Two halves

Experts predicted strong growth in both developed and developing markets at the start of the year. Then the credit crunch hit halfway through 2007 and central banks acted to ease the pain. Simon Hildrey forages for crumbs of comfort.

If an English football manager was to review the economy and stockmarket during 2007, he would probably use the classic cliché that it has been a game of two halves.

At the start of 2007, there was widespread bullishness about prospects for economic growth and equities. Merger mania was still in full swing, there was plenty of liquidity and there was still no sign of a housing slowdown in Britain.

In late spring, there was a widespread view that interest rates would have to rise in Western economies to restrain growth. During the first five months of 2007, consensus forecasts for GDP growth in developed economies excluding America and developing markets like China and India were being revised upwards for both 2007 and 2008.

As Mike Lenhoff, the chief strategist at Brewin Dolphin, said on May 31, this was good news for corporate earnings because it meant the earnings surprises could still be on the upside. That was also a good signal for equity markets.

The bad news at the end of May was that “interest rates may have to rise to higher levels than expected”, said Lenhoff. “However, for now the cost of debt servicing is low relative to earnings yields in equity markets so the economics underlying mergers and acquisitions still make sense. Again, that’s good news for equity markets.”

Of course, the surprise that came over the summer was the credit crunch. This transformed the economic and stockmarket environment for the second half of 2007. This has led to America and Britain desperately trying to fight off recession. Some economists argue America has already fallen into recession, at least as far as earnings are concerned. America has reduced rates by 1.0% to 4.25% through two cuts by November and the Bank of England cut interest rates by a quarter point in December to 5.5%.

Equity returns reflect the change in environment. From the start of the year to December 3, stockmarket returns were generally low but positive, such as for the MSCI World index (6.03%), S&P 500 (6.23%), FTSE 100 (6.89%) and FTSE All-Share (5.04%). The stockmarkets to stand out for the year as a whole are emerging markets and Japan. The MSCI Emerging Markets index was up 32.72% to December 3 and the MSCI Asia Pacific ex Japan index returned 32.14% while the Nikkei 225 fell 8.97%.

These returns, however, hide significant differences in performance between the first and second halves of the year. The Nikkei 225 was up 5.30% from the start of the year to July 2. Between July 2 and December 3 the index fell 13.55%. The FTSE All-Share returned 7.58% in the first half of the year and dropped 2.36% in the second half. The MSCI World rose 8.50% and then fell 2.27%.

Intriguingly, however, the MSCI Asia Pacific ex Japan index delivered exactly the same return in the first and the second half of the year at 14.95%. The return of the MSCI Emerging Markets index was also the same in the two halves at 15.26% and then 15.15%.

The second half of the year saw cycles of returns. Markets were hit in August and November but prospered in September. Unsurprisingly, therefore, volatility has increased generally. Peter Bickley, director of economics at Tilney Private Wealth Management, says the Vix (volatility index) of the American index has risen to about 25%. This is high compared with the 6% of the recent past but low against volatility above 40% that was reached previously.

Bickley and Trevor Greetham, director of asset allocation at Fidelity International, say that we are now in a late phase of the economic cycle. Arguably, it was to be expected that the global economy would slow as 2007 progressed and equities would deliver lower returns. Interest rates were rising in developed markets and the world had enjoyed strong economic growth and stockmarket returns over the previous four years. This was not sustainable. What was not known was when or how a slowdown would be prompted.

HSBC warned about problems in its household division in America in February but the subprime problems that started in earnest in the summer still surprised the markets. This came at the same time as American house prices generally were falling. This is the first time American house prices have been negative since records began in 1975 and probably since the second world war.

The credit crunch was sparked by the fact that many subprime borrowers were given mortgages at low rates that were fixed for two years. Bickley says these were granted at loss leader rates for the lenders but a lot of borrowers were only just able to afford to pay the mortgage. But as the two-year fixed rate mortgages have been coming to an end, many borrowers have found they could not maintain payments, especially as American rates had risen to 4.75%. As a result, defaults rose.

