Global equities rose again in October, with the MSCI World Index advancing 2.5% in US dollar terms. The US market lagged, with the S&P Index rising 1.5%, but Europe ex UK rose 4.3% while UK, Japan and emerging markets each rose approximately in line with the World Index. The weakness of the US dollar against all currencies (by 1.3% against sterling, by 2.4% against the euro and by 3.8% against the yen) accounted for much of the gain in markets, rather than underlying market strength.
10 year US government bonds yields fell back below 4% during the month, and ended it at 4.09%. The Citigroup Global Bond Index rose 3% in the month, with Europe, the UK and Japan outperforming the US. The Euro rose 2.2% against the US Dollar in the month and 2.1% in the quarter, while the Yen and Sterling fell 1% and 0.2% respectively. Consequently, our Benchmark Index rose 2.7% in the month.
Our tactical and strategic stance on bond markets continues to be negative. Although the US economy may have slowed down a little, this is largely due to the rise in the oil price, which is now retreating again. Economic growth at a moderate pace is likely to continue. The maturity of the bond portfolio continues to be short, to reduce exposure to loss of capital from a rise in yields.
We had been prepared for a setback in equity markets in September/October, and the rise in the price of oil to a peak of over USD55 did hold the market back. However, the equity market proved resilient, and so we were not surprised to see it move ahead as soon as the oil price started to retreat.
We always regarded the US presidential election as neutral for markets. Equity valuations remain attractive, both in absolute returns and, relative to bonds and bond yields, have remained below our expectations. Although the growth in earnings has slowed, there are signs that it has stabilised at satisfactory levels. Consequently, we are optimistic about the outlook.

Global equities continued to move higher in September, as a result of which the MSCI World Index rose 1.9% in US Dollar terms, but was still down 0.9% in the quarter. 10 year US government bonds yields fell to a low of 4%, but have since risen to 4.17%, compared to 4.55% at 30 th June. The Citigroup Global Bond Index rose 1.4%. in the month and 3.3% in the quarter, with Europe outperforming and Japan underperforming in both periods. The Euro rose 2.2% against the US Dollar in the month and 2.1% in the quarter, while the yen and sterling fell 1% and 0.2% respectively. Consequently, our Benchmark index rose 1.6% in the month and 1.2% in the quarter.

Our tactical and strategic stance on bond markets continues to be negative, and bond yields have drifted up. Although the US economy may have slowed down a little, growth continues at a moderate pace and it is premature to assume that interest rates will peak rather than pause at 2%. The maturity of the bond portfolio is short, to reduce exposure to loss of capital from a rise in yields but generate income which is still well above that from cash.

The Japanese equity market performed poorly in both the month and the quarter (down 2.5% and 7.9% respectively) but emerging markets were very strong (up 5.8% and 8.3%). The US was weak, despite a rally in September (up 1.1% but down 1.9% in the quarter), but Europe was marginally ahead in the quarter after a strong September, and the UK rose 3.3% and 3.1% respectively.

We have been wary of a market setback in the seasonally weak period of September/October, possibly driven by higher oil prices, but the resilience of the equity market is impressive and we have turned more positive. Equity valuations are attractive, both in absolute returns and relative to bonds and would remain so even if US Treasury yields rose to 5%. We expect earnings growth to continue in 2005, albeit at a slower pace, and this will further improve valuations.

The second quarter of 2004 has been characterised by a severe sell off in bond markets following an extended period of recovery from the oversold levels of last August. In the 'eye of the storm', US 10 year Treasury yields touched 4.87%, over 100 basis points above their March end levels before closing the quarter at 4.59%. Equity markets have benefited by the prospect of an earlier rise in interest rates in the USA, sharply higher oil prices, concerns about a 'hard landing' in China and the discrediting of George Bush's Iraq policy as the situation there deteriorated. Japanese, Asian and emerging market equities suffered as rising risk aversion caused sell offs in previously 'hot' areas. However, the markets of the USA and Europe ended the quarter higher and the MSCI World Index posted a gain of 1% in US Dollar terms. Currencies were little changed on the quarter with the exception of the Yen which rallied by 4.7% against the US Dollar.

Our fixed income stance remained extremely cautious going into the sell off in line with our primary view that bond yields remain below fair value and that the cyclical risks remain on the downside. However, given the severity of the move towards the end of the quarter, duration was increased on a tactical basis. From a currency perspective we remained positioned for a period of US Dollar recovery within a continuing bear market for that currency. We took advantage of equity market weakness to add to overall equity exposure in general and to build a strategically overweight exposure to Japanese equities.

Equities remain in a consolidation pattern with volatility and volume remaining at low levels.

