INVESTMENT THoughts

FINANCIAL REVIEW JULY 2008

Global equity markets have witnessed an exceptionally weak first half of the year – in the U.K., for example, the worst result for fourteen years. The cathartic moment of the Fed. orchestrated bail out of  Bear Stearns proved to be a false dawn and the downward slide resumed again in most markets from mid May. We are again haunted by the spectre of inflation: the Economist commodity price index has risen by 31.6% over the past year with food prices rising by 60.2%. Crude oil has risen by over 100%. Given that in energy importing countries the origin of the inflation is external, the policy response is difficult because the inflation itself is withdrawing purchasing power at precisely the time when economies are depressed by the shortage of credit. But central bankers are terrified that rising prices will translate into increased wage settlements and recreate the cost-push stagflation of the 1970’s.

In US Dollar terms, equities performed as follows between December 31st 2007 and June 25th 2008:

One notes that Japan, as so often, has been a good diversifier; the Chinese bubble has deflated without the collateral damage which was widely anticipated; Russia has proved a haven from sub-prime and Brazil, enjoying a treble bonanza of hard and soft commodities and oil, is one of the few emerging markets, along to a lesser extent, with Mexico and Argentina, to have decoupled.

USA

Thanks to fiscal stimulus and negative real interest rates (Fed. Funds at 2% compare with the CPI at 4.2%), the USA may narrowly have avoided a recession, though 2008 and 2009 are destined to be years of low growth. A survey by the University of Michigan points to inflation rising to 5% over the next year, suggesting that the Fed. would dearly love to increase rates as soon as the economy shows sustained recovery and, as importantly, when the risk diminishes of a major failure in the financial sector. A Goldman Sachs study has pointed to further significant write-downs in the second half. With weak consumer demand earnings prospects are poor. A best guess might be that for all of these reasons the Fed. will hold rates for the balance of the year, a view fortified by the fact that we are in an election year and traditionally the central bank is accommodative. For what it is worth (not much) an historic PE of 15.8 and dividend yield of 2.5% look fair value. As we discuss in the Thought of the Week of 30.6.08, on reversion to mean principles, the USA may be a dull market for several years (and most of the developed world historically has been closely correlated with it.)

Europe

The European Central Bank has the luxury of only having to concern itself with prices regardless of the impact on the economy. With Euro area growth overall at 2.2% in the last quarter, the ECB may feel emboldened to tackle inflation running at 3.7% and rising and indeed m. Trichet has hinted at raising interest rates from their present 4% level (which indeed he did after this paper was written). The German, French and Dutch economies look in reasonable shape while the PIGS of Portugal, Ireland, Greece and Spain (with Italy as an honorary member) are exhibiting sluggish growth and nagging inflation with budget deficits that leave little room for manoeuvre. Membership of the Euro precludes the traditional remedy of devaluation, suggesting that the only policy option will be slower growth and a downward adjustment in the real level of prices (the only variable left) and this is certainly what we are witnessing with Irish and Spanish housing.

No commentary on Europe in the second quarter of 2008 can omit a reference to the Irish referendum result. The Commission is in denial and one can be confident that the path to federalism will never again be subjected to democratic scrutiny – it is too risky as the Danes, Dutch, French and Irish (but, alas, not the British, who have not had the chance) have shown, whenever asked if a European super-state is supported. There is still a small chance that the “Treaty” will be overruled by the Czech courts and that their President will not sign. The Polish President is also unlikely to sign. All this matters because the EU seems determined to institutionalize European non-competitiveness with the emerging world and enter into suicidal geo-political experiments, such as energy sufficiency on Russia (see Thought of the Week 23.6.08).

UK

Unfortunately, our Prime Minister and former Chancellor has not, contrary to his many assertions, abolished the economic cycle. With a budget deficit after a decade of profligacy of 3.2% of GDP, the UK is in poor shape to react to higher energy and raw material costs. Amongst major nations only Hungary, Egypt and Pakistan are more dependent on deficit financing. The Governor of the Bank of England has effectively said that high inflation will have to be tolerated while extraneous factors work their way through the system; monetary severity would have too dire effect on the real economy. There is, however, a real risk that inflation is taking hold. The Shell tanker drivers received a 14% pay increase over two years and we have learnt that the cost of maintaining the Royal Family over the past year rose by 5.5% despite a lack of essential maintenance to the Royal palaces. (Hasley regards the £40 million bill for the latter as very good value for money but it illustrates the strains suffered by ordinary households and the resultant lack of purchasing power as well as the fundamental inaccuracy of both the CPI and the RPI as true measures of prices.)

Japan

The best news is that whereas a year ago Japanese prices were static, they were rising at an annual rate of 0.8% in April and with GDP rising at an annual rate of  4% in the last quarter, it is just possible that the Japanese are beginning to spend as well as save. Japan appears to have been comparatively immune from the credit crunch and bank balance sheets were reformed during the 1990’s. Corporate governance, payout ratios, share buybacks and foreign acquisitions are all on the agenda. Hasley is glad to have its modest Japanese exposure.

Emerging Markets

We wrote about Russia in the Thought of the Week (23.6.08), to show that it is awash with liquidity, the populace is entirely happy with its government and valuation levels are reasonable. Investment in infrastructure and the growth of the banking market should produce copious investment opportunities. China and India continue to grow at rates approaching double digits and their stock markets have fallen to levels, which look more reasonable on conventional valuation bases. Brazil looks remarkably stable in terms of all of growth, inflation and valuation.

Fixed Income

The message here is short duration, long credit. With inflation threatening, there can be little case for holding medium or long dated bond in any developed currency. Compare 10 year government bond yields with consensus inflation rates for 2009:

These markets show some meagre real returns, if one believes the stated inflation numbers.

There are, however, some fixed income strategies which are appealing. Senior floating rate syndicated credits, which had been trading at par until summer 2007, are now available in the very low nineties with no duration risk and the prospect of offering double digit returns even if there are some defaults. Low currency emerging market debt has also been offering double digit returns; note the much improved financial position of the South East Asian economies and of Brazil (which is now talking of creating a $250 billion sovereign wealth fund!) and the fact that a government can always issue debt in its own currency. There are also tactical opportunities such as those exploited in a multiplicity of small trades at JPM Highgrove. Another rewarding sector has been Vekseli, Russian collateralized promissory notes, which have returned almost twenty per cent over the past year.