In early December, the Mortgage Bankers Association said 994,000 households were in the process of foreclosure. It added that a record 5.59% of all American mortgages were in default in the third quarter, which was 0.47% higher than in the second quarter. Furthermore, existing home sales fell 1.2% to a nine-year low of 4.97m annualised in October.

Falling house prices and rising defaults in America are expected to hit consumer spending. In turn, consumer spending accounts for about 70% of America’s GDP.

Ben Bernanke, the Federal Reserve chairman, has studied the Wall Street crash of 1929 as well as the Japanese recession that started in the early 1990s. It should therefore not be a surprise that America has moved quickly to reduce rates.

What has been new about the subprime problem has been the extent to which it has spread around the world. It is now well known that subprime mortgages were packaged into collateralised debt obligations (CDOs), structured investment vehicles (Sivs) and other such structures.

This enabled the lenders to the subprime market to pass on risk. But this meant exposure to high-risk mortgages have ended up in surprising parts of the world, such as Landesbanks and enhanced money market funds. It is argued that this “disintermediation” meant banks had less need to check credit worthiness. The incentive, it is said, was for banks to write more loans, take a fee and sell on the loan.

While interest rates are being reduced in America and Britain, the interbank rates are higher, however. Libor, for example, has risen from about 5.7% in May 2007 to about 6.75%. This is more than one percentage point above the bank rate and this represents a nine-year high.

This means liquidity is still being squeezed as businesses and individuals have to pay a high rate to borrow money. Banks also became cautious about lending money to each other because they did not know which ones had a dangerous exposure to subprime mortgages. This difficulty to borrow from the wholesale markets led to concerns about the ability of Northern Rock to meet withdrawals by depositors. This prompted the unprecedented sight of long queues of savers outside Northern Rock branches across Britain.

To quell the panic, the government had to guarantee savers their money. Northern Rock has subsequently borrowed about £30 billion from the government. One school of thought is that cuts in interest rates in developed markets will prevent a recession. But other economists believe America has already entered a recession and central banks may be constrained in their ability to reduce rates because of the rise of inflationary pressures during 2007.

American third quarter earnings figures were down from the same period in 2006. Average earnings for S&P 500 companies in the fourth quarter are expected to fall by 0.8%, according to analysts. The financial sector is predicted to suffer a decline of 35%.

It is expected that S&P 500 earnings growth for 2007 will reach 3.2%. This would be its worst performance since 2002. At the start of the year, analysts predicted earnings growth would be about 9.3%.

China and other emerging markets have been viewed as having a deflationary effect on western economies. The rise of manufacturing and outsourcing of services to Asia in particular has reduced their cost to businesses and consumers in developed countries. But growing demand from emerging economies has also led to the rising cost of oil, other energy and commodities, notably soft commodities.

For example, inflation in the euro zone was at a six-year high of 3% in November. The price of oil has almost doubled from its $50 a barrel in January 2007. This has led to a 40% rise in petrol prices in the US to above $3 a gallon. Merrill Lynch says this is equivalent to a 1% wage cut for the average American employee. The British Retail Consortium says that food price inflation rose to 5.1% in October and 4.3% in November. Transport costs have been increasing at similar levels.

Interestingly, non-food prices have been falling and overall shop price inflation reached 1.1% in November. Indeed, inflation is slightly lower than it was in the spring although in October it has shown signs of rising again. The harmonised index used by the Bank of England peaked at 3.1% in March and reached 2.0% in October. The Retail Price Index also peaked at 4.8% in March and was at 4.2% in October. The Consumer Price Index increased 2.1% in October, which was above the 1.8% in September and the 2% target of the Bank of England.

This rise in energy and food prices is coming at a time when developed economies are set to suffer a slowdown. Can central banks afford to reduce interest rates to stimulate economic growth when inflation is rising? The European Central Bank kept rates at 4% in December but two members of the governing council even voted to raise rates.

This poses the risk of leading to the nightmare scenario for central banks of stagflation – stagnant economic growth and a high rate of inflation. Nevertheless, the Bank of England decided the risk of slower growth was greater than inflation by reducing interest rates from 5.75% to 5.5% on December 6.

