Following three cuts in UK interest rates early in 2008, the Bank of England has now held them at 5.00% for five months running. Faced with rising inflation, this is probably not a surprise; while the prospect of slowing economic growth proved more pressing up until April, the latest inflation reports halted any thoughts of further downward movements. However, in light of recent news from the banking and insurance markets, where will the Bank’s Monetary Policy Committee (MPC) go next?

All three original rate cuts were implemented to help stave off economic slowdown - and many commentators had believed that further cuts would be necessary. However, the Consumer Price Index went over 3% for the first time in May and is now 4.7%, more than double the Bank’s target of 2%. It would appear that the scope for further cuts is severely limited.

However, that was before the perhaps unprecedented events we have seen over recent days. First Lehman Brothers filed for bankruptcy, then Merrill Lynch gave itself up in a take over to Bank of America. With Bear Stearns, this means three of the top five investment banks have now disappeared as a result of the credit crunch.

This news was quickly followed by a US Federal Reserve bail out of AIG, once the world’s largest insurance company, with an US$85 billion loan. AIG had insured, amongst other things, sub-prime mortgage lending and then used the profits to take even greater positions in that market, gearing up their exposure to the problems. The fallout then directly hit the UK, and under fire bank HBOS began merger talks with Lloyds TSB.

Meanwhile, whilst these events took all the headlines, the oil price was falling back and the dollar was recovering. UK GDP officially hit zero and now many commentators believe we are actually in recession. Coupled with rising unemployment figures and the potential for further increases as the job losses due to these mergers and failures feed through, it is bad news for our already fragile economy.

Consequently, there are growing calls for the Bank of England to change its stance and start reconsidering rate cuts. It is possible that such a move may now be more imminent than we might have previously thought.

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As equity and bond markets have become increasingly unpredictable, the thought of a fund that might deliver positive returns year after year has become even more appealing. The result is a new breed of ‘absolute return’ funds which, while they do not come with any guarantees, set out to beat the returns on cash AND avoid the fluctuations of the markets.

This new generation of funds is quite sophisticated and uses a variety of different techniques to achieve their goals. One of the most popular is the multi-asset strategy which blends traditional asset classes like equities and bonds with alternative asset classes such as hedge funds, gold or private equity. In times like now, when the mainstream asset classes are volatile or losing money, these managers at least have the opportunity to invest in assets delivering positive returns.

The other popular technique is to invest purely in equities, but to ’short’ some of those stocks as well – ie: borrow more stock from someone else, sell it and then buy it back at a later date. There is a small price for borrowing but if the market moves down, the manager buys back the stock at a lower price than it was sold, thereby making a profit in the turnover. This acts like an insurance policy, counteracting some of the loss made on the actual fund holdings which will have fallen over the same period.

When you short stock you own, this is called ‘hedging’, allowing a manager to make some money whichever way the market goes – profiting on their actual holdings if it moves up and profiting on the borrowed stocks if it moves down. Overall, if the market moves up you profit a little less because of the payment made to borrow stock and the increment in cost to buy it back. However, if it moves down, you lose out less because the insurance policy of shorting balances some of it out. The result is smoother returns with lower peaks but also fewer shocks.

This approach looks set to be the focus for imminent new launches in the absolute return arena, but it is no panacea. Shorting stock is a particular skill and in the wrong hands can perform just as badly as, and sometimes even worse than, a traditional equity investment. So, despite the label ‘Absolute’, always remember that this is an objective rather than a guarantee. These funds are not suitable if you cannot take the risk of losing capital. However, managed well, they could represent an exciting alternative to traditional equity and bond funds for investors seeking smoother market returns.

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Equity markets appeared to finally find the floor in mid-July, after sliding since May, and have delivered steady, if lumpy, growth since. Within the sectors, leadership switched with a rebound in financials and deterioration in the price of energy and material stocks.

The fall in energy and material stocks came on the back of some of the biggest monthly declines in commodities for decades. Oil peaked at around $145 a barrel in mid-July before sliding to $124 at the end of the month and down again to $111 a barrel at the end of August. This eased global inflation pressures, but spelt bad news for oil shares. Gold also took a tumble as the dollar strengthened. The price peaked at around US$1,000 in March and peaked again just below that point in July. However, August saw it fall back through $800 as speculators left the market.