But the sector must be watched, because if the outcome of the present turmoil were recession and a collapse of inflation (not a forecast!), present yields would be interesting.

Gold

A theme of this review has been the resurgence of inflation  and gold is a classic investment policy response policy. For much of the quarter gold’s performance was disappointing and indeed Indian gold purchases for jewellery declined in the face of higher prices. Another explanation may be that there was a major forced seller of gold (a Swiss bank?). But in the final days of the quarter the gold price has risen rapidly to $925 per ounce and, if it is to recapture its traditional correlation with the oil price, there is a lot of catching up to do. Gold shares are cheap as compared with bullion and remain our preferred way to play the sector.

Natural Resources and Energy

The over-riding thesis is that economies which had remained dormant for decades (not just the BRICs but their many smaller neighbours as well plus OPEC) are booming and consuming as never before. According to World Bank data no less than 84 countries recorded real GDP growth of over 4% in 2007.  A huge increase in demand for hard commodities continues, as evidenced by last week’s massive increase in the iron ore price charged by RTZ to the steel producers. We do not see new sources of production coming on stream. Hasley continues to play this sector through natural resource equities, purchased via such old favourites as JP Morgan Natural Resources.

The same theme is true of agricultural commodities, suffering from production cut-backs after the over supply of the 1990s, misguided policies such as set -aside, protectionism by NAFTA and the CAP and the intrusions of bio-fuel. In the case of agriculture, supply could eventually rise to meet demand, but either way we believe that agricultural equities will be a beneficiary via our holdings of the Eclectica Agriculture Fund. With oil at over $140 per barrel we have no view as to its short term prospects, though on a five year view see little reason why it should be lower, especially with Chinese car ownership by 2025 expected to equal total global car sales in 2007. Let us hope that the experiments in Silicon Valley where genetically modified bugs eat any vegetable matter and excrete something similar to crude oil prove successful on an industrial scale.

Property

As we have previously discussed, UK commercial property will in due course again become attractive. Yields are rising and in some cases exceed financing costs. But with further evidence of the weakness of the UK economy emerging by the day, there is no hurry to invest. However, the prospect of funds moving back from a bid to an offer basis and of the discounts on the property companies narrowing will help to underwrite those who are too early.

Private Equity

Despite the shortage of credit and deteriorating Western economies, there are interesting opportunities for private equity,  particularly because secondary transactions are available at favourable prices and also have the merit of having passed the bottom of the J curve and entering the most profitable phase of their development. Our chosen vehicle, the Pantheon Investment Trust, is well placed to benefit from this opportunity and also trades at a discount.

Alternatives

A reader of the financial press would be forgiven for thinking that anything to do with hedge funds is in free fall. The investment trusts and quoted hedge funds either used by Hasley (or on their approved list) have had the following NAV performance over the past 12 months:

Of course, there is some equity correlation but this is a much more favourable result than experienced with so called blue chip long-only equity exposure.

The on-shore funds such as BlackRock UK Alpha and Epic Life Settlements have also continued to achieve excellent risk-adjusted returns. We consider these “alternatives” as the engine room of our portfolios.

Conclusion

The economic outlook is exceptionally depressing but all but the most myopic investor must have spotted this and, therefore, presumably much of the bad news is discounted. Even the Israeli-Iranian tension (see Thought of the Week 7.7.08) is presumably in the price. The Hasley portfolios are intensely diversified at the macro and micro level and should be as well equipped as any to weather the storm.                     

INVESTMENT THOUGHTS JUNE 2008

As we approach the middle of the year, it appears that monetary and fiscal stimulus in the USA, coupled with a strong export sector, will mean that any recession will have been mild. The time will then come to dealing with resurgent inflation with the University of Michigan predicting 5% over the next year and 3.5% over the next five years. In the UK the slowdown is less advanced than in the USA and the Governor of the Bank of England must be poised to write several inflationary apologies to the Chancellor during the course of the summer. But in both economies the inflation is derived from increases in energy and agricultural and soft commodity prices and it is not clear that monetary tightening would be an effective policy response to these external shocks.

In these circumstances, it is not surprising that bond yields have been rising. Five year US Treasuries have gone through 4% and the long bond now yields 4.71%. Similarly in the UK five and ten year gilts both yield 5%. But it is as interesting that the previously wafer- thin spreads are widening: in US dollars General Motors (B+) at 7.46% to 2031; in Sterling Boots (BBB) 11.36% to 2009 and Goldman Sachs (AA-)

at 7.92% to 2017. The widening of yield spreads has extended less to emerging markets with Ecuador (CCC), for example, in US dollars yielding 4.74% to 2030, suggesting that the markets believe in the improved balance of payments and reserve figures for these economies.

As we enter June, Royal Bank of Scotland successfully completed the rights issue that was never to be. But Bradford and Bingley was forced to take the unprecedented step of improving the terms of its own rights issue following a profits warning and at the insistence of its underwriters, ironically UBS and Citigroup. If the JP Morgan acquisition turns out to be the cathartic moment of the credit crunch, these events show that we will continue to witness some aftershocks.

The economic case for the emerging markets remains robust. They account for 14% of the MSCI World Index, yet 27% of the GDP of the countries covered by that index.

Hasley regularly reminds its investors that the economic centre of gravity of the world is moving to the emerging markets and particularly the East. Chinese car ownership is now forecast at 40 million cars for 2025, compared with global sales last year of 43 million. Against such a background we also see little medium term scope for energy prices to weaken.

Investment Thoughts May 2008

What a difference a month and a half makes. March 17th marked the low for most stock markets (as always closely correlated) with the cathartic moment of the Bear Sterns bail-out. Gold has retreated to $856, oil remains buoyant at $118, wheat is off its highs by 25%, rice is hitting all time highs and the US dollar shows some signs of stabilizing.

