Contact: Harvey Cole, (01962) 865930

1 Introduction

1.1 The following are the Independent Adviser's thoughts on the economic and financial scene, as of 1 November 2006.

1.2 It is more than usually likely that some updating will be necessary by the time the Panel meets, particularly in the light of the forthcoming US Congressional elections and fuller reactions to the Stern Report published only two days ago. Without being unduly cynical, I found that the initial response of one or two share prices in London appeared rather dismissive: Drax (running the largest coal-fired power station in Europe) reached its all-time high, and EasyJet was one of the largest risers of the day.

1.3 The theme of this report is that there are at least two sides to the coin where aspects of the economy are concerned. For example, there is a conflict of opinion between the heavyweight commentators as to whether imbalances in the Chinese financial position are due to excessive private saving or whether growth in Chinese personal consumption (said to be contributing more to world growth than America's) is already acting as a major engine of global growth.

1.4 While I will prudently avoid trying to adjudicate between such authorities as the Financial Times and the Economist (who respectively back the two horses described above) I draw attention to several other ambiguous trends, and offer one or two possibly illuminating statistics.

1 How do you Dow?

1.1 Last month the Dow Jones index hit an all-time peak - and the headlines. The importance of this event was at once more and less than suggested by the publicity it received.

1.2 The Dow Jones is a peculiar - if long lived - creation. It actually consists of 30 shares and not companies. The index is compiled by simply adding up the current price of each of 30 shares, and these shares are chosen very largely by the size of the companies issuing them, and the `weight' of the share itself. No attention is paid to the relative market value of the companies themselves once they have been selected.

1.3 This produces some oddities. One example is the relative performance of the machinery maker Caterpillar and Microsoft. Over the five years to the new index peak, Caterpillar shares rose by $39 to $66, whereas Microsoft dropped by half - from $54 to $27. The effect on the Dow was therefore the same as a combined increase of $12. But the market value of Caterpillar, after its 150 percent rise, was a mere $43 billion whereas Microsoft, in spite of dropping by half, was still worth $271 billion. So, a combined decline of around $245 billion actually showed up as a rise of 300 points in the index.

1.4 If this shows a flaw in the world's most familiar index, it only echoes problems with others which do reflect the market value of its component shares. Not everyone is happy with one like the FTSE 100, which means that those tracking it find that half of their money is tied up in ten companies, heavily weighted towards mining, oil, banking and pharmaceuticals.

1.5 Nevertheless, the Dow Jones break-through to 12,000 is a reflection of sentiment - even though it is still more than 10 percent below the 2000 high if it is adjusted for inflation. (The broader-based S&P 500 is more than a tenth below its own peak of six years ago).

1.6 But even the sentiment is ambiguous. Part of the explanation for the Dow's performance has been a switch towards larger companies. This is largely based on the belief that when conditions become tighter, the bigger players are more likely to maintain their profits and their dividends. So, the rise in the Dow could signal a relative decline in smaller companies, and a slowdown in the US economy.

1.7 That fear might be dispelled if the S&P also breaks into new high ground in the near future. On the other hand, if the Dow subsides below the allegedly magic 12,000, analysts will have a headache trying to interpret it.

2 Hedging on hedge funds

2.1 Hedge funds continue to attract a mixed press. Surveys both in the US and here suggest that the proportion of institutional investors and pension funds proposing to allocate money to this form of investment will continue to rise rapidly over the next four years.

2.2 On the other hand, increasingly sophisticated analyses of the performance of established funds appear to reveal less than compelling results. (Incidentally, a contender for the most striking remark of the year must be this, from a hedge fund manager explaining poor results earlier this year: "It is difficult to make money in these markets").

2.3 Many of the widely quoted surveys of hedge fund returns tend to conceal as much as they reveal. To start with, they are measuring a rapidly changing universe: in the past year almost a tenth of funds operating when it started are no longer in business. More important, the confidentiality about their transactions which most funds insist on extends to their choice as to if and when to release reports on their trading activity.

2.4 Studies by academic researchers in America have found that it is common for funds to start reporting only after a run of good results, and for them to opt out of providing information when things turn down.

2.5 One comprehensive study looked at 4,826 funds for the period January 1995 to April 2006. Strikingly, over 2,000 of them did not survive the 11 year course. Those that did appeared to produce a compound annual return of 16.4 percent (but this was reduced to 13.6 percent if the defunct ventures were included).