Financials improved on the back of stronger performance from key US banks such as JP Morgan and State Street. Investors are increasingly aware that banks which weather the sub-prime storm may emerge with increased market share as their weaker competitors fall by the wayside.

Developed markets were given a boost towards the end of the month with a surprise jump in US GDP figures. The US economy rebounded with a 3.3% rise in the second quarter, buoyed by strong exports and weak imports. The Department of Commerce had originally predicted a rise of just 1.9%. The figures came in spite of persistent rumours of a large scale banking failure and ongoing problems at mortgage groups Fannie Mae and Freddie Mac.

However, just as escaping recession seemed a real possibility for the US, the economic picture in the UK and Eurozone weakened. The UK showed no growth between April and June, ending 15 years of consecutive rises in GDP (source: Office of National Statistics). The Eurozone contracted by 0.2%, the first time since its creation in 1999. The largest economies of France and Germany both saw falls in GDP, yet high Eurozone inflation persisted; making interest rate cuts from the ECB increasingly unlikely.

Emerging markets compounded their dismal start to the year. The MSCI China Index dipped over the month, despite the Olympics and the MSCI Brazil Index followed suit. The only bright spot was India, which rebounded a little in spite of weaker growth data. Even though commodity prices are lower, inflation continues to exert pressure in these markets.

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The UK economy ground to a halt during the three-month period to June 2008, according to August figures from the Office for National Statistics (ONS). This was the UK economy’s weakest performance since 1992, when the country experienced its last recession. The news follows months of speculation that the UK’s economy is about to hit the skids, and is likely to add to pressure on the Bank of England (BoE) to cut interest rates in order to help shore up the UK’s faltering economy.

According to the ONS, activity in every major area of the UK economy appears to have slowed down during the second quarter of 2008. Manufacturing activity contracted by 0.8%, exports fell by 0.5% and activity in the construction industry declined. The services sector – a major contributor to the UK’s economy – grew slightly during the quarter, but its rise of only 0.2% was far from encouraging. Meanwhile, business investment has fallen sharply as companies tighten their belts in preparation for tough times ahead. Elsewhere, household spending fell by 0.1%, compared with growth of 1.1% in the first three months of the year. House prices continue to fall, and business and consumer confidence show no sign of improving.

The UK economy is feeling the pinch amid soaring food and energy prices and the ongoing effects of the global credit crunch. With inflation (measured by the Consumer Price Index) running at a hefty 4.4%, the UK could be facing an unappealing environment of “stagflation”, in which prices continue to rise while economic growth stagnates. The news that the economy has stalled has added to existing speculation that the UK is already in recession; technically, a recession takes place when the economy has contracted for two consecutive quarters; nevertheless, the official figures are based on historical data, and reflect what has already happened rather than what is happening right now.

On 25 August, the BoE’s new deputy governor, Charles Bean, warned that the current economic downturn could “drag on for some considerable time”, adding his view that the UK’s slowdown is as challenging as that of the 1970s. Nevertheless, he appears to regard the current environment as a “transitory period”, emphasising that “we will get through the other side”. How soon – and in what shape – we reach the other side remains unclear. However, the question on many analysts’ lips is now not whether the economy is expected to deteriorate further, but by how much.

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Japan’s reputation as a major economic power is long established – but now other Far Eastern countries are making the jump from “developing” to “developed”. In particular, the last two decades have seen China evolve from bystander to economic superpower and its growing economic influence has led some commentators to speculate about its longer-term position in the global pecking order. For now, the US remains the economic powerhouse of the world, but China is already viewed as a force to be reckoned with.

The rise of the middle class in China is significant, particularly at a time when the US, Europe and the UK are experiencing a consumer slowdown: demand from affluent consumers in developing nations could provide some support for companies whose established customer base is feeling the pinch. However, soaring food prices are having a negative effect on China’s people, many of whom have become accustomed to a relatively comfortable existence over the last few years. China’s agricultural capacity and processes have not kept pace with its urban and industrial expansion and, although incomes have grown significantly, food prices are now rising faster than wages.

