Meeting documents

Pension Fund Committee
Friday, 22 February 2002

PF220202-06E

Report by the Independent Financial Adviser

Global – The decline in the rate of economic growth has probably reached its low point in western economies, with the US scarcely touching recession (i.e. declining activity) and the UK and the Euro zone still showing modest growth. The US leading indicator has already turned up while the UK still has to do so.

The aggressive reduction in interest rates and the loosing of fiscal policy in the UK and US, together with more modest cuts in interest rates in the Euro zone, has ensured a recovery in economic growth, but the question remains as to how strong the recovery will be. There is a huge overhang of excess business investment that was made in the UK and US, and probably also in the Euro zone, since 1997 (see chart below) that has to be worked off. Much of it will be in information technology where obsolescence is much shorter.

The consumer is also over-extended, having built up a huge level of debt, particularly non-mortgage debt, since the mid 1990’s (see charts below).

With lower interest rates, servicing such debts is lower, while the asset side of personal balance sheets is helped by higher house and share prices, albeit the latter are now much lower, but the money still has to be repaid. So growth in consumer expenditure, which is around two thirds of GDP (gross domestic product) will probably moderate, especially if unemployment continues to rise. Thus, with the prospect of lower business investment and lower growth in consumer expenditure, the recovery in economic growth in western economies will probably be more modest.

UK – Expected to be least impacted by recessionary tendencies, with consensus economic growth forecast of 2.0% for 2002 compared with actual growth of 2.4% in 2001. Short term interest rates, with the Bank of England’s repo rate at 4%, are probably at the low for the cycle and are likely to be lifted to 4½%/5% in the second half of 2002.

USA – The consensus forecast for economic growth for 2002 is 1.0%, much the same as that achieved in 2001, but while growth was very low in the second half of 2001 and expected to be low in the first half of 2002, it should increase in the second half of the year. Short term interest rates (Fed. Funds rate), which are currently 1¾%, will probably be lifted to 2¼%/2¾% by the end of the year.

Euro zone – Economic growth, which was 1½% in 2001, is expected to be around the same level in 2002. Germany, which is the biggest economy, is forecast to grow by only 1%. The European Central Bank is expected to reduce short interest rates from the current 3¼% to 2½% by end 2002, as it reacts to the present inflation rate, which will probably continue to decline, rather than the forecast inflation rate in two years time, being the way the Bank of England operates.

Japan – The economy is forecast to slip further into recession with a decline in activity of 1% in 2002 compared with a decline of ¼% in 2001. Deflationary pressures are increasing and so the Bank of Japan is not only holding nominal interest rates at zero (which is 1½% real because of deflation), increasing money supply sharply and allowing the yen to weaken, but it is expected to try other tools, such as buying foreign bonds, to get the economy moving, while the government seems incapable of making any move to help the economy.

Currencies – while the £/$ rate has continued to trade in the $1.41 – 1.45 range and the euro in the €0.605 – 0.635 range against sterling, the Japanese yen has weakened from Yen 175 to £1 at end December to Yen 193. Medium term it is expected to weaken further, but in the short term it may consolidate around the present level. (See chart below). At the request of Schroders, the chairman of the Committee agreed that Schroders and also Deutsche Asset Management may hedge up to 100% of the Japanese portfolio they manage back into sterling. Schroders intend to use this authority, but Deutsche do not wish to hedge for the time being.

In western stock markets equities bounced sharply from the post 11 September low by around 20% by early December, since when equities have been treading water. At current levels equities, particularly in the USA, are pricing in a resumption of rapid economic growth and with it a sharp recovery in profits to levels seen in the latter half of the 1990’s, whereas that period was exceptional and as outlined above the recovery in growth is likely to be more modest on this occasion. Thus, although equity valuations may appear reasonable relative to bond yields, they are high absolutely against a background of more modest economic growth for this stage of the cycle. The UK equity market is currently trading on a price earnings ratio of 21 and a dividend yield of only 2.7%. Euro zone markets are on slightly lower valuations. In addition, the Enron debacle with its off-balance sheet subterfuges has made investors nervous of any company perceived to have a balance sheet potentially under pressure. Equity markets will probably later in the year begin to climb the ‘wall of worry’ which is usual at the beginning of a new bull market, but before then equities could experience a lot of volatility and test lower levels. During this period value stocks with a reasonable yield will probably continue to be favoured over growth stocks on a low yield. (Charts of the major equity markets and of UK growth versus value stocks are attached).

The Japanese equity market continues to sag as the Bank of Japan fails to act positively enough or in time to the growing deflationary pressures and the government talks about reform and restructuring, but fails to deliver. In the meantime the banks are effectively bankrupt and this acts as a dead weight on the economy.

Since end November bond markets have weakened with UK gilt 10 year yields rising ½% to nearly 5%, with similar moves in the US and Euro zone markets, as investors expected a resumption of rapid economic growth and a rise in inflation. Since neither of these factors are likely to occur in the short term, bond markets should rally and yields drop back towards previous levels.

A F BUSHELL
Independent Financial Adviser

February 2002