2.6 However, a substantial part of that figure was accounted for by so-called `back-filling' (a procedure rather like the widespread backdating of option grants to US company executives when a suitably low starting point for the shares concerned can be chosen from subsequent movements). Eliminating this cut the hedge funds' returns to just under 9 percent. The final step was to strip out the proportion of that which was attributable to general market movements, leaving the contribution of hedge fund managers at a fraction over 3 percent - just about equalling their own fees.

2.7 The studies also show that large funds tend to be more successful than smaller ones - but also tend to be closed to outside investors much more rapidly. And any general index of hedge fund performance must be adjusted to allow for the constant drop-out (at low or nil value) and new entrants (at higher asset valuations).

3 The oil conundrum

3.1 The price of oil has duly fallen back to below $62, and is struggling to keep its head above the $60 level. If high oil prices were threatening the stability of the world's economy, surely a fall of over a quarter from the peak must be a good thing? And the same could be said for other commodities?

3.2 Only up to a point, Lord Copper.

3.3 It is very difficult to tell how far speculative activity contributed to the surge of oil to over $70, although the collapse of the Amaranth hedge fund as a result of a very large very bad bet on a continuing rise in gas futures may provide an indication.

3.4 Certainly, at present levels inflationary pressure on industry and consumers has been reduced. However, this may also reflect a weakening overall demand for oil, and therefore an imminent flagging in economic activity.

3.5 Nor is the fall in price as large a bonus to the petrol-buying public as some commentators have suggested. The fall from $78 to under $60 a barrel has been calculated as being worth $200 a year to American consumers - money now available to spend on other things. Not quite.

3.6 That figure would be true if pump prices had been at their peak for a full year, and then dropped by over a quarter. In real life the average price paid during 2006 will not be all that far short of $60, so that if that level is held through 2007, the saving will be minimal: it is more a question of saving on higher prices that will not continue. While this is obviously welcome, it is not money that you can now go out and spend.

3.7 Other aspects of the lower oil price also indicate a subdued effect. Not a great deal of oil has actually been used by industry at or close to peak prices. This is partly due to widespread hedging operations. At the same time, the costs of expensive oil have not yet been passed on to customers. This is a process that has still to unwind.

3.8 Cheaper oil will also reduce incentives to step up exploration for new reserves and the exploitation of existing relatively expensive sources. This again has mixed implications. Reduced consumption will extend the lifespan of the (ultimately limited) world supplies, and the rate at which they are burned off into the atmosphere. At the same time, cutting back on the search for new fields will leave the risk of a future squeeze on available supplies as the world's appetite for oil resumes its advance.

3.9 The real problem is that the viability of attempts to open up large new sources, such as the Canadian tar sands, depend not so much on the cost of the operation but on the amount of energy that has to be consumed in order to produce new supplies. If it takes the equivalent of four barrels of oil to produce five barrels worth of new energy, the equation looks forbidding regardless of what the current oil price happens to be.

4 Housing tremors

4.1 The faltering of the American economy in recent months has been widely, and convincingly, attributed to the weakening of the housing market. However, the risk of this broadening out into a more pronounced setback has been discounted by commentators who take heart from the apparent failure of softening house prices in other countries - notably Britain and Australia - to infect the economy as a whole.

4.2 However, this overlooks a very important difference between the role of house-building in the US and in this country. Here the annual level of building fluctuates relatively little from year to year, and output accounts for well under 1 percent of the existing stock. Indeed, at the first sign of a weakening in house prices, British builders tend to cut back their activity and leave their supplies of land banked to increase in value for the future.

4.3 The American construction industry accounts each year for a much larger proportion of the housing stock. Activity levels fluctuate more widely, and the effects of a slowdown in demand are correspondingly amplified. Stocks of unsold property have built up to an average of something like three months' worth of sales at earlier rates. The result is a greater scaling back of activity and employment than is the case in this country. It is this rather than any general downturn in prices that makes it likely that the downturn in the American housing market will have greater repercussions even though the preceding boom in prices was markedly less sharp than here. Residential investment has been falling at 15-20 percent annually. If this goes on for another two or three quarters, it would knock a full percentage point off America's total growth rate.

4.4 On this side of the pond, housing prices seem to be firming up again. However, it may prove that this is to some extent an optical illusion.

4.5 The various house-price indices that report on trends in the market rely on monitoring the prices of houses that actually change hands each month. It is therefore implicitly assumed that these represent a reliable sample of the total housing stock. That is not necessarily so.

4.6 A feature of the market this year has been the disproportionate rise in prices in and around London, which is thought to reflect current and prospective bonuses being paid to those working in the City. (A recent estimate suggests that such payments to the 340,000 or so employed in the City will amount to around £9 billion this year, accounting for 3 percent of all the pay increases going to the entire British labour force of 29 million).