The 'bears' expect this ultimately to be resolved to the downside as the recovery ebbs and the realities of excessive debt accumulation re-assert themselves, whereas the bulls maintain that the balance of probabilities suggest that a sustainable and globally synchronised recovery is in the process of unfolding. In the meantime, multiples have continued to unwind as earnings growth has continued to surprise consensus expectations. As a result of bottom up stock selection the fund is overweight Asian equities. After the recent sell off, speculative positions have been cut, valuations in that region are again attractive and earnings growth continues to be strong.

Global equity, bond and currency markets continued to be volatile in May, focussing on the twin concerns of rising interest rates and rising oil prices. We continue to "look through" current volatility and are focussing on the three processes we use to add value in this fund: strategic asset allocation, bottom-up stock selection and disciplined bond and currency positioning.

It is in the nature of "strategic" views to change only infrequently, and our cautious stance remains unchanged. From current valuation levels it is as clear as anything can be in financial markets, that future returns from both equities and bonds will be low. The current abnormally low rate of interest in the US (and elsewhere to a lesser extent) is encouraging investors to seek the higher yields available in riskier assets. As these assets are bought, so their yields (a proxy for their future returns) fall. In the short run this has generated high levels of abnormal return from just about every asset class whether equity, bond or real estate. But you can't have your cake and eat it: abnormally high returns today driven by unsustainably low interest rates lead to abnormally low returns tomorrow. The US Federal Reserve has successfully engineered what has been a very mild recession by historic standards.

However, this recession is at the cost of inflating a second and much wider asset bubble, the bursting of which, when and if it happens, is likely to have more serious consequences than the bursting of the more narrowly based TMT bubble of 1999-2000.

Strong economic data and new highs in the price of oil have led investors to bring forward their expectations for a rise in US interest rates. This in turn has triggered a sell-off in all financial markets, bond and equity, as leverage (borrowing to speculate) is unwound. The more obvious leveraged plays - Asian and Japanese equities and emerging market bonds - have been hurt the most. On the other side of the coin, the US Dollar has risen while gold has fallen sharply.

It is in the nature of "strategic" views to change only infrequently, and our cautious stance remains unchanged. From current valuation levels it is as clear as anything can be in financial markets, that future returns from both equities and bonds will be low. The current abnormally low rate of interest in the US (and elsewhere to a lesser extent) is encouraging investors to seek the higher yields available in riskier assets. As these assets are bought, so their yields (a proxy for their future returns) fall. In the short run this has generated high levels of abnormal return from just about every asset class whether equity, bond or real estate. But you can't have your cake and eat it: abnormally high returns today driven by unsustainably low interest rates lead to abnormally low returns tomorrow. The US Federal Reserve has successfully engineered what has been a very mild recession by historic standards.

However, this recession is at the cost of inflating a second and much wider asset bubble, the bursting of which, when and if it happens, is likely to have more serious consequences than the bursting of the more narrowly based TMT bubble of 1999-2000.

We remain cautiously positioned with respect to global equities and global bonds, rather favouring non-US Dollar cash.

Global equity markets continued to trade higher through the fourth quarter, supported by ongoing positive economic releases. Further significant US Dollar weakness boosted global equity returns in US Dollar terms. Global bonds spent most of the quarter trading in a relatively narrow range. Strong economic data tended to put upward pressure on yields (downward pressure on bond prices) while the monetary authorities, the US Federal Reserve especially, continued to stress their lack of haste to raise interest rates from their current abnormally low level, providing some support for bond prices at the lower end of their trading range.

As you are aware, we have maintained a cautious medium term view of the global and especially the US economy, while explicitly recognising that there would certainly be periods of apparent economic strength or recovery, before the combined weight of the what we have called the "post-bubble imbalances" asserted itself again. Over the past quarter, just as through most of 2003 as a whole, those imbalances - most clearly seen in the extraordinary scale of the ballooning US current account deficit which is the counterpart of the still ballooning levels of debt in the US economy - have continued to deteriorate. While saving can effectively be described as "postponed consumption", so dis-saving (debt accumulation) can just as effectively be described as consumption brought forward. The same dollar cannot be consumed twice.

At some stage debt will have to be repaid and the rate of saving will have to rise: this is as true as night follows day. As true, but not as easy to time! However, with substantially less fiscal and monetary stimulus being applied through 2004 compared to the massive stimuli applied through 2003, the coming year will prove "crunch time" for the global economy. In the meantime, equity valuations remain historically very high and, notably, investor expectations as measured by leading surveys of investor sentiment are at levels of optimism only matched by those observed at the end of 1999! Under these circumstances we believe that 2004 is likely to prove a more difficult year for equity markets than 2003.