In its Financial Stability Report, the Bank of England is signalling that the sub-prime crisis is over. It estimates sub-prime exposure at $900billion; this should be discounted by 19% for loan losses yet the market is pricing in a 42% write off. Sub-prime represents, therefore, a $200billion+ profit opportunity. The Bank would be happy with this outcome, since it has been a reluctant rate-cutter and its injection of £50billion of liquidity into the markets came late. The Federal Reserve Board has continued to stimulate with 3.25% of cuts in the Fed. Funds rate to 2%, the lowest level since December 2004. The move was accompanied by a further injection of $76billion liquidity injection by the Fed., ECB and the Swiss National Bank with our own Bank a notable absentee. It seems, however, that reports of the death of the US economy may have been exaggerated with data looking stronger, the Fed. hinting that rate cutting is not indefinite and the $170 billion fiscal stimulus flowing through to consumers – who spent no less than 25% of the 2001 rebate at Walmart. George Soros is retracting warnings of a Depression and Warren Buffett is co-financing the Mars bid for Wrigley. There is also the conundrum that despite the explosive growth in credit, the present inflationary threat is demand driven through energy and hard and soft commodities and, therefore, less susceptible to control through tight monetary policies.

We note that S&P now rates Brazil as investment grade; money is flowing into money market and bond funds and out of equity funds; we see US index linked treasuries yielding less than prospective inflation rates; the Shanghai market has now corrected by a staggering 50% without the world imploding; Japan has broken out of its three down-cycle against the MSCI World Index and banks everywhere are repairing their balance sheets with rights issues.

The situation looks particularly kaleidoscopic and Hasley draws two conclusions. First, remain diversified: we are glad that in our Multi-Strategy Fund we maintained our long only equity exposure during the dog days of March – not through any predictive skills but because we did not know. Secondly, one should not be tempted to extrapolate short term market movements and should have the courage to stick with themes. We do not see where energy and commodity supply is going to meet demand and nor do we believe that in a world where intellectual property and finance are mobile the high paying developed economies can outperform their emerging rivals, hence exposure to the commodities super-cycle and emerging markets.  

Financial Review April 2008

It is now 15 months since the first US sub-prime write-downs, which accelerated into the nascent credit crunch of August 2008. The affair has been like a slow motion film of a car crash. By September Northern Rock needed Bank of England support; some of the German Landesbanken succumbed; we have witnessed increasing write-downs from Merrill Lynch, Citigroup, Lehman and Morgan Stanley; public and private sector institutions from the Arctic Circle to Australia have suffered losses; UBS has been humiliated by the sheer magnitude of its slowly revealed losses and Bear Stearns has been “rescued” by JP Morgan with the support of the Federal Reserve Board, doubtless remembering Bear’s reluctance to participate in the 1998 rescue package of Long Term Capital Markets, despite being its clearing agent.

At first there was a view that this was a purely financial affair which did not affect the real economy, yet progressively liquidity dried up, as financial institutions sold off their highest grade credits; inter-bank rates failed to reflect official central bank lending rates and there was an eventual realisation that developed world economic growth could no longer be sustained by the plentiful credit of the previous decades.

In a letter to shareholders the Chief Executive of JPMorgan has written, “we must be prepared for a severe economic downturn”, a view shared by Ben Bernanke at the Fed., who having been “behind the curve” during the autumn entered into a furious bout of rate cutting and other liquidity creating measures during the spring to forestall recession and the collapse of pivotal financial institutions. It was during the first quarter that stock markets woke up to these problems and gave investors their worst first quarter return since 2002.

Some of the key market indices performed as follows in local currency terms:

% change between 2.4.08 and 31.12.07

Amongst others, there are three interesting features to this list. First, the Chinese bubble appears to be deflating and not bursting and, unlike in 2007, the rest of the world is not unduly alarmed. Secondly, hedge funds have largely done their job: few are completely market neutral but they have been successful volatility dampeners. But thirdly and most importantly the stock markets have joined the credit markets in their concerns about the world economy.

Finally we also note that the Credit Suisse risk appetite measure over some sixty equity and fixed interest markets, which fluctuates between euphoria and panic, is now into panic territory and at its lowest level since 2003. Historically, it has been a good contrary indicator.

USA

US interest rates have been cut by 200 basis points since the beginning of the year and by 300 basis points over the past twelve months. Fiscal stimulus of +/- $1000 should begin to impact on every American family from the middle of the year. The consensus view seems to be that the US will experience (is experiencing?) a shallow recession from which it will emerge during the second half of the year; the Primary Dealer Credit Facility will strengthen the investment banks (though at the cost of additional regulation); an end will come to the credit crunch as banks refinance themselves (e.g. UBS for the second time) and that the inflationary price (Economist consensus 3.3% for 2008) for reflation is tolerable.

Hasley does not make short or medium term equity market predictions but we would comment that valuations are not stretched even assuming downward earnings revisions (which could be significant particularly for financials); the negative period for the market is comparatively mature by historical standards and when upturns occur, they can be very rapid. We therefore have some modest US equity exposure through a130/30 fund with additional exposure through, for example, our hard and soft commodity equity funds.

We see little case for holding US Treasuries, where 10 year Treasuries give a negligible real rate of return. However, there is a case for monitoring lower grade credits where yield spreads of up to 1000 basis points surely discount risks of delinquency.

As previously noted, the US dollar’s weakness has created a US export boom which is successfully diminishing the current account deficit. But with two thirds of the world’s foreign currency reserves still held sometimes reluctantly in US dollars, we think it safer to remain agnostic about the prospects for the world’s major currency.

Europe

Economic divergence is materialising within the Euro zone, which will severely test the single monetary policy of the Euro. Northern European countries (especially Germany and the Netherlands) are looking robust, whereas the Mediterranean bloc is facing flagging growth, poor current accounts and budgetary indiscipline. German industrial production is growing at 7% p.a. and Germany is forecast to enjoy a budget surplus in 2008 of 0.8% of GDP. The comparable numbers for Italy, for example, are 0.5% and -2.8%. Note also the dire numbers for some European peripheral nations, e.g. Hungary with a current account deficit of 5.9% of GDP and a budget deficit of 4.1%. A devaluing Forint may look an appealing alternative to the Euro.

