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 April 2007.

2 The general situation

2.1 The first quarter of the year has been a period that might be described as an attempt by reality to break into an investment world tempted to believe that the law of gravity had been repealed.

2.2 To change the metaphor, markets had been basking on an idyllic beach, soaking up the sea and sunshine, while investors reassured each other that the weather was set fine for the indefinite future. All kinds of justification for optimism were available but mainly based on the recent past rather than an attempt to identify reasons as to why the fine weather should break. Past indicators such as previous profit levels were given more prominence than any concerns as to what might happen to the continuing flood of money being pumped into the system as industrial investment stagnated and cash pursued an increasing variety of new-fangled assets.

2.3 Even those who tapped their barometers with a slight degree of scepticism were looking in the wrong direction: they should have kept an eye on their seismographs because, while the sun continued to shine and the sea beckoned, it was underground stresses that were building up to spoil the picnic.

2.4 What had been overlooked, except for a few voices that attracted little attention and less credence, was the destabilising element of risk - or, more precisely, the growing risk of risk. The theory seemed impeccable. Instead of the banks and other major institutions keeping the risk of loans made to customers on their own books, slices of their exposure were parcelled up into separate packages with varying characteristics including the length of the loan and the expected degree of risk (and therefore the level of interest rates). The result was a multiplicity of `pick and choose' investments with purchasers able to build up portfolios according to their appetite for risk and objectives for a return.

2.5 Amid all the proliferation of new financial instruments it became difficult - if not nearly impossible - to discern where the residual risk resided. Even the banks themselves, operating on the proprietary side of their businesses, could not tell whether they were actually buying back some of the risks that they thought they had already offloaded. The extremely low level of interest rates, and the almost ludicrous cheapness of insuring against credit default, simply added to the pace of the merry-go-round. The fact that actual defaults on junk bonds hit their lowest levels for over a quarter of a century was interpreted as a sign of the soundness of markets rather than a serious warning. In the early part of this year it was in fact cheaper to insure against default on some bonds of below investment status, than to secure cover against a loss on US Treasury bonds.

2.6 Two spasmodic fits of nerves shook the markets as the first tremors of doubt made it clear that the world of the international economy and trade - analysis of which continued to suggest smooth progress - was nevertheless subject to disruption from a range of other factors. The trigger was the implosion of the so-called sub-prime market in US housing mortgages.

2.7 The extent to which the housing market had been sustained by lending of large amounts of money to thousands of people who had no prospect of keeping up with the payments (particularly after introductory periods of bargain interest rates had expired) had been seriously underestimated. It is now clear that the way in which the US housing market appeared to brush aside mounting fears during 2006 that a bubble was developing was accounted for by the artificial support provided by the rising tide of suspect lending.

2.8 Not merely is the extent to which the consequent fall-off in housebuilding on the wider economy still not fully appreciated, but it is becoming clear that a similar exposure of over-ambitious loading up with debt is likely to affect many other sectors. Hence, it is probable that further destabilising seismic shocks will occur later this year - quite independently of all the usual indicators of basic economic activity continuing to appear positive.

3 Too much money too cheap

3.1 The single characteristic that marks out the world today from previous periods is the excess of money and the speed with which it is moved from place to place. This flood is created by a combination of generally very cheap credit and, surprisingly, a relatively low rate of investment in the industrialised economies. Companies are not merely paying out dividends but buying back their own capital at a rapid rate. The result is a pursuit of all kinds of non-productive assets and a corresponding surge in their prices.

3.2 It may be said that anything remains cheap as long as there is money seeking to buy it. Conventional inflation (misleadingly identified with the prices of goods and services rather than the incomes available to buy them) has remained at generally low rates, but inflation of asset values has gone on at a pace unprecedented in the post-war world.

3.3 There are two ways in which this excess of cash can be eliminated. First, prices of goods can rise to absorb the money - which does not add to real wealth. (However, it might lead to a further boost to asset values by allowing loans on the enhanced `worth' of existing holdings to be taken out, as with equity release on the rising value of houses). Secondly, as and when the desire to realise a paper profit on assets outweighs the demand to go on buying, money can be destroyed as quickly as it was created as, for example, prices at fine art auctions collapse.

3.4 The same applies to shares and other financial instruments, and changes of sentiment are both unpredictable and not subject to rational evaluation. Arguments that price/earnings ratios are not at excessive levels, or that the Chinese appetite for copper or consumer goods is growing at unprecedented rates, cannot prevail against a reversal of sentiment.

