Looking Ahead .
EQUITY MARKETS
Against an unsettled economic backdrop, we believe that 2008 could produce one of the most interesting years that equity markets have seen
in a long time.
With two of the three pillars that have supported equity markets since 2003 leverage, consumer spending and corporate profits
unlikely to be as strong as in recent times, traditional investment fundamentals will be central to uncovering those stocks most likely to do well.
The volatility that has swept back into markets through 2007 is unlikely to go away in 2008.
History shows a clear link between equity market volatility and the actions of the Fed.
Generally, there is a two-year lag between the Fed raising rates and increased equity market volatility. The Fed ended its last tightening cycle in mid 2006, suggesting it could be the latter part of 2008 before we start to see market volatility settle down again.
Aftershocks from the credit crunch will continue to be felt in the banking sector. Consumer stocks may also continue to suffer. They have already struggled to keep pace with the market in the second half of 2007 as markets anticipate a consumer slowdown.
Unless these fears prove unfounded, it is hard to see how the sector will not continue to feel the pain of the credit squeeze next year. However, investors in western equity markets should still be able to make gains, provided that they are careful about stock selection We believe that successful investing in 2008 will lie in the large cap space, with the identification of companies with strong cash flow, solid balance sheets and attractive risk/ return profiles. Against the turbulent backdrop of the west, one of the most likely places to find such companies is Asia. Share prices in Asia have risen sharply especially in markets such as China but the story for investors there has been one of pure growth, not leverage. That provides a very solid base for growth whilst the rest of the world is suffering from the aftermath of a period of over-leverage. So we expect the region to rise in importance in global economic terms and for the continued growth there to be increasingly reflected in equity markets.
FIXED INCOME MARKETS
Late summer 2007 marked a significant re-pricing of risk in global fixed income markets.
Investors sought refuge away from the fall-out of the US sub-prime market and its relationship with structured debt products such as
collateralised debt obligations (CDOs) through a flight to quality, in particular into government bonds.
Government bond markets have strengthened and yields have fallen a long way since then and are now discounting a series of interest rate
cuts that many analysts believe may come through more slowly than the market expects, due to the inflationary concerns mentioned previously.
As investors moved into safer assets, credit spreads the additional yield investors demand for taking on the extra risk of investing in
non-government debt have widened a long way in 2007. However, we do not believe that, even if global economies slow, corporate bond default rates
(which remain low) will rise to the levels seen in the last credit bear market of 2001 and 2002. Over the medium term, credit looks good value,
although good analysis and strong stock selection is of vital importance in this volatile environment. By the second half
of 2008, investors willing to roam the credit markets again might find some very interesting opportunities. In particular, asset backed securities
bonds underpinned by the cash flows from long term businesses, including mortgages should begin to provide very interesting yields for funds that
can capture them. Whilst economies will slow and the evolving US housing problems and tighter credit conditions will have an impact on bond markets,
the general perception about growth prospects may be too gloomy. Yields already seem to factor in a lot of potential bad news.
Selective issuer and credit selection should still offer fixed income investors attractive opportunities in the coming year.
CONCLUSION
The increased market volatility which has been in evidence since summer 2007 is likely to continue. Volatility is not necessarily a bad thing.
Oftentimes it makes it easier to uncover quality investments. However, volatility also highlights the importance of building a diversified portfolio
of assets. In 2007, we have seen evidence of the inverted relationship between equities and fixed income, government bonds especially.
Property and commodity markets have also shown their own, distinct investment traits. These distinctions are likely to be equally important in 2008
as markets grapple with an uncertain economic backdrop and the ongoing troubles of the financial sector. Good, solid, fundamentally sound investment
opportunities do still exist in such a market. It continues to remain important to look to the longer term with investments rather than concentrate
on the day to day trends of currently very volatile markets.