The principal cloud on the Euro zone horizon is inflation running at 3.3%, where the strong Euro has not been sufficient to shield it from global rising energy and commodity prices and where even the Germans, after a period of discipline to make themselves uber-competitive within the Euro, have accepted some high public sector wage settlements. Mr Trichet would doubtless like to hold interest rates at 4% but the plight of his southern neighbours and the possibility of more financial institutions in difficulty may make this increasingly difficult. The tensions within the Eurozone are illustrated by the 50 basis point yield differential between 10 year Greek or Italian and German government bonds.  If a cut in Euro interest rates were to weaken the Euro (far from certain because of the capital account pressures on the dollar) this might ease Mr Sarkozy’s threats of a trade war with the USA.

Our European exposure is based largely on our managers’ selection of individually attractive companies on a bottom-up basis and as a diversifier.

Britain

Contrary to the Chancellor’s budget speech, the UK is not well placed to withstand the global credit crunch. The budget deficit already stands at 3.2% of GDP, giving minimal scope for Keynesian stimulus now that it is required.  Indeed the recent budget actually increased taxation, not least for the lowest paid, who no longer enjoy the special 10% tax band. The current account deficit amounts to 4.5% of GDP. The banks are restricting credit and very slow growth or a recession look probable. Housing will at best be weak limiting scope for the equity withdrawal that has stimulated the economy in recent years.

Interest rates have reluctantly been reduced this year by 25 basis points to 5.25% and further reductions appear likely. The reappointed Bank Governor may focus less on “moral hazard” and inflationary risks now that the Bank’s role in Bank supervision is receiving greater attention.

For those who follow PEs and dividend yields, valuations do not look demanding.  The FT tells us that the UK market is on a trailing PE of 10.8 and dividend yield of 4.3%, which even allowing for dividend cuts and falling earnings is fair value. Furthermore, the bear market is quite mature and savage: smaller companies have fallen by over 27% over the past twelve months. As always, thank heavens, less than half the exposure of the UK market is to the US economy.

By the standards of most UK private client portfolios our UK equity exposure is light, though not so as a proportion of the MSCI world index. We see little appeal in bond yields compared with prospective inflation rates. Sterling is extremely expensive on a purchasing power parity basis and a short Sterling play might be appealing, if only it was clear what to buy.

Japan

It is extraordinary that the world’s second largest economy and the holder of its largest foreign currency reserves should remain an enigma. Part of the clue is Japan’s ageing population: some of the least favourable demographics in the world. On a GDP per capita basis Japan consistently outperforms the USA. No one blames an elderly person for dipping into capital, which is what high savings Japan is doing. Interest rates of 0.75% compared with a 2008 forecast inflation rate of 0.7% will do little to support the Yen and both the domestic and offshore yen carry trades will become more attractive as the Yen appreciates.

Despite all this, the Japanese market is a very useful diversifier and, for example, the Topix was down only 5.5% in local currency terms during Q1 2008. We have an excellent Japanese manager whose equity selection should reduce overall portfolio volatility and in good times contribute to alpha. Incidentally, Japan trades at below all of its five to twenty five year moving averages (which should encourage those who believe in reversion to mean) and is half as expensive as the USA or UK in terms of price/sales, which is one of the valuation measures which is the least prone to misinterpretation.

Emerging Markets

The “Financial Times” of April 1st contained a useful article on emerging markets by Mark Mobius, the President of Templeton Emerging Markets. He points out that with globalisation decoupling is impossible. But this year the developed world (USA, UK, Europe, Japan, Australia and New Zealand) will grow at some 2%, whereas emerging markets are growing at some 7%, fuelled largely by domestic demand. This year the consumption baton is held by countries such as China, India, Brazil, Russia, Turkey, United Arab Emirates, Egypt, Mexico, Poland and many others. The highest growth rates are in the world’s two most populous countries. Some of the resultant demand should be reflected in the developed world.

But as so often, growth is accompanied by inflation, which in the BRICs is now running respectively at 4.6%, 12.7%, 7.6% and 8.7%, which means that the era of cheap imported manufactured goods to moderate developed world inflation is over.

Commodities

Readers will be aware that Hasley subscribes to the concept of the commodities super cycle. As the US enters recession there has naturally been some weakening of demand and prices have become more volatile. Furthermore, whenever rays of hope appear in the credit crisis, energy, precious metal and hard commodity prices have retreated. But a Lehman study has indicated that the most substantial price rises have been for non-exchange traded metals such as molybdenum and cobalt, in which there is no speculative interest. At Hasley we prefer to look through these unpredictable secondary movements at the bull market induced by new demand referred to in the section above.

The bull market for agricultural commodities remains white hot, with rice rising in price by a staggering 50% over the past fortnight. Soy, corn and wheat are also appreciating, contributing to an already inflationary world. Hasley’s investment in the Eclectica Fund gives exposure to equities in areas such as fertilizers, irrigation and farm machinery, which should benefit from efforts to increase agricultural production. (Really nervous investors may want to consider exposure to global index linked investments, currently offering about LIBOR + 100 b.p. but which would provide a safe haven if inflation takes off.)

Absolute Return/Hedge Funds of Funds

 Very few hedge funds are truly market neutral and the sector is bound to suffer in a period such as Q1 2008, though not nearly as much as long-only equities. In such periods it is normal for discounts to emerge in investment trusts of hedge funds, which creates a buying opportunity. Some of the discounts have occurred because of a lack of liquidity at the market makers and it is anticipated that the boards of companies of trusts with discounts may buy in stock. Non-equity related strategies such as those of Dexion Trading and FRM Credit Alpha have fared well.

The onshore absolute return funds have for the most part achieved their objectives,which are frequently to leave exposure to alpha while removing beta by such techniques as pair trades or simply by shorting the market with futures. Our exposure to life policies has also been useful. JPM Cautious and BlackRock UK Absolute Alpha have been particularly successful; the Morley Tactical Asset Allocator which targets the highest returns in the sector, though at the price of higher volatility, has not over the past six months matched its historic performance and MPC Strategic Reserve, which employs proprietary trading techniques, has returned somewhat over cash. The EAF Life Settlement Fund, which has a zero correlation with equities, has been a particularly successful and consistent performer.

Property

The indicator that the fifteen year bull market in UK commercial property was ending came at the end of 2006 when rental yields dropped below financing costs. (See “Thought of the Week” 7.4.08) Not long afterwards investors were horrified to see their bricks and mortar funds move from an offer to a bid basis and then be closed. Rental yields have now at least risen through MLR, which is absolutely not a purchasing signal, but an indication that a correction is taking place. Property should thus go onto a watch list for the second half of 2008 with the knowledge that if timing is not perfect the swing back from bid to offer will be rewarding.