3.5 The extent to which markets are irrational is persistently underestimated. This is partly due to the ease with which a persuasive explanation is always found for an unexpected movement - after the event. A good example of this is provided by the sudden worldwide dip in share prices in February. Many reasons were put forward, but the most favoured was that the whole thing had been triggered by the Shanghai market following rumoured steps to be taken by the authorities to rein in speculation. But the 13 per cent plunge in Shanghai had been preceded by one of over 14 per cent in January, which had not attracted any notice by the pundits of the City and Wall Street.

3.6 It sometimes seems as if the most rational aspects of market analysis consist of finding explanations for its irrational behaviour. Simple logic holds good as long as established trends persist but is incapable of predicting turning points in those trends - which is what really matters. Most investment behaviour consists of making a series of small bets at short odds, and thus clocking up small profits, but then seeing those profits slashed by a losing bet the odds against which have been seriously underestimated.

3.7 While investment advice often boils down to the self-evident truth that you should buy when prices are low and sell when they are high, no bells ring (as the old saying has it) to tell you when a high or low point arrives. To discover that you have to look at charts of the past. In fact, there is also an in-built instinct it would seem, to avoid rational decisions. After a prolonged fall in share prices when they are self-evidently cheap, it tends to be the institutions rather than individuals that decide to plunge back into the markets. The peculiarity of the individuals' reaction is illustrated by imagining that when a large store announced a special sale at rock-bottom prices, its departments look immediately deserted by shoppers.

4 Policy in an uncertain world

4.1 It is nothing new for the future to be clouded in uncertainty. But it is probable that the degree of obscurity at the moment is greater than for a long time.

4.2 The best policy, particularly for a pension fund in these circumstances, is to take the long view, and not to make too many attempts to guess short-term trends in great detail.

4.3 However there are a number of guidelines which should be borne in mind when considering investment policy, particularly where equities are concerned.

4.4 First and foremost it is vital to establish as closely as possible the extent of exposure to any risk, and the nature of that risk, because it can crop up in unexpected ways. A good example is the increase in risk attaching to investment in that most conventional of vehicles, the FTSE 100. Over the past year takeover bids have removed some £70 billion in the market capitalisation of the index. Not merely is this sum about £25 billion more than the value of newly listed stocks, but the newcomers have been predominantly (a) foreign companies with a strong Kazakh accent, and (b) in the mining sector and banks with a Chinese accent. The risk element in the FTSE must accordingly be reckoned to have increased.

4.5 A second maxim is to assess as accurately as possible where the real risks in proposed investments lie - particularly when new asset forms are concerned. This is not always easy to do, but it will often become apparent that what is claimed to be an opportunity to spread risk by diversifying into an alternative new asset form is in reality no more than an exercise in varying the proportion of existing assets, together with some financial gearing. The search for enhanced performance must also be qualified by an assessment of the degree of leverage embodied in particular proposed investments - together with the impact of possible serial layers of management fees.

4.6 The iceberg of moral hazard - extending well below what is visible above the surface - should never be neglected. The magic of the new sophisticated financial instruments in apparently slashing risk by ensuring it is widely spread rather than concentrated can actually raise the chances of loss. If lenders act on the basis that transferring risk automatically provides a degree of insurance against default, they will be much more likely to lend too much to weak borrowers (shades of the sub-prime saga in the US). Thus, instead of being concentrated in the hands of large (and therefore more resilient) lenders, defaults will tend to hit a number of less substantial companies. Add to that the fact that the parcelling out of loans and leveraging them could actually lead to an increase in risk, then a high degree of caution is essential.

4.7 The extent to which leverage can rapidly escalate to unsafe levels is shown by what is not an untypical example. Take a hedge fund which is itself modestly leveraged twice over. It is partly financed by fund of funds money leveraged three times, and invests in CDOs (collateralised debt obligations to ordinary mortals) which can be typically leveraged eight to nine times. Should the value of the CDOs drop by a mere 2 per cent, all the equity capital is destroyed.

4.8 At the moment, while there are no dark clouds on the interest rate horizon, and nothing sinister on the seismograph, any significant increase in the cost of money will have exaggerated consequences precisely because of the enormous credit structure that has been constructed in the long period of cheap borrowing.

4.9 At some point the apparently inexhaustible recycling of money through the so called `carry trade' must come to an end, and if this happens abruptly the disruptive impact could be large and serious. It is impossible, by definition, for the whole of Japan's currency to be borrowed for reinvestment in higher yielding currencies, and therefore the differential between Japanese and many other central bank interest rates cannot persist indefinitely. At some point there must be a rush to exit: the chances of a panic increase in direct proportion to the number of players who reckon that they can safely join the back of the queue.

4.10 Meanwhile, a final motto: low volatility in the past is no guarantee of low volatility in the future.

Recommendation

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.

NB: The list excludes:

None.