Contact: Harvey Cole, (01962) 865930

With the concurrence of the Chairman under Section 100B (4)(b) of the Local Government Act 1972, this matter has been included on the agenda to ensure the most up-to-date information is brought to the attention of the Panel.

1 Introduction

1.1 This report provides the independent adviser's comments on the current economic outlook, the pensions debate, the equity outlook and progress of the "dartboard portfolio".

1 The Broad Picture

1.1 Future generations - if any - may look back on the first years of the 21^st century as a period of widespread inflation, unacknowledged because it was taking new forms. As measured by the `cost of living', price increases throughout most of the world have been unusually subdued for nearly a whole decade. However, this conceals some peculiarities.

1.2 One is the concept of `core inflation'. Long ago, before the long reign of Alan Greenspan at the Fed, and even before that of his predecessor, Paul Volcker, the US was suffering from double digit inflation. Something needed to be done urgently and the then Fed Chairman, Arthur Burns, proposed excluding some of the more volatile elements from the calculation of the consumer price index. These happened to be: food; housing; and energy. Although it might have seemed that these items themselves gave a good measure of basic inflation, they were duly magicked out of the figures. Since then core inflation has regularly come in at a lower, and politically more acceptable rate.

1.3 On the other hand, this has meant that consumers' incomes have been under greater real pressure than the official statistics indicate, although it is still true that inflation, however measured, has been relatively benign.

1.4 But at the same time, while growth in incomes has, in total, advanced at a moderate to good pace in most developed countries, the average rate has been flattered by a very skewed distribution. In the US the real increase in household incomes between 2001 and 2004 was a mere 1.6 per cent, and wage levels actually fell as more people in an average home were in work. At the other end of the scale, the top 1 per cent of earners took a quarter of growth in wages and salaries. That left them with a share of 11 per cent of all earnings, and, to add to that, they also received 34 per cent of non-wage incomes. The top 10 per cent of incomes now account for 12 per cent of the total, while the top 0.1 per cent (i.e. the one-in-a-thousand person) takes 5 per cent of it.

1.5 To add one final statistic: in 1973 American CEOs averaged 27 times the pay of their employees. By 2004 it was approaching 400 times. (This rather puts in the shade the comparable trend in the UK, where the multiple went from 10 in 1979 to a mere 54 in 2004).

1.6 This pattern of income distribution has meant that very large amounts of money almost literally cannot be spent on day to day purchases and expenses. Instead it is increasingly concentrated into buying all kinds of assets, from houses to artworks and gold or hedge funds.

1.7 The result is the displacement of inflation from immediate consumption to asset values and on a scale that has rarely, if ever, occurred before.

1.8 This trend is having major international repercussions. It shows itself basically as an apparent surplus of savings over investment (taking investment by businesses). Despite its rapid industrial expansion and the rise in the spendable incomes of most of its urban population, China has still amassed foreign exchange reserves of more than $600 per head. While China's own industrial and commercial investment has been on a large enough scale to trigger very sharp rises in the price of almost every commodity, the effect would have been even greater had more of its own resources been channelled into increasing the levels of consumption by its own population.

1.9 Instead the money has been sterilised and recycled to finance, at low rates of interest that have hardly risen in spite of 15 successive increases in US short term rates, American purchases of imported goods. Paradoxically, in a world of asset inflation prices of virtually every kind of manufactured consumer goods have been falling.

1.10 Current rates of asset inflation are clearly unsustainable. Markets are divided as to whether it will end with deflation (a collapse of asset prices) or inflation (a resurgence of incomes). This may explain the apparent paradox of both bulls and bears piling into gold, thought of as a permanent source of value although yielding no income. But if it also proves to be a hedge against a big fall in the dollar, the benefits to those now buying at prices already more than doubled in less than a year may not be very big if they are paying in other currencies. With an exchange rate around £1.80 an ounce of gold at $650 costs £360. If the dollar fell to $3 against the £, then the dollar price of gold would need to rise to $1,030 for a sterling purchaser to break even. It would obviously rise, but a further 66 per cent may be over-optimistic.

1.11 This underlines the extent to which asset values do not necessarily mean an increase in wealth as they rise. A good example is the appreciation of house prices. The growth in wealth of property owners is in effect simply a borrowing from, and a depreciation for the next generation of buyers who will be expected to pay higher prices when buying houses for themselves. If house prices increasingly outrun incomes, then there will eventually be a shortage of buyers - with a predictable effect on prices.

