Investment outlook for the balance of 2005

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1 Investment outlook for the balance of 2005 There has been no significant change in our economic outlook over the last three months. Going overweight in Japanese and Asia Pacific ex Japan equities, taking on a slight underweight position in UK equities and shifting the emphasis amongst our bond underweights were the most notable changes to our tactical asset allocation s global scenarios focus on the impact of interest rate and economic rebalancing Central View: Normalisation 40 Inflation Trouble 30 Cautious Scenario 20 Global Rebalancing 10 US short rates normalising quicker than market expectations. Two more ¼ hikes necessary. Inflation above trend at 3 but declining in 06. Slowing productivity, US GDP from 3.4 to 2.5 in 06. Margins normalise, but currency trends equalise profits in US/UK/EU at 8 05 & Dollar falls against Asia, but Euro and vulnerable to swings between dollar and valuation forces. Economics favour equities over bonds. Equities up in H2 but held back by higher bond yields. Euro equities under perform US. Asia still best markets. US economy full capacity/ employment Wages push US inflation over 3 US short rates reach 5 in 06 Bond rout, 6. $ firms, equities weak Recent M&A boom short-lived. Investment below normal cycle Japan policy error, UK/EU GDP/profits growth slump UK/EU bond markets strong, equities struggle Credit expansion in EU/Japan succeeds EU joins UK/US housing bubble. Japanese reflation Perfect for global cycle: bonds flat, equities strong, euro/yen up Page 1

2 Morley asset allocation: 12/08/05 EQUITIES 6-9 month view: NEUTRAL Long-term return: 7½-8 BONDS 6-9 month view: UNDERWEIGH T Long-term return: 4½-5 PROPERTY 6-9 month view: NEUTRAL 05 Economic fundamentals supportive Valuations good vs. bonds, fair vs. trend Global support from pensions, UK over-owned Main risk is bond market decline Cycle unhelpful, inflation risks Pensions & Asia buying props Value very poor, no risk Good demand, premia value modest, u/weight for 06 EQUITIES Short-term stance BONDS Short-term stance Growth OK, as market recently re-discovered US and UK short rates disappoint market UK/Euro/Asia markets overbought in very short run Will buy into setback Beginning to see sense but more to go. Reduce underweight at 4.4 UK yield, 4.5 in US, 3.5 EU PROPERTY Short-term stance UK Europe US Japan Asia Pacific ex Emerging Japan Markets Gilts Overseas Credit Slight underweight, prefer big cap companies Underweight, favour Germany /Sweden over France/Italy Slight overweight, unloved but limited long-term value Overweight, improving domestic demand Overweight, best region (unhedged), China bubble Neutral. Should do okay, but Asian markets are preferred Underweight, prefer indexlinked to conventionals Very underweight, US bonds still vulnerable Investment grade better value than gilts, high yield expensive H returns fine, risk-reward fades into European property better value. CASH 6-9 month view: OVERWEIGHT Reasonable value, expect 4½ trend rate. CASH Short-term stance UK interest rates have already dropped ¼ in H2 but not the start of a trend. Favour Asian currencies which should appreciate against US dollar Page 2

3 UK equity market outlook UK equities have performed encouragingly over 2005 so far, primarily as a result of a wave of merger and acquisition activity. The increasing trend for companies to return cash to shareholders (via share buy backs and/or increased dividend payments) has also supported the market. While merger and acquisition activity is likely to continue in the short term (as private equity and venture capital funds remain awash with cash), the strong performance of the UK in recent months means that valuations look less attractive relative to other developed world markets such as the US or Japan. As a result, a moderately underweight position is currently targeted in UK equities. On a longer-term view, our valuation models suggest that UK equities should be able to deliver total returns of around 7.5 to 8.0 per annum, with dividend yield forming the main component of this figure. The surging oil price has provided a major boost to the UK market this year, however recent index changes (namely Royal Dutch Shell taking up its full weighting) means that oil & gas alone now accounts for over 17 of the UK market. As a result, the UK could be vulnerable to any medium-term softening of the oil price. The slow down of consumption/housing in the UK and the likely hit to consumer sentiment stemming from the recent London bombings prompted the MPC to shave 25 basis points off base rates, taking them to 4.5, mainly as an insurance measure. No aggressive rate cutting cycle is anticipated from the MPC. Large caps should outperform expensive small and mid caps while exports should strengthen. Page 3