Geo-political considerations

Even if the credit crunch ultimately works its way through the system and growth eventually picks up in the developed world, there will be other causes for concern: 

• the rise in agricultural commodity prices will lead to hunger and civil unrest; 

• there will be US/Russian tensions over issues such as the expansion of NATO into Georgia and the Ukraine and the deployment of anti-missile missiles in Eastern Europe; 

• the Beijing Olympics will be marred by civil liberties protests; 

• the next US President will either be  a free spending Democrat or a Republican sympathetic to militaristic foreign adventures;

• and, above all, those developments which are not anticipated.

Conclusion

In an uncertain world Hasley strives to mix investments which are likely to appreciate over the medium term with assets with lower levels of volatility or low correlations with equities to smooth portfolio performance. This approach is adopted in the S&W Hasley Multi-Strategy Fund.

Those investors seeking a more cautious approach will use the S&W Hasley Diversifier Fund, invested predominantly in assets with a zero or low correlation to equities or absolute return vehicles. This fund will experience some slight volatility on a month to month basis but on a yearly basis is designed to give superior returns to fixed income.

In the autumn Hasley will launch a “best ideas”, which will target potentially higher performing assets, which may also be more volatile.

INVESTMENT THOUGHTS MARCH 2008

Warren Buffett has declared that the US is already in recession and certainly weak home sales, declining durable goods orders and rising initial jobless claims substantiate the fear. Mr Bernanke’s statements indicate that his absolute priority is to re-stimulate the economy and a further 50 or 75 basis point cut in Fed. Funds is widely anticipated for the March FOMC meeting. The price will be inflation and index linked Treasuries are now predicting a 3% inflation rate.

The US dollar has been a casualty of the rate cutting in the face of an obdurate European Central Bank for whom the priority has been the suppression of inflation and which has, therefore, eschewed rate cuts. At the time of writing the US dollar is trading at nearly 1.54 against the Euro; gold is at $984 within striking distance of the $1000 level (though on an inflation-adjusted basis it would need to exceed $2000 to create an all-time high) and oil is trading at above $100 per barrel. Meanwhile the commodities boom remains white hot with, for example, President Gloria Arroyo of the Philippines making a personal appeal to the Vietnamese President Nguyen Tan Dung to guarantee rice supplies.

The Russian equity market (to which Hasley has exposure via the Jupiter New Europe SICAV) appreciated 8% during February celebrating that country’s favourable valuations and the transfer of power to Dmitry Medvedev, who represents to Russians a continuation of the successful Putin era.

In the UK we have received the astonishing news that the nationalized Northern Rock is to be treated as “off balance sheet” so as to preserve the Government’s cherished borrowing ratios and we await Alistair Darling’s budget to see whether his damaging plans for the taxation of non- domiciliaries and reform of CGT really are going to be confirmed in the Finance Act. What wanton damage to London as a financial centre. But his real problem will be the parlous state of the public finances.

Meanwhile, the absolute return vehicles which feature in Hasley portfolios continue to produce positive returns, providing an element of stability in these times which are returning to their usual level of volatility after the 2003-2007 paradigm.

Investment Thoughts February 2008

January 2008 witnessed the worst ever start to the year for equity markets as investors fretted about the risk of the US moving into recession. The Administration has approved a US$150 billion fiscal stimulus which should be made available during the course of the summer. Meanwhile, after months of being criticized for being “behind the curve” the Fed. Chairman Ben Bernanke has presided over an unprecedented 1.25% cut in Fed. Funds to 3% with the promise of more to come. America’s problems remain largely housing-related with exports, business investment and, surprisingly, consumer spending quite buoyant. The malaise spread to all markets with the MSCI world index falling by 5.6% in sterling terms.

The sell-off was aggravated by the secretive closure of positions entered into by Jerome Kerviel on behalf of Societe Generale, which cost the bank some £3.7billion. Indeed some sources have argued that this selling was a factor in the Fed’s first 0.75% Rate cut.

Meanwhile OPEC, the BRICs and other developing countries are providing an engine for global growth with the International Monetary Fund forecasting the world economy to grow by 4.1% in 2008 following 4.9% in 2007 – hardly a global recession.

February began in a very different manner to January. Microsoft’s massive US$44 billion bid for Yahoo was a reminder that if banks have suffered liquidity shortages, corporate finances are strong. Chinalco’s US$14 billion dawn raid in conjunction with Alcoa, which netted a 12% stake in Rio was significant for two reasons. It underlines the case for the commodities supercycle as China tries to secure the raw materials on which its 10% GDP growth rate depends. It also shows the growing interventionism of the sovereign wealth funds as China Investment Corporation makes available a further US$120 billion for the acquisition of the whole of Rio, if required.

Neither the UK nor Euroland will be able to respond as vigorously as the US to their own slowing economies, with the UK facing a growing budget deficit and Europe suffering from accelerating inflation.

 FINANCIAL REVIEW JANUARY 2008

Retrospective on 2007
Equity markets performed as follows during 2007 in local currency terms:

Despite a series of credit related panics inducing falls of some 10% and subsequent recoveries (with the VIX rising from 11.6% to 23.2%) 2007 was a remarkably stable year. The features were a lacklustre performance in developed markets; another disappointing year in Japan; a stellar performance in emerging markets and very strong performance for mining and precious metals. The local currency returns understate the returns in Sterling, which was unchanged for the year against the US dollar but which fell, for example, by 10% against the Euro. Also noteworthy was the reversal of the UK commercial property market, which through bricks and mortar funds and property companies have come to play such an important part in UK private client portfolios. World bonds appreciated by 12.3% during the year, perhaps less on account of any inherent attractions in terms of a comparison of yields and prospective inflation than as a safe haven as volatility increased. While The HFRX hedge fund index rose by 4.3%, Hasley’s own experience (GAM, Stenham, Jupiter Absolute, KGR, Invesco Perpetual etc.) was into double digits.

