Market commentary - October 2007

Market commentary

The period six months ending 5th October 2007


It has been a tumultuous period for global financial markets and it appears that we have reached an inflection point in the world economy with the era of borrowing at low interest rates coming to an end.

In recent years, banks in the United States have been increasingly lending to borrowers with poor credit histories in what has become to be known as the ‘sub prime’ sector. The combination of rising interest rates and falling house prices has caused a rise in the number of borrowers missing mortgage repayments (the default rate) and subsequently the banks have made large provisions in their accounts for the losses incurred. Unfortunately, UK banks have exposure to some of these investments and with analysts unable to quantify the full extent of the problem it was inevitable that financial markets suffered considerable volatility over the summer months.

UK Equities

The mortgage bank Northern Rock was the largest casualty in the UK as it’s business model relied heavily on borrowing funds from the wholesale money markets. As sub-prime liabilities were identified, UK banks became unwilling to lend to each other in the Interbank Market (overnight lending) in case of further defaults restricting their source of funds. It soon became clear that depositors were also unwilling to risk their capital and started withdrawing deposit based funds from the Northern Rock forcing them to request assistance from the Bank of England.

The broader indices in the UK including the FTSE All Share Index and the FTSE 100 index fell over the summer but quickly recovered by September. Indeed, at the 5th October the FTSE 100 index stood at 6595 up 3.1% on the 5th April levels. The FTSE 250 index (measuring mid sized companies) did not perform as well and finished 5.56% down in the same period and likewise, the FTSE All Small Companies Index finished down 10.11%.

Economic growth in the UK remains robust and the Organisation for Co-operation and Development (OECD) have forecast growth of 2.5% for 2008 although they have warned of potential weaknesses in the economy most notably in the residential housing market. Whilst, the publication of the Bank of England’s quarterly inflation report pointed towards further interest rises in the future, the Monetary Policy Committee are unlikely to raise rates in the short term given the backdrop of volatile markets.

There is still value to be found in the UK stock market particularly in the larger companies in the FTSE 100 index which are trading on cheaper valuations relative to their peers and offer greater liquidity (ability to sell investments easily) in the event of a downturn. The investment team at IFPC are allocating investments towards larger capitalised companies.

International Equities

In Europe, there are likely to be economic slowdowns in Spain, Ireland and the UK whilst Germany produced some gloomy economic numbers following a strong recovery in recent years. In his first budget, the French President Nicholas Sarkozy put on hold any plans to reduce the public deficit. During the period the French CAC 40 index finished up 1.77% and the German DAX index finished up 12.71%. There is still strong growth in Central Europe and the developing economies and the European Commission predicts economic growth of 2.8% across Euroland for 2008. A strong Euro and a weakening dollar may pose challenges to exporters.



In the U.S., the S&P 500 index (a broader measure than the Dow Jones index) finished up 8.21% over the period although dollar weakness has reduced the returns to UK investors on conversion back into UK pounds by 3.62%. Indeed, since June 2001, the dollar has weakened by 46% relative to the pound which has had a significant impact on investment returns.

The investment team at IFPC are now cautiously increasing asset weightings to the U.S. (albeit from a low base) in anticipation of a more stable dollar over the coming years although further dollar weakness is expected in the short term.

In Japan, the Nikkei 225 index finished down 2.44% as it continues to experience a protracted and lumpy economic recovery. The Japanese Yen weakened by 1.4% against the pound in the period and has weakened by 36.37% since 2000 reducing returns to UK investors. Small and medium sized companies have been particularly weak. The investment team are strategically increasing weightings to Japan in anticipation of better stock market returns and currency benefits in the future.

The Far East, Pacific and emerging markets have provided a safe haven for investors to the surprise of analysts. In retrospect, this period may be viewed as a watershed for asset allocators to increase their weightings towards the East in preference to Western economies. The Hong Kong stock market (measured by the Hang Seng index) and China have produced unprecedented investment returns in recent months but are almost certainly overvalued in the short term. We remain very cautious on this market at current valuations and await a pullback before committing further investments.

Fixed Interest Securities

Over the period, the expectation of rising inflation and interest rates has put pressure on global bonds although they still represent a less volatile asset class relative to their equity counterparts during market downturns. Strategically, we are selectively reducing our weightings in corporate bonds and are looking for replacement products with capital protecting qualities.

Commercial Property

The largest investment funds investing in UK commercial property have raised substantial amounts of money over the last year as investors focus on superior historic returns. Our research and meetings with property managers suggests that this may be symptomatic of excessive valuation, excess cash balances held by funds and hence the likelihood of a period of low nominal returns. In response, the investment team is increasing weightings in international property funds that invest in bricks and mortar (not property companies and equities) abroad with opportunities in the Far East and Europe.

Commodities and Resources

The oil price has exceeded $90 a barrel during the period increasing energy costs. The price of Gold and other precious metals for that matter continue to rise to record highs whilst the U.S. dollar has continued to weaken. The investment team is cautious on commodity investments in the short term but remain confident of allocating further funds strategically over the long term.

Prices of soft commodities and staple foods such as wheat and corn are at a five year high whilst supply is at a five year low.

Source: Data from Sharescope Alpha, Oct 07

IFPC Ltd is Authorised and regulated by the Financial Services Authority

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