Contact: Harvey Cole, (01962) 865930

1 Introduction

1.1 The following are the thoughts of the Independent Adviser on the economic and financial scene, as of 22 April 2008. In view of the heavy agenda, members may wish to take up any points at the meeting on 23 May 2008.

2 Overview

2.1 Had anyone accurately predicted six months ago the events which have occurred since then, they would have been laughed out of sight. To pick out just some of the high spots. We have seen the most sophisticated banking and investment houses in the world fooled by their own conjuring tricks with new-fangled financial instruments designed to spread risk more evenly. In practice what happened was to spread universal fear and doubt as to where risks had been redeployed.

2.2 As the financial house of cards tumbled, it emerged that a back-room trader had almost destroyed one of Europe's leading banks in attempts to cover up previous unauthorised profits he had made on the currency markets. As the dominoes started to topple other household names on Wall Street, in the City and in Paris and Switzerland successively announced that they had suffered little damage, tutted over the plight of others, and then revealed even larger losses of their own.

2.3 The point was eventually reached where it seemed that the larger the additional write-offs you announced, the higher your share price bounced. This was accompanied by offers from some of the most heavily affected institutions to underwrite the raising of new capital by others, and by an ingenious scheme to get billions of dollars of sub-prime assets off their own books by not merely selling them to private equity and hedge funds, but also to finance their purchase.

2.4 Perhaps the height of absurdity was reached when the British clearing and investment banks informed the Prime Minister that it was the Government's responsibility to ensure that liquidity was pumped back into the system - reminiscent of the gambling addict who recently sued his bookmaker for not preventing him continuing to place losing bets.

2.5 We have now probably reached the point at which no further major damage is likely to emerge. But even though the ship may now be nearly watertight, the task of pumping it out will be long and complicated. Some assurance that the low point may be in sight is provided by the implied rate of eventual write-offs of the initial value of sub-prime mortgages in the US. The market is discounting a 50 per cent default on these, and a `recovery rate' (i.e. the prices eventually realised from selling these) of 70 per cent of the initial loan. That equates to a write-off of 35 per cent overall. If that proves over-optimistic most bets on an early recovery would be off.

2.6 Not merely has anything up to $1 trillion ($1,000,000,000,000) evaporated, but capital to replace it can only be raised slowly - and at rates which must make profits to the financial system harder to come by, and the supply of credit to industry and commerce more difficult to secure and probably more costly and more tightly conditioned.

2.7 This means that the slowdown which must affect what is still called the `real economy' has yet to get under way. But to be soundly based, recovery from it will need to be slow and prolonged. An immediate bounce would be a bad sign.

2.8 This is because the collapse of the cheap and over-leveraged edifice of new fangled financial instruments will also compel remedies to be found for the fundamental distortions in the world economy stemming from the enormous trade deficits of, primarily, the US and Britain. This must mean shifting more of their resources into exports and investment, with savings rising at the expense of consumption. Short-term efforts to boost, or sustain, consumer expenditure can only result in renewed crisis.

2.9 There is much debate (which I look at in a little more detail later) as to whether the slowdown in the economies of the developed world will be outweighed by continuing rapid expansion in the so-called BRIC countries (Brazil, Russia, India and China) together with other emerging nations. Strangely enough, it is often those who have been advocating globalisation who take the view that there will be a decoupling of the two groups of economies.

2.10 Growing inter-connectedness will ensure that their courses remain linked to some extent: about a third of China's GDP is accounted for by exports, and slowing markets in the US and Europe will have an impact. (China's stock markets have already shown the largest falls in the last eight months.)

2.11 While commodity prices have risen rapidly, and an element of speculation has contributed to this as investors have sought new (and hopefully uncorrelated asset classes) they are vulnerable to a weakening of activity. But there may well be a difference between industrial and agricultural commodities. Demand for metals, and possibly oil, could well be less strong this year, while both demand and supply indicators for foodstuffs appear more bullish.

2.12 Thus, whichever way the global economy goes, Britain could find itself confronting a decline in activity accompanied by continuing upward pressure on food prices.

2.13 Our heavily overloaded economy must abandon as unrealistic all hope of a vertical take-off. A long, slow but steady ascent is the only safe course.