Currencies
Hasley is sufficiently cautious about currency forecasting that investment strategies are not predicated on particular currency views. Nevertheless, it is important to rehearse the issues, if only to try to avoid risks. In the USA exports are booming and the current account (though still at 5.5% of 2007 GDP) is correcting. Hasley believes, however, that the US dollar’s problems are now more of a capital account nature with too may unwilling holders of dollars, which still account for 60% of foreign currency reserves. Falling US interest rates will offer little support. In the Euro area, where inflation stands at 3.1% and rising Mr Trichet appears to be achieving the balancing act of making credit both plentiful and comparatively expensive, which presumably will provide support for the Euro. But note that the yield on 30 year Italian government bonds of 4.90% compares with 4.49% on comparable German bonds, suggesting that some Euros are more equal than others. In theory the Yen should be a strong currency with the lack of interest rate support mitigated by a current account surplus of almost Chinese proportions. The overseas element of the Yen carry may unwind as investors are reluctant to invest in risky assets but the equally important domestic element will remain intact as Japanese savers seek better yields than those available at home. Taking a view on the Yen is particularly perilous. The outlook does not look good for sterling, which is extremely expensive on a purchasing power parity basis (with the situation getting worse as inflation hugely exceeds the official 2.1% CPI) and the Bank’s Monetary Policy Committee now apparently set on an interest rate cutting cycle. The Far Eastern currencies will probably continue to appreciate (e.g. Renminbi up 6.7% and Singapore dollar up 5.9% during 2007).

Fixed Income
Bond markets offer us the following trade-off between yield and inflation:

In probability bonds appear unappealing but they are worth monitoring in case the outcome in any of the major economies becomes a deflationary recession or even depression – not a central forecast but a real possibility.

Equity Markets
Clients of Hasley will be aware of our profound scepticism about any claims to be able to predict the progress of equity markets over the medium term. The world appears to be faced by the prospect of stagflation and tight credit in the wake of the sub-prime crisis and its wider knock-on effect in terms of credit generally. On the other hand, all this is known; equity market valuations are not demanding (if you believe in P/E ratios); central banks are supplying liquidity and the sovereign funds are present as massive new potential equity investors. Looking at the evidence, Hasley is predisposed to be cautious but equity markets have a wonderful ability to confound the commentators. The markets are quite capable of looking at a recovery more than a year away, with benign monetary conditions in the meantime, on the principle that “it is better to travel hopefully than to arrive”. In such an uncertain world diversification is the only prudent course.

In the USA December’s weak employment numbers suggest that the economy is teetering on the brink of recession. Interest rates are trending downwards and at about 15x historic earnings equities are not necessarily expensive. Even banks are finding fresh equity from sovereign investors. Surely also it is not over-optimistic to hope that the year end reporting season will reveal the full extent ($400 billion?) of sub-prime exposure. Nevertheless, we see no compelling case for a significant exposure to US equities.

Likewise in the UK at 11.8 times historic earnings equities are statistically in a buying range, though yields are below gilt yields. Monetary policy will surely be more accommodative but will ultimately be constrained by the strong inflationary pressures in almost all branches of the economy (see “Thought of the Week” 7.1.08). Furthermore, the UK’s budget deficit now amounts to 3.1% of GDP meaning that thanks to the Government’s profligacy there is little scope for deficit financing to rekindle the economy. This horrible news is visible and should be discounted but again a significant weighting to UK equities is not obviously appealing.

Similarly, the situation in Europe does not look enticing. Unlike, the USA and UK there is little scope for monetary stimulus with the European Central Bank acting as the Bundesbank reincarnate. Stimulus, which might be appropriate for the Netherlands and Germany, will not be suitable for peripheral Europe, particularly the Club Med. with its budget deficits and higher inflation rates.

Japan now allegedly trades on 17.5x historic earnings, meaning that at last sanity has returned to valuations. The economy is managing to grow at 1.9% p.a.. There are signs that attention is at last being paid to shareholders – payout ratios are increasing and some aggressive takeovers are tolerated. But as with its currency, Japan’s equity market is notoriously unpredictable – except in its role as a very effective low-correlated diversifier.

Chinese equity valuations are as preposterous as those of Japan in the late 1980’s. They are a bubble waiting to burst but there is no reason why the bubble should not swell to twice its present size before this occurs. One imagines that the Chinese authorities will want to maintain the status quo at least until the showpiece Olympic Games in the summer when the world will marvel at the Chinese miracle. Hasley has never advocated exposure to these super-expensive domestic Chinese “A” shares. But here lies the dilemma. We structurally favour South East Asia where we anticipate long term above average GDP and corporate profits growth and where over the predictable long term we expect equity out-performance. When the Chinese earthquake occurs these markets will suffer but the patient investor should not be distracted.

There are two other emerging markets we favour. Russia is statistically cheap; its economy consists of much more than energy and natural resources and commentators seem obsessed by the political situation which in China, for example, they overlook.

Brazil has also undergone a remarkable transformation with strong reserves and a modernizing economy only now entering into areas such as housing finance. It would be affected by a US downturn but one should look through it.

We also remain structurally positive on energy, hard and soft commodities and precious metals – themes which have been widely discussed in various Hasley papers.

The thesis is that there is huge new demand from the BRICs and other newly emergent nations which is not being met by new supply. China adds generating capacity each year equivalent to the entire UK grid, And Chinese per capita oil demand is still at the level of the USA in 1904. We do not deny that these sectors would be affected by a US recession but the evidence suggests that we are in a commodities super-cycle.

Property
Perversely, UK commercial property may be an attractive area in the second half of 2008. Yields are rising, interest rates are falling, the sector is entirely unfashionable and there are forced sellers. Discounts on property companies are as much as 50%. Not to buy yet, but an opportunity.

Alternative Investments
Just as there has been a dispersion of returns within private equity making it essential to have exposure to the best managers, so in the fund of hedge fund universe manager selection is important. At Hasley we have identified a series of managers, whose methodology we respect, and which represent the “engine rooms” of our portfolios. These tend to be multi-strategy funds/investment trusts where the managers are selected on a bottom up basis and with an overview that there is no excessive exposure to an underlying style. Some of the funds/trusts we use have a regional specialization (e.g. KGR for Far East) or a sector specialization (e.g. FRM Credit Alpha for credit). We also use several on-shore managers operating under UCITS III (e.g. Merrill Lynch UK Absolute Alpha) who have quasi market-neutral strategies and have been very effective. Another very useful fund, which has no equity correlation, invests in US life policies, diversified by life company and illness and with life expectancy verified by two doctors, hedged back into sterling. The fund has produced very reliable absolute returns.