4 UK economic forecasts as at 12/08/05. MFM GDP growth Base rates (year end) Consensus GDP growth Base rates (year end) Source: Morley Fund Management; Consensus figures are from Consensus Forecasts July Survey. Page 4

5 Overseas equity market outlook The expectation that US equities could rally further in the second half of the year underpins our overweight position in this asset class. US equities produced strong sterling returns in July. European equity markets have thus far performed strongly in 2005, with merger and acquisition activity and the stronger dollar driving growth. However, given unattractive valuations and largely uninspiring domestic economic conditions, balanced funds continue to target an underweight position in European equities. In valuation terms, Japan continues to look cheap relative to other markets, and has scope to catch up in the second half of 2005, hence our overweight position in the asset class. Exports, particularly to the US, are likely to be crucial to the performance of Japanese equities over the balance of the year. Asia Pacific ex Japan equity markets continued to rally in July, outperforming global equity markets. The outlook for the asset class appears soft, as the US slowdown and high oil prices have led to growth slowing in every country across the Asia Pacific region, with the exception of China. Nevertheless, valuations continue to compare favourably with those of western equity markets and returns should outstrip those of developed markets in 2005, although they are likely to be lower than they were last year. We have a modest overweight position in this asset class. Page 5

6 Overseas economic forecasts as at 12/08/05. US Eurozone MFM GDP growth Fed Funds (year end) MFM GDP growth ECB Repo (year end) Consensus GDP growth Fed Funds (year end) Consensus GDP growth ECB Repo (year end) Japan MFM GDP growth 3-month interbank rates (year end) Consensus GDP growth 3-month interbank rates (year end) Source: Morley Fund Management; Consensus figures are from Consensus Forecasts July Survey. Page 6

7 Gilt market outlook We think the gilt market is overbought at current levels and that investors are being too optimistic in assuming we will see a sustained period of monetary loosening. Although the UK bond market is expensive, significant asset shifts should provide support. 10-year gilts are expected to move towards 5. Taking a longer-term perspective, the Bank of England will want to ensure that it is providing sufficient stimulus to the economy to help it weather the expected rise in taxes next April. Given the small size of the gilt market in relation to the eurozone bond market, low eurozone bond yields should continue to exert downward pressure on gilt yields. Page 7

8 Forecast table: UK GDP GDP (quarterly change) Composition of growth consumption govt. spend investment stocks* exports imports other GDP private final public total stocks* net trade* 2003 q q q q q q q q q q q q q q q q q q q q q q q q q q q q q q q q * contribution to GDP growth Source: Morley Fund Management. Page 8

9 Overseas bond market outlook In the US, we expect to see interest rates rise to 4 by the year-end, as the US economy continues to grow above its trend rate and slowing labour productivity increases inflationary pressure. The Federal Reserve s measured approach to tightening monetary policy should exert upward pressure on Treasury yields throughout 2005, simultaneously dragging bond prices down. We are comfortable with the underweight position we hold in this asset class. With inflationary pressure rising from a combination of high oil prices, money supply growth and overheating housing markets in several countries, we expect the ECB to raise interest rates by 0.25 by the end of 2005, a move that should trigger higher bond yields. The loosening of the Stability and Growth Pact is likely to cause spreads between Germany and peripheral countries such as Italy and Greece to widen, as fears over future fiscal indiscipline grow. We see Japan continuing to move out of its deflationary cycle, as rising domestic demand leads to higher consumption and gains in employment. Page 9

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