Will China go unchallenged as a global economic force of the future? Perhaps not. For now, China remains the most populous country in the world with 1.3 billion people, closely followed by India, which has a population of 1.1 billion, and whose booming economy has also been the focus of much attention. Looking ahead, the government’s official “one-family, one child” policy is likely to mean that China’s population begins to plateau over the next few decades, while India’s population is expected to increase.

China’s development has influenced almost every area of the global economy. Strong demand from other nations for its cheaply manufactured products has helped the economy expand rapidly; however, this vibrant economic growth has had its downside, and the Chinese government has sought to cool down the country’s export-fuelled growth. Meanwhile, inflation continues to run at very high levels, stoked by surging food prices, and the country’s insatiable appetite for raw materials and oil, driven by the rapid development of its infrastructure and booming demand for its exports, has helped to stoke surging commodity prices. Ultimately, in common with the rest of Asia, China is unlikely to prove immune to the full effects of a US-led slowdown, and this could help to put a brake on China’s growth in the short term.

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Sovereign wealth funds have been in the news recently amid rising concern about their activities. But what are sovereign wealth funds, who is behind them, and why are people worried about them?

Sovereign wealth funds are government-controlled investment funds, created when countries with surplus cash elect to invest some of that money. Most of the significant sovereign wealth funds are owned by the governments of booming Asian countries, such as China, or oil-rich countries such as Kuwait or Norway. Their substantial assets under management mean that, when they buy shares in a company, their stake tends to be sizeable.

Sovereign wealth funds hit the headlines initially last year as investment banks took their investments as support in the outbreak of the credit crisis. More recently, a Chinese fund has accrued a stake of almost 1% in UK oil giant BP, following the acquisition of an already significant stake in French oil company Total. Some market watchers have become concerned about the motives behind these purchases; China needs to have oil in order to fuel its ongoing expansion, and some commentators have flagged the possibility that China might be building stakes in major oil companies in order to gain influence within the sector.

Most of these funds tend to be secretive, a factor that has fuelled these questions about motivation. Many detractors are concerned about the possibility that an underlying government might actually aim to interfere in the running of a company in which they are invested. In addition, accusations of speculative activity have been levelled against some managers. However, defendants of the funds argue that the managers are just looking for long-term, stable returns like any other investor.

Although sovereign wealth funds have hit the headlines relatively recently, they are hardly the new kids on the block. Indeed, some have been around for a long time; for example, the Kuwait Investment Authority was founded more than fifty years ago in 1953.

Looking ahead, there are moves afoot to persuade sovereign wealth funds to sign up to a code of conduct that would ensure greater disclosure about their assets and investment strategy. It is unlikely that all the governments involved would be willing to accede to such an agreement; however, until sovereign wealth funds become more open about their investment activity, their detractors are likely to remain critical.

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It’s a tough time to be a borrower at the moment. Until relatively recently, credit was cheap and easily available, and mortgage lenders were all but fighting each other to win business.

However, the boot is now on the other foot. Since the credit crunch took hold last year, it has become increasingly difficult and expensive to borrow; banks and building societies have tightened their lending criteria and raised their rates, and the availability of mortgages has contracted sharply.

In its recent Credit Conditions Survey, the Bank of England has warned not only of a decline in the availability of mortgages, but also of a likely increase in the proportion of defaults by struggling homeowners. The heightened risk that some borrowers might default on their mortgage payments has spurred many lenders to make their lending criteria more restrictive, reducing the opportunity for higher-risk applicants to borrow money.

Meanwhile, new mortgage approvals declined from 74,000 to 73,000 during February, a drop that took the figures close to their 13-year low. Steepening mortgage rates are deterring potential first-time buyers from entering the housing market. However, demand is still relatively high in certain areas – the fixed-rate deals of over a million borrowers will expire this year, forcing them to look for new deals. Meanwhile, following the collapse of Northern Rock and its subsequent nationalisation, many of its customers are looking to move their mortgages to an alternative lender.

Several lenders have reduced access to their mortgages; and attractive deals have become increasingly rare, so any company offering competitive rates has been swamped with potential customers. First Direct has temporarily stopped offering mortgages to new customers while it catches up with the paperwork, and Abbey has now withdrawn the last straightforward 100% deal ‘in order to maintain high service levels’.