These “alternative investments” in the experience of Hasley have offered particularly favourable volatility/reward characteristics as compared with the long only equity, fixed income and property investments still favoured by some managers.

Conclusion
Hasley does not subscribe to the crystal ball school of investment where it claims to be more prescient than the market and its peers. Our balanced portfolios seek to offer long term equity rewards, for those who can tolerate short to medium term unpredictability and volatility, with exposure also to alternative investments likely to provide more reliable returns on an absolute return basis.

December 2007

The MSCI World Index dropped by 4% in November, its worst monthly performance since December 2002, although its year to date performance is some 9.5%. In the last week of the month the mood was very different with the S&P 500 up by 2.8% and (which will come as no surprise to students of correlation in financial markets) the FTSE 100 up by 2.7%.

As we have discussed in previous papers, the central tension remains between inflation and recession. The worst outcome is that in America credit ceases on account of sub-prime fears and drives the economy into recession (depression?); in Europe recession also follows on account of the overvalued Euro and rising inflation and the developing world finds that it has not decoupled from its developed world markets. Policy-makers have now begun to focus on this risk rather on punishing imprudent bankers for their moral hazard. A little inflation later is better than recession now. And so, after a remarkably short space of time, the tone has changed. with Donald Kohn, the Fed Vice Chairman making emollient remarks about monetary easing and Mervyn King at the Bank of England doing the same (though later reiterating his inflationary worries). But if action is more important than words all of the Fed, B of E and ECB are injecting liquidity into the money markets and hence last week’s rally in equities. It remains to be seen, however, whether the inter-bank market itself is ready to ease.

Two remarkable pieces of refinancing were announced last week. Citigroup, mauled by its sub-prime problems, sold a 4.9% stake in itself for $7.5 billion at an eye-watering effective rate of 11%. Alliance & Leicester has received a syndicated credit via Credit Suisse for £4 billion at an undisclosed cost. At a price credit is still there.

The sub-prime crisis continues with $40 billion of write-offs announced to date with losses occurring even in four towns in the Norwegian Arctic.

The other notable news of the month has been the various bids for Northern Rock, all of which leave massive amounts of Bank of England lending in place. The mismanagement of this sorry affair continues and this free-market writer reflects that surely the best course is to take the Rock into temporary public ownership and turn it into the country’s best mortgage bank, rather than let the tax-payer provide the debt for a private equity deal. (Incidentally we have as much sympathy for those who have become shareholders since the crisis broke as we do for householders who bought their homes near Heathrow in the last fifty years.)

We are thus at a very finely balanced turning point between an economic downturn or a reflated recovery with all the attendant inflationary risks. Long term investors should not worry about equities but they will be comforted in the short to medium term by holding a substantial proportion of low and non-correlated and absolute return assets.

November 2007

Having regained their equilibrium equity markets experienced a new bout of vertigo as we enter November. On October 31st the federal funds rate was reduced, as anticipated, to 4.5% but with a dissenting voice from the Governor of the Kansas City Fed. and a stern warning that “the upside risks to inflation roughly balance the downside risks to growth.” Nevertheless Q3 GDP growth came through at 3.9% suggesting that the problems in the housing market are not yet affecting the wider economy. Nevertheless there is a malaise in the US economy as Warren Buffett expresses concerns about the dollar and prefers South East Asian investment. The trigger has been yet again the sub-prime crisis and its impact on financial institutions such as Citibank, Morgan Stanley and Merrill Lynch and the fear that the economy could be driven into recession by a shortage of credit. We doubt this and feel that for all the protestations the economy remains underwritten by the Bernanke put. There is also a fear of inflation – potatoes are the only item on the Thanksgiving shopping list where there have not been severe price increases.

The dollar now trades at Euro 1.45 and at an amazing $2.09 against the pound, a twenty five year low. Gold has gone through $800 an ounce and the oil price could test $100 per barrel. Just as in the 1970’s Sterling could not find equilibrium until the end of its role as a reserve currency, so the dollar will remain weak until there are no more unwilling holders of dollars. But the weakening dollar is already resulting in a surge of US exports and a reduction of the current account deficit. Hasley sees little reason currently to hold dollars or invest in Wall Street.

For those who look at such indicators markets are not expensive in PE terms. The UK market trades on a forward PE of 11.8 compared with 23.5 in July 2000. The S&P is on 17.3 compared with 31.6 in March 2000. Even Japan now trades at 15.1 x forward earnings compared with 75 x in 1994. And emerging markets, which have now become an investment haven away from the sub-prime problems of the developed world, are on a forward PE of 13.1 compared with 39 in 1999.

Hasley’s response to these conditions has been to emphasize emerging market, South East Asian and hard and soft commodities exposure within equity portfolios. But crucially it maintains a high proportion of low and non-correlated assets such as funds of hedge funds and absolute return vehicles to protect portfolios at a time when volatility is increasing.

October 2007

As we enter the fourth quarter, the August credit crisis seems a distant memory with Mr Bernanke having exercised his put (correctly in our view). Others would say that he has entered a Mephistophelian pact with inflation for which the US economy will pay dearly later. Equity returns for the year look respectable, especially in US dollar terms:

We believe that Mr Bernanke’s half point cut in the Fed. Funds rate was the correct course because a recession would be catastrophic. Essentially he has bought time. Note that on the occasion of the rate cut both long bond yields and the gold price rose, indicating that markets could see the inflationary risk. Given that the US economy is growing at about 2% p.a., below its long term trend and that serious problems persist throughout the housing market, inflation is probably more of a problem for 2009. A weakening dollar, rising energy and commodity prices (soft as well as hard) and more expensive Chinese imports will make the next upturn challenging for the Fed.

The data above shows just how weak the dollar has been and indeed last week it fell to an all time low against the Euro and is even trading at parity with the Canadian dollar. A somewhat weak dollar is helpful and indeed has been aiding US exports but with central banks diversifying their holdings of reserve currencies there is a risk that it could turn into a rout. If that were the case, we would witness a reversal of Fed. policy and recession might be considered a price worth paying.

