Oil prices breached $60 in June reflecting strong demand from the US and developing economies rather than disruption to supply. Demand is growing at around 2% per annum and oil usage in the developing world now matches that of industrialised countries. The pressure on the oil price in the short term is mainly due to a refining bottleneck where, after 20 years of reducing overcapacity, refinery utilisation rates have risen above the critical 95% level at which new refineries are required. Given that these can take up to six years to build, an oil price in excess of $40 is likely to be the norm.

Growth is strongest in the developing world with India, China, Russia and parts of Latin America all likely to record GDP growth in excess of 6%. China continues to show improving consumption, strong investment and robust exports. We expect industrial production to moderate from the current 17% growth rate but exports are still growing at 30% and more than offsetting import growth of 15%. Textile exports have been a recent flashpoint and trade disputes may escalate if there is no movement on China’s exchange rate policy. The revival in Japanese economic growth in 2004/05 was largely attributable to machine tool exports to China but these have now turned down. Nevertheless business and consumer confidence remains strong in Japan and corporate restructuring continues to make the region an attractive recovery opportunity.

In the developed world growth is strongest in the US where higher than expected exports and housing sales resulted in another upward revision to 3.8% of Q1 GDP. This is the eighth successive quarter growth has exceeded 3% making it the best economic performance in two decades. Q2 is likely to see slower progress but with housing continuing to boom the impact on growth of higher oil prices appears limited so far. US consumer confidence rose to a three year high in June on the back of improving employment prospects. Growth in core retail sales has been running at about 5% although we expect this to slow. Inflation is very subdued but we believe the Federal Reserve may surprise markets by continuing to raise rates to a level which provides more flexibility in the future. Consensus profit forecasts have been revised up to around 14% growth in 2005.

Conditions in the UK are not quite as buoyant mainly because real interest rates are higher. Q1 GDP data was revised downwards as were previous quarters indicating that the economy may now be growing slightly below trend. The recent weakness in retail sales reflects the slowdown in house price growth to 4% as well as the erosion of real incomes from rising inflation. CPI inflation of 1.9% is the highest in seven years and may well breach the 2% target later this year. Despite this household incomes, jobs and personal wealth remain reasonably buoyant and we expect consumption to slow rather than collapse. Talk of an imminent cut in interest rates appears premature but narrowing differentials with the US mean that sterling may continue to weaken. Company profits are forecast to grow by around 11% in 2005.

The European economy remains moribund. Manufacturing confidence rose a little in June while retail, construction and service sectors fell slightly. Consumer confidence was unchanged but overall is still running slightly below the average since 1990. We suggested recently that the rejection of the constitution by some countries would not have a direct economic impact but might slow the pace of structural reform and the acrimonious debate over the 2007-2013 EU Budget could be an indication of the problems to come. The referenda may have contributed to short-term weakness in the Euro but speculation about the possible demise of EMU appears overdone. The potential benefits of EMU membership may now appear limited but are still worthwhile compared to the potential upheaval of withdrawing. Company profits are still likely to grow by just under 10% in 2005.

Long-term interest rates have moved lower over the last year despite strong economic growth, higher inflation, a sharp rise in the oil price and attempts to tighten monetary policy via higher short-term rates. However, most market participants expect even lower bond yields as part of a return to the pre-1970’s inflation era. Our view is that the market may be too complacent about interest rates nearing their peak, especially in the US, and we see further measured increases until the real inflation adjusted rate is at a more normal level. Strong growth, low interest rates, increasing profits and reasonable valuations mean the outlook for equities remains encouraging although we would be surprised if the impending half-year corporate results failed to express concern over cost/margin pressures resulting from the high oil price. Morgan Stanley Quilter ms/summer-05-01

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Ever thought about investing into commodities?

You are probably doing it already, but didn’t know. But are you getting the investment return from commodities that you would expect?