3 Decoupling - or all in the same boat?

3.1 Probably the most widely held view of the world economy is that a slowdown in the US, UK and Europe is inevitable during this year and next, but that this will be largely - if not entirely - offset by continuing expansion in Asia, Russia and South America.

3.2 In support of this thesis it is argued that China alone has been contributing as much as the US towards world growth in recent years, and looks set to continue expanding at 8-10 per cent a year - as does India. But to make up for, some say, a 3 per cent decline in the developed world (which, with its 11 per cent of population accounts for 47 per cent of total GDP) China and co. would have to raise their own performance by a further 4 or 5 percentage points.

3.3 That looks improbable to say the least. What is more, slowdown in America and Europe will have a direct impact on the Asian economies: a third of China's GDP is accounted for by exports, largely to the more developed world.

3.4 Certainly, there is no evidence of decoupling in the behaviour of the Chinese stock market, which has fallen by almost 40 per cent in the last six months, and may affect growth in domestic spending before long.

3.5 What is clear is that there will be a redistribution of economic growth around the world. Relatively, the emerging countries will gain at the expense of the developed economies, even if that simply means a less marked slowing down.

3.6 Given the short to medium term pressure on supply of food and raw materials, even a worldwide slowing down short of recession would still produce inflationary pressure on prices.

3.7 Although to avoid the rebalancing of the world economy now under way as the trading deficits of America and the UK start to unwind would merely result in a temporary boost followed by a more serious crisis as the underlying imbalances reasserted themselves. The key to a successful longer-term outcome to current problems is to ensure that the major debtor countries divert resources to export and investment and resist all immediate temptations to shore up consumer spending.

4 Commodities conundrum

4.1 One asset class that has attracted funds over recent months has been commodities. Two contrasting arguments in favour of this sector have been advanced - and both cannot be right in the longer term.

4.2 First, it is said that commodities are not correlated to the prices of shares or bonds. That has brought a flood of money, but in the absence of established futures markets for many commodities, that has taken the form of a variety of derivatives. The small scale of the potential of these to absorb large shifts from financial sectors has exaggerated the bubble effect.

4.3 Despite almost daily reports of some material or other reaching record prices, the level of commodity markets as a whole has only recently regained, in real terms, the earlier peaks of the early 1970s. Although food prices have been more buoyant than those of industrial materials, wheat for example, fell by 80 per cent between 1973 and 2005, and only broke into new high ground earlier this year. Similarly, although rice has spectacularly almost doubled in price in the last six weeks or so, it is still at less than a third of the level it reached, briefly, in the early `70s.

4.4 The second argument has been that, in spite of expected slowdown in the US and EU economies, continuing growth in China, India and other Asian countries will provide growing demand to support prices.

4.5 I discuss the global outlook is another section of these notes, but the immediate point is that, whichever way events turn out, it is inevitable that the correlation between commodity prices and the world economy will increase.

4.6 Bets on commodities are therefore dependent on the balance between growth and slowdown among the world's trading countries. They are also a bet on low stocks and slow expansion of capacity forcing up prices even in the face of declining activity.

4.7 The scale of the bet is demonstrated by the fact that `non-commercial' trading in commodities now accounts for more than half of all activity - led by hedge funds.

5 Patterns of downturn

5.1 With widespread downturns over the world economy now almost universally expected, there is what might be called an alphabetical discussion underway as to what shape it will take. Will it be a short and sharp V, a more prolonged U, a double dip and recovery in the form of a W, or an aborted rise shaped like an M?

5.2 Given the scale of the economic and financial adjustment needed to restore balance to the world economy, a long period of recovery must be expected. Something like an M immediately followed by an L may be the most likely, although the horizontal leg of the L could well be pointing upwards. But the important lesson is that the various shocks to the system have been so great that return to a new normality needs to be both steady and prolonged.

6 Regulation

6.1 Alan Greenspan recently said that:

"(financial) regulators, to be effective, have to be forward looking to anticipate the next financial misfunction. This has not proved feasible."

Like generals who, with luck, are prepared to fight the last war, regulators focus on the activities that precipitated the previous crisis.

6.2 Scepticism is therefore in order as to whether tighter controls or supervision of banks, hedge funds and their activities are the best way of trying to prevent the next implosion of markets.