SEPTEMBER 2007

As we enter September most stock markets have regained their equilibrium. The FTSE is at a three week high and is in positive territory for the year. The sub-prime induced sell-off seems to have caused a bout of vertigo similar to that previous February/March sell off induced by temporary weakness on Chinese stock markets; Alan Greenspan’s injudicious comments about the growth prospects for the US economy and, even then, the $11 billion write down of the HSBC subprime loan book. The Federal Reserve’s handling of the crisis has, to date, been exemplary sailing between the Scylla of excessive monetary easing (to create a “Bernanke put”) and the Charybdis of letting bank illiquidity, falling house prices and a weak stock market create a recession. At the Jackson Hole symposium hosted by the Reserve Bank of Kansas City and attended by the Fed, BoJ, BofE and ECB, Mr Bernanke said the Fed. would “act as needed” to contain the “adverse effects that may arise from disruption in markets.” A cut in the Fed Funds rate is now widely anticipated for the scheduled meeting on September 18th. Having supplied early liquidity to the Eurozone, Mr Trichet still seems tempted to raise the repo rate from 4 to 4 ¼%, despite the fact that so much of the subprime fall-out has been in Europe and particularly with the Landesbanken. While the Bank of England has given liquidity to the market and lent to Barclays at the discount window to compensate for computer settlement failures, it has allowed interbank rates significantly to exceed its own base rate, thus risking illiquidity and disruption of the money markets.

Reflecting on the crisis, the rating agencies are bound to come under greater scrutiny both in terms of their competence and whether they suffer a conflict of interest. Equally, the Achilles heel of the structured investment vehicles at the heart of the crisis is that they have borrowed short to lend long, a strategy which has always required particular care. And, whether it is the BNP-Paribas and MacQuarie funds, Sachsen Bank or even Bank of China, which has revealed a $9.6 billion subprime exposure, investors seem to have been overtrustful of doubtful assets. Finally, private equity may no longer be there to provide a floor for quoted equity.

Meanwhile, much of the “real economy” appears to be functioning normally. As Irwin Stelzer reported, 94% of Americans are either satisfied or very satisfied with the lives they lead and the proportion is rising. Significant real GDP growth is anticipated for the approaching fifty economies covered in the “Economist” poll for 2007 and 2008.

Doubtless there will be more subprime upsets as unpredictably there are further defaults on the underlying mortgages. But markets are now ready to live with this unkown with the reassurance that there would be a monetary policy response. More worrying would be the next unpredictable accident – a serious disruption to Chinese economics or politics or a deterioration of relations with Iran. Hence the desirability of continuing to be diversified between low and non-correlated assets.

August 2007

In last month’s Investment Thoughts we said that if there was a cloud on the horizon, it was to do with credit. The cloud has turned out to be a fully fledged storm. Readers will be aware that problems commenced in the US sub-prime mortgage market, where first banks were forced to write down their mortgage portfolios, to be rapidly followed by hedge funds with exposure to the sector. Contagion has indeed occurred with the difficulties extending as far, for example, as IKB Deutsche Industriebank, a German small business lender; a Macquarie mutual fund in Australia and two American mortgage insurers, not to mention a series of hedge funds. The alarm has spread to equities with American Home Mortgage Investment, a major lender, announcing it could no longer fund home loans and its share price dropping by 90%. And this at a time when Countrywide, America’s second largest homebuilder, saying that it was experiencing the worst market conditions since the Great depression. The market’s nervousness is illustrated by the ratings of credit default swaps for Bear Sterns, Goldman Sachs, Merrill Lynch and Morgan Stanley which have fallen to “junk” status despite their official investment grade ratings. Global equity markets have fallen on fears that the sub-prime problems could be the harbinger of a more generalized credit crunch.

On the other hand many hedge funds have profited enormously from the sub-prime problems. And Goldman Sachs is creating a fund specifically to invest in distressed credit products. The global economy remains strong and in the USA real GDP growth at 3.4% remains strong. As yet, liquidity remains plentiful and a JP Morgan study estimates that global liquidity is still growing at an annualized 15%. Equity valuations do not look demanding, e.g. a forward P/E of 12 for European equities and equity earnings yields are at the top of their range as compared with bond yields. Corporate balance sheets are strong and equity investors worldwide are benefiting from unprecedented returns of capital through dividends, share repurchases and cash takeovers at a time when equity markets are shrinking through deequitization and are 7-8% cheaper than they were barely ten days ago. It is also hard to believe that central banks will stand idly by as the world moves into recession. The interest cycle in the USA may have peaked and it is notable that two internal members of the Bank of England’s Monetary Policy Committee voted against the last rise in base rate.

In the unpredictable world of financial market’s Hasley’s response is that the only prudent policy is to be well diversified into low and non-correlated asset classes prior to the kind of shakeout we have witnessed over the last ten days.

July 2007

The first half of 2007 has been a rewarding period for equity investors. Measured in local currency terms until July 4th returns have been as follows:

Hedge funds(HFRX) did what they were meant to at +6.4% for the period, while world bonds only managed +0.1%.

If there is a particular cloud on the horizon, it must lie with credit. On the one hand central banks have been tightening monetary policy to ensure a more “normal” positive relationship between interest rates and inflation. This is probably at the end of the cycle in the United States, approaching (hopefully) the end of the cycle in the United Kingdom and with some way to go for the hawkish European central Bank. At the same time the problems affecting the sub-prime US residential mortgage market claimed more casualties in the form of two Bear Stearns hedge funds. This could lead to contagion into equity markets as a threat emerges that the valuation of collateralized debt obligations (CDOs) will have to be revised downwards, threatening the earnings of financial institutions, which are so important a component of the S&P 500. Many commentators already anticipate a reduction in the growth rate of Q2 earnings to the lowest level since 2002. Furthermore, we have seen bond issues being cancelled and credit spreads widening; if it becomes more difficult for private equity to finance their transactions, an important floor for equity markets will be removed. Some widening of the VIX (volatility index) points to somewhat more nervous conditions in financial markets.

A theme which Hasley continues to research and which will soon be reflected in client portfolios relates rising soft commodity prices. The causes include increased demand from the BR