holding stocks in a traditional way to make money if its price rises. Other more sophisticated 'macro' techniques might aim to make money from currencies or interest rates. And some hedge fund managers will borrow to try and magnify their returns - and it is these highly-geared funds that have been the source of most of the wellpublicised problems. Because of all these different techniques, hedge funds are only suitable for the most sophisticated or experienced investors who can understand the processes and therefore appreciate the full extent of the risks involved.

A new flat rate
The new tax year on 6 April brought in a new Capital Gains Tax regime. Out went indexation, taper relief and marginal tax rates and in came a flat rate of 18%. Most investors, particularly higher rate tax payers, should therefore pay less. The only real exception to this is business owners who will experience a rise in liability from their current 10% - but ‘entrepreneur’s relief’ accompanied the new rules, allowing people with a ‘material stake’ of 5% or more in a new business to dispose of assets at a rate of only 10% on gains (subject to a lifetime limit of £1m). In this way, the positive environment for new business growth remains whilst closing the perceived loop holes of the old regime.

Global market update
Volatility in global stockmarkets show no sign of abating. Although the first two weeks of April saw a more positive mood and the FTSE 100 rise above 6,000, there remained little confidence that this could be sustained. None of the economic worries that have plagued markets have yet been resolved. Banks are still reporting huge losses and the final tally from the sub-prime problems are far from fully established. Citibank posted a $6bn loss for this quarter. Even higher losses are predicted from the Royal Bank of Scotland, which recently angered shareholders with plans for a rights issue to boost its flagging balance sheet in the wake of the ABN Amro deal. There is also no indication as to the depth of the US recession. The economic news coming from the US remains poor. Only the export sector shows signs of picking up, aided by the weak dollar. The dramatic cuts in interest rates at the start of the year have yet to improve the economic outlook. That said, markets have been encouraged by the Fed’s swift action, plus its willingness to lend further support to the banking system through special loans and credit lines. This is not the case in the UK, where the Government has been widely criticised for its lack of action so far over the crisis. Chancellor Alistair Darling met banking leaders in mid-April, but failed to announce plans to improve the situation in the banking sector until the Bank of England finally unveiled a plan to swap £50bn of government bonds for British banks' mortgages. The inter-bank lending rate has stubbornly remained significantly higher than the Bank of England base rate. What effect this action will have and whether it will help restart lending activity at sensible rates we will have to wait and see. The ECB continues to be reluctant to lower interest rates. Inflation remains high at 3.6%, but eurozone unemployment figures remain relatively buoyant and the Euro has continued to strengthen against both sterling and the dollar. In China, growth showed signs of weakening as well. The National Bureau of Statistics revealed that economic growth dipped to 10.6% from 11.2% in the last quarter of 2007. Commodity prices weakened after a strong start to the year. The notable exception was the gold price, which broke through $1,000 per ounce in late March. 

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