6.3 Regulators are doomed always to be (at least) one step behind the ingenuity of those they attempt to monitor. For every new rule there is likely to be one or more loopholes. Precise definition of the amounts of capital to be held against specified liabilities simply led to the proliferation of off-balance sheet vehicles developed by the banks (and which would perhaps not have materialised otherwise). And setting limits on the volume of securities issued with a maturity of more than one year merely produced an explosion of those with a life of 364 days (in the case of the leap year 2008, 365 days.)

6.4 The phrase `too large to fail' has been widely heard in the land in recent months. In an extraordinary statement before leaders of the major banks met the Prime Minister in April, they informed Gordon Brown that `the authorities (i.e., the government) must intervene to boost liquidity and confidence in the financial system' as if any lack of such confidence had nothing whatever to do with the actions, and inactions, of the banks themselves.

6.5 Probably the most effective approach is to ensure that no financial institution can become too large to fail. In particular, traditional banking activities (lending money and providing advice) and new-style proprietary trading should be separated. Much of the latter is simply a zero-sum game, applying extravagant leverage to secure tiny margins on enormous turnovers - with the occasional, but inevitable, large destabilising loss interrupting a series of very small gains.

6.6 One of the extraordinary features of recent months has been the spectacle of leading investment banks commentating on the level of write-offs they expected their competitors to have to announce, and then disclosing that they themselves had large and unexpected losses.

6.7 The key fact about any financial collapse is that what was thought of as value is inevitably destroyed. In effect, money evaporates. Re-establishing stability is a larger and more difficult business than most people are prepared to recognise. It is common to describe each new boom or slump as `being different this time'. Usually this is just the usual factors in a new combination. But on this occasion there is a new element in that the process of rebuilding financial structures and disentangling risks will take years even though the worst of the panic may well be over.

6.8 And it will take a great deal of money to re-establish stability. A possible flood of rights issues by the banks lies ahead - as well as continuing attempts to tap the so-called sovereign funds for a recycling of the funds accumulated out of the trading deficits of western countries to bolster the capital structure of the banking system.

6.9 All this means that, whatever the trend of interest rates, the effective supply of finance for commerce and industry will be limited for the next two or three years. Fortunately, most companies are currently fairly flush with cash and have no immediate need to raise funds. But further ahead there is a big question-mark.

7 Investment sectors

a. Equities

7.1 Given the scale of disruption the financial system has experienced, the relative strength of equities in the US, UK and Europe is striking. London is well within 10 per cent of its 2007 high - and that after a shell-shocked performance by the banking sector. Compare that with a 40 per cent drop in Shanghai.

7.2 Another peculiar feature is the way in which the London and EU markets have been in virtual lock-step (see chart). Conventional wisdom has it that the US and British economies face similar problems, with the EU - apart from a potential problem in export markets from the strength of the Euro - has a more favourable outlook. Between 2003 and 2006 it was in fact London and Wall Street that were closely correlated, with the EU following a different path.

7.3 Given the universal expectation of a slowdown in the US (and this is one occasion on which a contrarian view seems unjustified) it must be anomalous for profit projections there to be running at +12% in 2008 and +16% for 2009. If and when these figures prove over-optimistic share prices would be very vulnerable.

7.4 One possible explanation is that markets are performing their claimed function of discounting the immediate future and looking beyond the dip to the subsequent heavens. It is always dangerous to disagree with the market, but on this occasion it could be that the peculiar features of the present disruption have not been fully taken into account - precisely because, as already discussed, it really is rather different this time.

b. Hedge funds

7.5 One clear lesson of the last few months is that it is a mistake to regard hedge funds as a single asset class. The variety of styles and strategies - and the resulting enormous divergence in outcomes - make this clear. Probably in no other forum of investment is selection so important, but the level of information available and problems of gaining effective access to the more successful ventures remain.

7.6 In the present context, hedge funds will probably find their access to cheap funding with which to increase new leverage harder to come by. That will limit both their potential for extraordinary profits and also the risk of spectacular failure when things go wrong. And how wrong things can go is illustrated by the failure of Carlyle Capital - with an impeccable background and connections - which leveraged each $1 of capital with $31 of debt and was unable to meet margin calls when what was basically still a sound portfolio with solid value could not raise the funds needed.