The Bank of England has cut interest rates to 5.5%, and rates are widely expected to fall further over coming months. Despite this, many lenders have actually raised their mortgage rates; the global credit crunch has deterred banks and building societies from lending to one another, so the companies are working to protect their profit margins. In the long term, banks and building societies are likely to regard the current situation as an opportunity to clean up their lending books and emerge in better shape; in the immediate future, both borrowers and lenders are likely to feel the pain.

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Prospects for US interest rates remain firmly in the spotlight. An unscheduled and drastic cut in US rates in January was swiftly followed by an additional and substantial reduction at the Federal Reserve’s scheduled January meeting. In March, another 0.75% cut was announced as markets reacted badly to the takeover of Bear Stearns by JP Morgan Chase following a US$30 billion Federal Reserve (Fed) aid package. US interest rates are now just 2.25%.

Nevertheless, investors remain nervous and the Fed has been criticised for what some economists view as a short-term approach to the deeper-seated problem. The economic outlook continues to deteriorate following the collapse of the domestic housing market, the global credit crunch, and soaring fuel prices.

US interest rates have now undergone six cuts since September 2007 – so where do we go from here? The Fed has cut its forecast for economic growth in the US and appears to anticipate a greater-than-expected rise in unemployment over the course of 2008. Meanwhile, inflation is forecast to reach as high as 2.4% in 2008, driven by surging prices. The current scenario has raised the unwelcome spectre of stagflation, in which prices continue to rise while growth stagnates.

Despite the risks to inflation, the deteriorating environment had boosted expectations of interest-rate cuts in 2008, and Fed chairman Ben Bernanke has favoured monetary easing to stave off a recession in the US and ease the effects of the credit crunch. Lower interest rates in the US will have a direct influence on the global economy: the US economy is still the largest in the world and an economic slowdown in the US would have a negative effect on economic growth in many countries in Europe and Asia, where exports to the US can make up a significant proportion of revenue.

Any recovery in US demand would be well received, but lower interest rates do undermine the already weak US dollar, providing additional impetus for the booming oil price, which could stoke inflationary pressures. Where the Fed now goes from here remains to be seen, but policymakers are having to perform a delicate balancing act in trying to ensure the economy does not stall, at the same time as keeping inflation in check.

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The price of gold has reached new highs recently, boosted by ongoing speculation over further cuts in US interest rates. Many investors view gold not only as a “safe haven” in times of stock-market turmoil, but also as a way to mitigate the effects of rising inflation and a weak US dollar.

Growing fears of a recession in the US have led policymakers to reduce US interest rates in order to stimulate economic growth. However, these lower interest rates could help to stoke inflation and exacerbate the decline of the faltering US dollar. A weak dollar helps to drive the gold price higher: like oil, gold is priced in US dollars, so dollar weakness makes gold cheaper for investors buying in other currencies.

The effects of increased demand for gold have been compounded by a growing shortage of supply. Electrical power cuts have halted production at some of South Africa’s most important mines when the South African government was forced to take the radical decision to ration electrical power. This, combined with fears that gold production could be halted for several weeks, helped to boost gold prices to their recent highs.

A good diversifier

Volatile market conditions, coupled with the fallout from the global credit crunch and growing fears over prospects for the global economy, have led many investors to add gold to their investment portfolios. However, gold does not have to be viewed purely as a safe haven; for many investors, it has become an important, long-term element within a diversified investment portfolio. It is vital to acknowledge that gold is not a risk-free investment: its price is volatile and can fluctuate rapidly. Nevertheless, gold’s low correlation with the equity market and bond market make it a useful means of diversification within an investment portfolio.

Some investors favour owning gold directly, which can be bought in the shape of gold coins and bullion bars; others prefer to gain exposure via exchange-traded funds: investment funds that track the price of gold. A lower-risk approach – in relative terms – might be to opt for a diversified commodities or natural resources fund, thereby spreading an investment over a wider area than just gold.

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A: In January, Mervyn King warned that 2008 could be a tough year for the UK economy. He forecast a slowdown as consumers tighten their belts and reduce their spending. This fuelled expectations of an interest rate cut. However, fuel prices and energy bills are high and King predicted “a period of above-target inflation”. This leaves the Bank of England caught between a rock and hard place. If rates are eased further, it could fuel inflation – but if rates stay on hold, this risks suppressing the prospects for economic growth.

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