Why?
The range of commodity investments is far wider than most people think. Perhaps most are familiar with oil and gas companies, certainly these are the most “accessible” for investors. Then there are the mining companies, whether for gold or other metals, minerals or coal and coke. But a very large part of the commodity market is also represented by the agriculture sector. This can be through grains, or a vast array of other agricultural products. Commodities now represent more than 25% of global trade, so clearly this is not a small business area.

Commodities prices have been through a long period of negative returns, until the last couple of years. By most estimates they have just finished a 20 year downward spiral, as a result of the supply/demand imbalance. However, it is increasingly clear that raw materials stocks are at record low levels, thus leading to potential for price rises.

Commodities are also an inflation-hedge. Apart from often being the cause of inflation, they are also positively correlated to inflation, thus if, as many expect, we are to see a return to an inflationary period, it can be expected this will enhance commodity prices also.

How?
Of course if you want to invest into commodities, you can always buy the physical. But this will require finding storage space, getting it insured, etc. Not always easy. Many people will be familiar with the commodity futures market, as an alternative way of participating, but this requires both specialist knowledge and a strong constitution, given how volatile it can be. As said earlier, the most common way of participating has been through buying commodity-related equities, such as oil company shares. Certainly this gives partial exposure, but stocks are just as likely to perform in line with the overall equity market, rather than reflect the increasing value of commodity prices. This just leaves the use of commodity indices. There are a number of these, and some are also investible. This means that there is an investment fund (usually a mutual fund) that aims to follow the movement of the underlying index just like a tracker fund. These are by far the most suitable for most investors, as they not only provide the access, they also are liquid and transparent, thus you will know what you’ve got, and the return you are getting.

A word of warning
Commodities are a volatile investment. Whilst they may be at something of a low point in their price history, recovery to higher levels is quite likely to be accompanied with much volatility. For this reason, many investment advisers look to provide some form of capital protection when investing in commodities. This will usually be in the form of a structured note-type of product. This doesn’t suit everyone, and clearly it is usually likely to only be suitable for more sophisticated investors who seek diversification for their assets. Investment advisers are best placed to provide guidance on this, as they are likely to be familiar with the different types of products around, and how they might suit your own circumstances. Stewart Aldcroft of Noble Investments ms/summer-05-03

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Abolishing estate duty in Hong Kong In the government budget for 2005/06, the financial secretary announced the proposed abolition of estate duty. The proposal is part of measures designed to encourage investments – and promote the asset management business – in Hong Kong. Currently, the tax-free threshold for estate duty is HK$7.5m, with a maximum rate of 15% on estates valued at more than HK$10.5m. The financial secretary said that legislation will be introduced as soon as possible. However, the proposed cut-off date for estate duty liability will not be effective until the legislation is actually enacted. Following abolition, estate duty will no longer be charged on the Hong Kong assets of any person upon their death. Consequently, the procedures for obtaining grants of probate and letters of administration will be simplified. At present, estate duty clearance must be obtained before the court will make a grant of representation. Nigel Bacon - Partner, Kennedys ms/summer-05-04

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Critical Illness Protection

No one can argue that since the first heart transplant, there have been some very encouraging advances in medical care. With the development of ever sophisticated scanners, more precision instrumentation and specialized drugs we have seen a great improvement in medical treatment. We can now expect to live longer as we survive many of the critical illnesses which our grandparents, at one time, considered immediately life threatening.

• This means that whilst we are likely to survive a physical trauma, we may not survive the financial consequences

• Many sufferers do not work again and their life insurance policies will not pay out except upon death leaving them with bills to pay, and little to pay them with.

• A Critical Illness Policy can pay either
o a lump sum or
o a monthly benefit
• Even if a full recovery is expected, or if the condition was caught before it could fully develop, the critical illness benefits would be paid.

With the cost of university education continually rising, the fear of debt may deter families from encouraging their children to take a place at university.

More and more parents are becoming increasingly concerned about the future education needs of their children. Carlos Sabugueiro, Regional Director of Zurich International Life Limited, Hong Kong tells us why a good education is an investment for the future.