4.7 One outlet for this flood of bonus money is trading up in the housing market. This year will see about 12,000 homes sold for over £1 million, and the average price rise in this bracket is running at 25 percent year on year. (About 9,000 of these are in or near London).

4.8 Overall, house prices are projected to go up by 4-5 percent this year. That means that about a quarter of the increase in `average' prices will be accounted for by the £1 million plus homes.

4.9 This makes the use of estimated average prices quite misleading. The inflation at the top of the market does not affect the vast majority of other houses (except perhaps marginally at the upper end). More important it leaves the median home completely unaffected: that is the house which has 50 percent of all homes more expensive that itself and 50 percent less costly. In a market with values skewed at the top of the scale, it follows that there are more houses below the median than below the average.

4.10 To the extent that there is a new housing bubble, it therefore seems that it is rooms at the top that are the most vulnerable.

5 Bonds In Equities Out

5.1 The early summer saw some excitement as long-term interest rates in the US dropped marginally below short term borrowing costs. Some thought that this indicated a growing threat of recession, but it was then argued that as the negative differential affected Federal 10 year bonds as against the 3 year issue, it was probably temporary and not significant. However, it was suggested that an inverse yield curve affecting shorter term money would be a different matter.

5.2 Five months on, the 10 year bond is returning a full 0.5 percent less than 7 day money in New York, and yet no dogs are barking.

5.3 Indeed, voices are saying soothingly that this is not a harbinger of a sharp slowdown in the US economy - as would have been predicted at almost any time in the past.

5.4 There is a plausible explanation for this. Demand for Federal funds from abroad, almost entirely from foreign governments, continues at high levels, and is concentrated very largely on the 10 year issue, thereby driving down its yield.

5.5 While it is usually China that is signalled out for running a large export surplus and channelling the resulting inflow back into US dollars, it is overlooked that Japan and the Gulf states have export surpluses of similar proportions of their GDP and also sit on foreign currency reserves of much the same size as China's.

5.6 Perhaps the surprising thing is not so much that these flows are continuing as that the dollar has not strengthened as much as this inflow might have been expected to bring about.

5.7 Part of the explanation has been the accelerating investment by US funds in foreign equities. Since the beginning of 2005, 80 percent of the money placed with American mutual funds by individual investors in equities has gone abroad. So far in 2006, 87 percent of the total equity of $120 billion has been placed abroad, and the figure is running at double last year's rate.

5.8 This differential trend means that some positive future contribution is being made to America's balance of payments, in that the return on foreign equities will boost US invisible income more than the same amount going into Fed funds will raise its own interest costs.

5.9 On the downside, if American investors are in fact channelling abroad much of the money they are receiving from dividends and share buy-backs from domestic companies, this must indicate at least a relative decline in confidence in American industry. That will also reduce the prospective level of increasing physical investment in plant and equipment, and with it the prospect of such investment taking up the running from flagging consumers in keeping the economy's growth going. The burden will therefore shift to the export sector, but it is far from clear that American companies are well placed to capture a rising share of what may be a shrinking world market.

6 Sidelines on world trade

6.1 Steel

Trends towards consolidation of the world steel industry continue apace. This is resulting in big changes in the league of major steel producers. China is by far the largest producer, with 350 million tonnes last year. Together with India in 8^th place with 38 million tonnes, it now turns out as much as Japan, the US, Russia, South Korea, Germany and Italy combined.

6.2 Commodity prices

Surprising, but apparently true: since 1956 the prices of commodities other than fuel have fallen by an average of 1.6 percent annually - a cumulative decline of 55 percent in real terms. In spite of the strong increases in recent years, the present levels thus reflect the extent of the long-term fall. Indeed, the IMF, while allowing for continued strong growth in demand, suggests that increasing supply will ensure there will be a further fall. They are predicting that copper will fall 57 percent by 2010 and aluminium by 3.5 percent. Perhaps we should bear in mind the warning that past performance does not necessarily translate into future trends.

6.3 The export league tables

While China regularly attracts attention because of the size of its exports, Germany remain the champions as far as total sales are concerned, followed by the US with China in third place. Britain is seventh in the top ten.

A rather different pattern emerges if the criterion of exports per head of population is adopted: the Netherlands is the clear winner here, while the US is in the relegation zone. The UK comes out relatively well, slightly behind France, but above Japan, China and Italy, as well as the US. Britain also comes third out of eight in terms of export growth between 2003 and 2005. The chart illustrates these points.

Recommendation

1 That the adviser's comments be used as background to the discussions of the Panel.

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.

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1. Published works.

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