1.12 Like all bubbles the asset bubble will eventually deflate or burst. But it is impossible to predict when this will occur. As Keynes said: "markets can remain irrational longer than you can stay solvent."

1.13 Meanwhile, asset markets remain a rather dangerous game of pass-the-parcel. The idea is to pass them on to someone who thinks the price will rise further: they are not necessarily for using. It is like the old story of the East End trader who told his friend that he had actually opened and eaten a tin of sardines from a consignment that had been changing hands regularly. "For heaven's sake" came the reply, "those sardines were meant for buying and selling, not for eating."

2 The Pensions Debate

2.1 Discussion and argument over the future pattern of pension provision rumbles on - and the question of assets and their valuation remains at the heart of it.

2.2 One extraordinary feature of the discussion on Lord Turner's proposals has been the complete failure of all those taking part to recognise that their affordability crucially depends on the rate at which the economy expands (or fails to do so) in the future.

2.3 Gordon Brown is reportedly concerned over the prospective increase (of rather over one percentage point) in the share of GDP that Turner's ideas would pre-empt. But this is to concentrate on the slice of the cake represented by pensions, rather than the size of the cake from which that slice will be cut.

2.4 At a growth rate of 1.55 per cent, GDP will double by 2050. Politically, that would be regarded as a disappointing outcome (at the `normal' rate of 2.5 per cent projected by the Treasury, GDP would treble).

2.5 Allowing for a rise of some 10 per cent in the population and near-doubling of the numbers of pensionable age, this would still leave scope for the real incomes of pensioners to be more than doubled, while raising the incomes of the rest of the population by around 80 per cent - and with no change in the age of retirement.

2.6 If that may therefore be something of a non-problem, the financing and valuation of pension funds is anything but. Some weird, but not particularly wonderful, things have been happening. A good example was the rush by pension funds into the new long-dated indexed gilt edged stock as a useful match for long term liabilities. This had the perverse effect of driving down yields on the stock - at one stage to below 0.4 per cent. In turn the application of the adopted actuarial principles correspondingly inflated the present value of future liabilities, thereby increasing the theoretical deficit on the funds acquiring the stock.

2.7 A similar nonsense occurred when it was calculated that future liabilities had been greatly reduced by the continuing recovery in equities. In theory, and what is more alarming, also in practice, a doubling of interest rates would cut pension fund deficits in half.

2.8 There is an in-built voodoo-like belief that liabilities can in some way effectively be reduced by varying the collection of assets available to meet them. Hence, the riskier the investment (and therefore the higher potential return) the more any deficit can be reduced. This is like borrowing money from the bank and then telling the manager that you propose to alter the agreed schedule of repayments because all the money will be invested in a series of long-priced bets on promising horses.

2.9 It must be more sensible to move away from the largely theoretical basis that any deficit should be eliminated over a period of around ten years, to the more realistic approach of annual insurance against the obligations of the fund being crystallised in the following twelve months. This would relate the cost to individual companies to the real perceived risk, and probably prove no more costly than the current clumsy Pension Protection Scheme. This, at £573 million a year, absorbs only 0.5 per cent of reported profits, and can hardly be held responsible for firms cutting much needed investment in a period of low interest rates with a growing addiction to the return of cash to shareholders.

2.10 Such an approach would also reduce pressure to extend asset selection into new, higher-yielding but potentially also higher risk asset classes. Some of these are easier to assess than others. It is reminiscent of the actuary who was asked by a farmer to estimate the number of sheep in two nearby fields. "109" he replied instantaneously. The farmer was most impressed. "How did you do that?". "Simple" was the reply "I can see nine in that field and there are about 100 in the other."

2.11 There is also some evidence that returns from private equity are tending to fall - although there is always the hope if not the expectation of beating the averages. But returns from private equity ventures between 1980 and 2005 show an overall average of 10.4 per cent annualised, barely in line with the FT All-Share index. While the top quartile showed 22 per cent, the second produced no more than 9.5 per cent, while the fourth quartile was negative. It is also relevant that private equity has the benefit of considerable leverage and is, by definition, actively managed, whereas the FT index is a purely passive indicator.

2.12 While there is clearly good money to be made in private equity (and hedge funds) it may also be more difficult to secure access to opportunities that will yield average returns in practice.