Why is it important to save for a child’s education?
If you are planning to send your children or grandchildren to university or have private education, then you may be aware of the continually increasing costs involved. It may not be just the cost of education you need to worry about; the costs for living accommodation can be equally as expensive, especially for students who attend university outside of their home country. The total costs for university education include:

• Tuition fees HKD42,100 per annum for local students and HKD60,000 for all non-Hong Kong students
• Total living expenses and tuition fees are from HKD100,00 per annum
Source: hku.hk/admission/financial (May 2005)

There are few parents who can afford to meet all the university costs from just their income alone. Zurich International Life can offer you a savings plan that helps you to plan for the future and meet the potential university expenses.

What are the benefits of investing Zurich International Life’s savings plan?
Zurich International Life’s savings plan can provide a flexible solution to savings and life insurance, so as circumstances change, so the plan can be adapted to suit individual requirements.

It is also a plan that allows you to choose from a range of currencies in which your contributions and the education fees will be made available to. You can also select from a series of risk rated investment portfolios to match your family’s educational saving needs.

What can a client expect to receive from the savings plan?
The table below illustrates the amount a client could receive, after the deduction of fees and charges, excluding the planned school fees, and based on the following assumptions:See table below.

At the end of the term, the savings value at maturity will be HKD362,534 based on a 7% rate of return. The maturity figures shown is for illustrative purposes and is not guaranteed.
Source: Zurich International Life (May 2005)

What other features are available?
Special optional features are also available with the plan. You can have additional life cover, waiver of contribution, escalation of premiums to account for inflation and wide fund choice for investment. All of these provide you with additional security for you and your family.

Why is it so important?
By starting a plan now, you are making the best investment for your child – their future.
If you would like any further information...

...Talk to TTG Today.

Source: Zurich International Life Limited (May) ms/summer-05-06

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There are lots of excuses but no reasons for failing to make a will.

While most people recognise that a will is probably the most important document they ever have to sign, Consumer Reports – a consumer research organisation based in the US – has recently reported that over 60% of adults in the US are intestate. Other surveys suggest that the number may be even higher, citing superstition, ignorance or laziness as the main reasons for people’s failure to tackle the issue. USA Today reports that many of those surveyed said that they did not have the time, although 30% conceded that they had never even thought about it.

Why do it?
Wills serve two principal purposes:

(1) they dispose of property and designate people to administer that property; and
(2) in the case of surviving children, they can be used to appoint a guardian to look after the children. Indeed, the surveys show that the main reason why people make a will is to name the person who is to take care of their children.

Some of those surveyed thought there was no need to make a will unless they were conducting a sophisticated tax planning exercise. In fact, a will is essential for anyone who wants to leave their affairs in order and to provide for family members or other beneficiaries. If someone fails to make a will, then their estate will pass to members of their family as determined by the law. Given the sad frequency of family disputes, this is often not what people want to achieve.

Hong Kong wills
A will made in accordance with Hong Kong law generally covers the whole of an individual’s estate, both in Hong Kong and elsewhere in the world. For most expatriates, therefore, a will made in Hong Kong should satisfy all their requirements. There are exceptions, though, in the case of someone who holds property (or is domiciled) in a country where the law requires all or part of an estate to pass in accordance with its legal regime. Such laws or attendant tax considerations may make it advisable to draw up separate wills for assets in different countries. A person can make two or more wills, each covering assets in different countries, so that the assets in the various jurisdictions can be dealt with simultaneously.

Keeping up with events
In the US surveys, even those who have wills are not perfect. Over one in four of such testators have not changed their wills to keep up with the major developments in their lives. Most people are apparently unaware that wills can easily be changed and should be reviewed whenever there is a major shift in personal circumstances. Lawyers did notice a significant increase in instructions over wills after tragic events such as 9/11; but the majority of people are still ignorant of basic notions – for example, that marriage generally revokes an existing will.