The slowdown in house prices in the latter part of 2007 has given the Bank of England more room for manoeuvre in reducing interest rates. In recent weeks, Nationwide, Halifax, Hometrack, the Royal Institution of Chartered Surveyors and Rightmove have reported falls in house prices. Nationwide, for example, said house prices fell 0.8% in November.

The number of approved new mortgages fell from 100,000 in September to 88,000 in October. This was the lowest level for just under two years. Mortgage defaults are expected to rise in Britain next year. The Financial Services Authority says at least 1.4m borrowers are on short-term fixed rates that are due to end in 2008.

The Organisation for Economic Cooperation and Development (OECD) is still relatively optimistic about prospects for economic growth in developed markets. It does believe growth will slow from 3.7% in 2007 in Britain to 2% in 2008.

The projection for next year has been reduced from the 2.5% made in May 2007. It predicts GDP growth in America to fall from 2.2% in 2007 to 2.0% in 2008, while growth will decline from 1.9% to 1.6% in Japan and 2.6% to 1.9% in the eurozone. Overall growth in the OECD will drop from 2.7% to 2.3%.

These forecasts are more optimistic than many economists, however. Merrill Lynch, for example, forecasts economic growth in America will slow to 1.4% in 2008 from 2.2%.

The OECD also expects inflation to fall in developed countries from 2.3% in 2007 to 2.1% in 2008. Jorgen Elmeskov, acting head of the economics department at the OECD, said in the report issued on 6 December: “Several shocks have hit OECD economies recently – financial turmoil, cooling housing markets and higher prices of energy and other commodities.

“Fortunately, they have occurred at a time when growth was being supported by high employment that boosts income and consumption, by high profits and strong balance sheets and by still buoyant world trade driven by robust growth in emerging economies.

“Accelerated adjustment in the US housing sector will drag down growth to low levels in the near term but will not trigger a recession and will only modestly push up unemployment.

“Over the next two years, inflation will revert to a more comfortable level and the recent fall in the external deficit will be preserved – in both cases despite high oil and commodity prices.”

The deficit and the American economy have received help in the form of the weaker dollar during 2007. This has boosted exports although it is another factor adding to inflationary pressures as it increases import prices.

The fall in the dollar is also inflationary in countries that are pegged to the dollar, including in the Middle East, China and Hong Kong. As America lowers rates so do these countries. Indeed, inflation is not only being exported from emerging markets but is rising in these economies as well. In China, for instance, prices are rising at 6.5% a year. Like developed economies, this is being driven by energy and food.

The year has been marked by strong economic growth in emerging markets. The Indian economy has been growing at more than 9% this year and China’s has been in double digits.

Much of the discussion this year has been about whether emerging market economies will be able to withstand and offset a slowdown in America and other developed countries. Bickley says we are in new territory because emerging markets account for a greater proportion of the global economy than ever before. But the answer is probably dependent on the degree of the slowdown in the American economy.

Bickley estimates that the first two quarters of 2008 will experience a sharp slowdown, which will be accompanied by volatile stockmarkets. But he adds that equities will start recovering as markets realise reductions in interest rates will start having an impact in the second half of next year.

As we enter 2008, there are several uncertainties facing the global economy and thus stockmarkets. These include the full impact of the credit crunch, the degree of the slowdown in American consumer spending, the degree to which emerging markets can offset slower growth in the west and the impact of inflationary pressures.

As Donald Rumsfeld, George W Bush’s first defence secretary, might have said, there are known unknowns and unknown unknowns. This should make 2008 as interesting a year as 2007.

Industry trends
The multi-manager sector has expanded over the past few years. The sector has sold itself on the fact that there are constant changes in the managers of funds. Multi-managers argue they have the time and expertise to monitor this movement and decide whether or not to sell the underlying funds. But Mark Dampier, head of research at Hargreaves Lansdown, says it is ironic that one of the features of 2007 has been the merry-go-round of multi-managers switching between asset managers.