7.7 The basic strategy of making a series of small `odds-on' bets through arbitrage or derivatives ahead of running into a large loss-making operation must now be called in question - although the ingenuity of the operators will inevitably come up with some innovative variations.

c. Private equity

7.8 The changing investment climate has mixed implications for private equity. On the one hand leveraged finance will be less available (and probably more expensive). This is important because it is the availability of large amounts of debt, even more than its cost, which has underpinned the sector's performance in the past.

7.9 In 2006 Citibank produced a study demonstrating that leveraging the main stock market indices in the same proportions as used by private equity would have produced very similar returns for quoted companies. While it is of course true that in practice such operations may not be possible on a large scale, the real point is that, in the new technical jargon, what private equity firms are achieving is not alpha returns but simply the application of leverage to beta.

7.10 That does not necessarily matter. If a trick works it is not necessarily less successful because you find out how it is done.

7.11 The second impact on private equity is more promising. Clearly there are likely to be more potential candidates for treatment in uncertain conditions. And funding is committed, but not actually drawn down from subscribers, for several years ahead so finance - even though it may be less leveraged - is in place. Timescales may become extended and paybacks deferred and, in many cases, probably diminished. But positive outcomes should still predominate, and selective performance against other equity strategies should not fluctuate widely.

d. Property

7.12 Both property and property share prices have undergone the same kind of sharp decline that has marked previous endings of a period of boom and expansion. As regularly happens, banks have found themselves making the same kind of extravagant loans at bargain basement rates and with weak covenants that they solemnly swore to never make again, but have felt themselves compelled to follow their competitors rather than lose market share.

7.13 It remains to be seen how long the latest resolutions to be more responsible will last once recovery eventually sets in: it may well be that, helped by a prospective oversupply of new build, and perhaps more relevantly, by their much diminished firepower in future, the next boom will be less likely to get out of hand.

7.14 Perversely perhaps, this bolsters the case for retaining long-term property holdings. If there is any kind of long-term future for the economy, then property must at least hold its own as compared to other asset classes, even though relative prices will continue to diverge through booms and slumps.

7.15 I have almost reached the end of these notes without having mentioned housing. While it has hit all the headlines, I regard the housing crisis as more of a symptom of an underlying malfunctioning of the financial system than a cause of the collapse: a symptom that provided the trigger.

7.16 In itself, a drop in house prices is to be welcomed rather than deplored. Exaggerated prices do not reflect any growth in real wealth, but are in effect simply a transfer of future wealth to the present generation. This is clearly seen in the new phenomenon of the young not being able `to get a foot on the housing ladder' without help from relatives while, at the same time, more and more people have been planning to make use of the investment in their homes to provide them with a pension in their retirement - to the discomfort of children who then find their hopes of an inheritance disappointed.

7.17 Stability, or even a slow decline, in the real (after-inflation) cost of homes would be desirable: indeed, the housing `problem' cannot be solved by a series of subsidies and special schemes which only underpin current price levels. It is both ridiculous and unsustainable for house prices to rise permanently faster than GDP itself. Prices will fall only when supply is large enough to exceed demand and remains so for many years, together with stable mortgage conditions. That presents obvious problems, both for the building industry, and for a Government that presided over a long-term decline in house prices - losers are always more vocal than gainers even when the latter are the majority.

7.18 Ironically, we are now entering a period in which supply is likely to rise and house prices to fall. But this is more than offset by the growing difficulty of obtaining mortgage finance because of the continuing squeeze on credit. Even with the bailing out of the banks, this must be expected to continue for two to three years.

8 Portfolio issues

8.1 A number of suggestions have been made in recent weeks for possible additions to the number of asset classes to be covered by the fund, and other possible ways of protecting holdings against adverse price movements. These include: currency (both as a hedge and as a specific investment); structured instruments; so-called 130/30 funds, which allow an element of short-selling; and further splitting of the equity mandates to include a specialist `emerging markets' component.

8.2 As these issues appear more relevant to the next meeting of the Panel on 23 May, and as I am attending further meetings and seminars at which some of these will be discussed between now and then, it seem appropriate for me to make my comments on these matters in a report to that meeting.

Recommendations

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.