3 Equity Outlook

3.1 At the time of my last report, the London market was fighting towards the 5000 mark on the FTSE 100 index. Having achieved that, it spent some time struggling to establish a firm base above that level, suffering a mini decline of around 5 per cent in October. Having finally consolidated it then moved rapidly up to the 6000 barrier and again has spent some time dithering either side of it. A repetition of an upward burst once it has shown it can stay above 6000 would actually take it back to the all-time peak achieved in late 2000. (It may be noted that the junior 250 index has already hit that target, moving up to new ground when it flirted with the 10000 mark in April).

3.2 The immediate question, therefore, is whether the main index will have the power and energy to reach new highs. It has been pointed out that after a strong run from the low point of 2003, the bull phase has already lasted a lot longer than the average, and that there is an 80 per cent chance that a rise of over 20 per cent (e.g. 5000 to 6000) will be followed by a correction of at least 5 per cent - even if that does not mean an end to the boom itself.

3.3 The main reason for wondering about the accuracy of this forecast is that a large majority of analysts and fund managers now seem to be subscribing to it. If most active participants in the market have already discounted it, the chances of it happening in practice must be lessened.

3.4 However, an alternative scenario has some credibility. The expected correction will happen, but the anticipated bounce back will not. That could see share prices lose around 10 per cent of current values and then enter a period of trendless activity.

3.5 It must be said that the chances of something like this happening turn more on the pattern of outside events rather than the likely trends in the world's economic fortunes. There can be no doubt that the market is vulnerable to political disturbances which have not been sufficiently discounted although they are widely apprehended. And there is always the possibility that one or other of the current asset bubbles will implode, triggering a chain reaction.

3.6 Technically, there are a number of factors which could continue to support share prices. Prominent among them is what is becoming known as `deequitisation'. This is the practice of companies reducing their equity capital in favour of substituting fixed interest financing while interest rates are low, and distributing cash for which they cannot find an investment outlet back to shareholders by buying back the company's own shares.

3.7 The operations of private equity hedge funds are stimulating this activity. But again there is a series of opposing considerations as on the other (by now the third) hand there is a limit to this process. Prospective yields are being driven down while the amounts of money seeking to enter these new fields continues to soar - not least from growing interest of pension funds. It appears that private equity funds have some £43 billion awaiting a home or a target - four times last year's level. And hedge funds are becoming prepared to take less risk as a result of being able to charge their previous high management fees on much larger portfolios and do not want to jeopardise that. (They are also burning out managers at a more rapid rate: one major fund now reckons the effective life of a bright young manager is no more than about eighteen months before they run out of ideas).

4 Dartboard Portfolio

4.1 Over the last seven months a number of changes have occurred in the composition of the portfolio. Two shares have been the subject of takeovers, and one is no longer quoted on the back prices page of the FT. The classification of the sectors has also been altered quite considerably. This does not seem to have been done with complete and obvious logic in all cases. For example, when looking to replace in the dartboard selection a housebuilder which had been taken over, the choice now has to be made from `Household Goods'. Companies such as Persimmon and Wimpey, previously under `Construction and Building Materials' are now grouped with the likes of Reckitt and AGA Food Service Group - and the result of the chance dart projection was to select Reckitts.

4.2 Continuity has thus been made difficult, and I have decided that it is perhaps time to wind up the portfolio. It has probably demonstrated the main point it was intended for: the tendency of a random selection to perform in line, not merely with the average, but with a wide range of variation from its own average.

4.3 The results for the period from September 2004 to the end of April 2006 are summarised in the table below. The Dartboard has maintained its lead over the four main FT indices, although it will be seen that the buoyant performance of the FT 250 over the past seven months has slightly put it in the shade.

4.4 The FTSE 100 has proved more ponderous, and it will be seen that its dominance in terms of valuation of the overall index is such that it has acted as a drag on both the FTSE 350 and the All-Share simply because it accounts for such a high proportion of these two measures.

Recommendation

1 That the adviser's comments be used as background in the discussions with the investment managers.

Section 100 D - Local Government Act 1972 - background documents

The following documents discuss facts or matters on which this report, or an important part of it, is based and have been relied upon to a material extent in the preparation of this report.

NB the list excludes:

1. Published works.

2. Documents which disclose exempt or confidential information as defined in the Act.