“This sends a bad message to investors,” says Dampier. “Some investors turn to fund of funds because they are fed up with having to follow the changes in the management of funds. There are costs involved in changing multi-manager funds in terms of charges and potentially capital gains tax [CGT] liabilities.”

The process was started by the announcement in February that Robert Burdett and Gary Potter were to leave Credit Suisse Asset Management (CSAM) for Thames River Capital.

Burdett and Potter spent six months on gardening leave and were replaced by Graham Duce and Rob Bowie from Credit Suisse’s private bank. CSAM also recruited Aidan Kearney from Premier Asset Management to co-head the UK multi-management team.

In the summer, Resolution Asset Management recruited three members of Fidelity International’s multi-manager team – Chris Ralph, Jason Collins and Simon Mungall.

At the start of autumn, there was another merry-go-round of multi-manager managers. Mark Harries and four colleagues (Simon Wood, Lyndon Gill, Natalie Burnard and Andrew Perham) left to join Scottish Widows Investment Partnership (Swip).

Cazenove announced that Marcus Brookes would join in 2008 to head the multi-management operation. Brookes, who was deputy head of multi-manager at Gartmore, has taken Robin McDonald with him from the asset manager.

Gartmore has in turn recruited Tony Lanning and Kate Trowsdale to replace Brookes and McDonald.

Several “niche products” have attracted attention this year. These include 130/30, Africa, infrastructure, soft commodities and climate change funds.

Darius McDermott, managing director of Chelsea Financial Services, says areas such as 130/30, Africa and climate change funds are likely to offer long-term investment themes.

Among the potential exemptions are UBS Global Asset Management’s 130/30 US equity fund managed by Tom Digenan. McDermott highlights this fund because UBS has a track record of a US 130/30 fund in the domestic market.

New Star launched the Heart of Africa fund while among the asset managers to launch climate change funds are HSBC Investments and Schroders.

The commercial property fund sector has seen a reversal in its popularity among investors. The past couple of months have seen outflows from bricks and mortar funds as British commercial property returns turned negative. The Investment Management Association (IMA) says there were net outflows of £159m or 1% of total assets in October. Some funds have reduced their values while others have put restrictions on redemptions. Advisers have been turning to the New Star International Property fund to provide diversification away from Britain.

Two asset managers to attract attention this year are CSAM and Neptune Investment Management. “Neptune has continued to deliver strong performance this year,” says Dampier. Among the popular funds managed by Neptune are its Balanced, European Opportunities, Global Alpha, Global Equity, Income, Russia and Greater Russia and UK Equity funds.

When it was announced that Burdett and Potter were to leave CSAM, some questioned prospects for the asset manager in Britain. They were the latest in a line of fund managers to leave CSAM, including Bill Mott and Errol Francis. Furthermore, Ian Chimes, managing director, and Mark Thomas, retail sales director, had left the asset manager.

A key issue for financial advisers this year has been the prospect of a shake-up of the advice market through the Retail Distribution Review (RDR). The Financial Services Authority’s discussion paper A Review of Retail Distribution was published in June 2007. Responses are to be submitted by December 31, 2007.

The FSA says an interim paper will be published in April 2008 with a detailed response coming in October 2008. But the RDR will not be implemented for another two and a half years. This means financial advisers do not need to decide quite yet whether to qualify as professional financial planners or become general financial advisers.

A key issue for investors will be the change to the CGT regime that was proposed in the pre-Budget report in October. If the proposal is implemented it will introduce one rate of 18%. This has prompted debate about whether insurance bonds will continue to have a role to play in holding funds.

For higher rate taxpayers, several factors need to be considered, including the degree of trading investors will do and whether investors are looking for income or growth funds, says Ian Tait, executive director of London and Capital.

Among the corporate action during 2007 was Jupiter joining forces with TA Associates to achieve a management buyout of the asset manager from Commerzbank.

Hargreaves Lansdown attracted enormous publicity for an IFA firm when it floated on the London Stock Exchange in the spring. Stephen Lansdown and Peter Hargreaves, its founders, are expected to earn £250m each while senior employees will become millionaires.