It is likely that any survey in Hong Kong would produce similar results to the US studies. So, to the 60% of the population who haven’t yet made a will, we ask, “What’s your excuse?” We don’t know any good ones. Nigel Bacon - Partner, Kennedys ms/summer-05-07

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Last month’s downgrade of US automakers General Motors and Ford raised questions about the performance of hedge funds in the near term and sparked market speculation that one or more managers may have incurred substantial losses that could have a knock-on effect in other markets. A month later, there is yet to any be evidence of such an event, and credit marks have begun to settle, suggesting that investors are beginning to discount this theory.

One impact of the downgrade was that high-yield credit spreads, which had been hovering near all time lows, widened considerably in May. That could have hurt the returns of distressed securities funds, which have benefited over the past couple of years from a consistent narrowing in credit spreads to almost a quarter of the level seen in 2002.

The uncertainty in credit markets also triggered renewed selling of convertible bonds and it seems likely that CB Arbitrageurs will have continued their extended losing streak in May. The strategies has been a poor performer of late, and while some multi-strategy relative value managers are now being tempted back into this market by bargain basement prices, it could be a little too early to call a recovery. Credit arbitrage funds could also have been affected by the price moves. With two arbitrage strategies facing a down month, the relative value style as a whole could deliver negative returns for May.

That being said, while the timing of the downgrades may have caught some investors by surprise, it was no secret that rating agencies were planning to downgrade the US automakers and it seems likely that several managers will have either hedged their positions or even profited from the news.

It now seems clear that the initial media reaction to the downgrades was overblown. Even if it were not, however, it is worth noting that only three strategies would have been seriously affected which is unlikely to present significant long-term performance issues in the context of a well diversified portfolio with sufficient risk controls and a well-balanced asset allocation process.
MAN Investments (Hong Kong) Limited ms/summer-05-08

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What is the European Union Savings Directive
The European Union Savings Directive (EUSD) is an agreement between the Member States of the European Union (EU) to automatically exchange information about individuals who have savings income in one EU Member state but reside in another ( the automatic exchange of information option) or to retain a withholding tax on savings income.

For an initial transitional period three EU member states- Austria, Belgium and Luxembourg are entitled to apply withholding tax. Under these arrangements tax will be deducted at source from income earned by EU resident individuals on savings held in other EU countries (the withholding tax option).

The other 22 EU Member States have elected for the automatic exchange of information option.
The legal scope of the measures does not extend outside the EU. However, its implementation also affects Andorra, Anguilla, Aruba, British Virgin Islands, Cayman Islands, Guernsey, Isle of Man, Jersey, Liechtenstein, Monaco, Montserrat, Netherlands Antilles, San Marino, Switzerland, Turks and Caicos Islands. These countries and territories have undertaken to apply the same or equivalent measures.

It is understood that most of the other countries and territories affected by the EUSD have elected for the withholding tax option. This option will be known as the retention tax option in the Channel Islands and the Isle of Man.

Who will EUSD affect?
If you are an individual of an EU Member State and earn bank interest or other savings income on deposits or investments held in the name in another EU Member State, Third Country or territory identified above, then you will be affected by the implementation of the EUSD.

The EUSD does not apply to persons (including EU Nationals) who are resident outside the EU.

What is the withholding tax option and how it will work?
Under this option, banks and other paying agents will automatically deduct tax from interest and other savings income and pass it to their local tax authority, indicating how much of the total amount relates to individuals in each Member State. The receiving Member State receives a bulk payment but does not receive personal details in respect of individuals.

What is the automatic exchange of information option and how it will work?
If an individual chooses the exchange of information option instead of withholding tax details of the individual’s identity and residence their paying agent, the level of savings income received and the period to which it relates will be reported to the local tax authority in the country, in which it is held and then forwarded to the tax authority of the country in which the individual is resident.

If you take no action at this time in countries where the withholding tax option applies?
If you take no action, withholding tax will be deducted from savings income paid from 1st July 2005. However, where a bilateral agreement is in place exchange of information may be able to take place as mentioned above.

What information will be exchanged?
Details regarding an individual’s identity, residence and the interest income earned and the period to which it relates will be reported to an individual’s income tax authorities.

What is savings income?
In laymen’s terms savings income is essentially interest received on bank current deposits, savings accounts, payments from fund containing a percentage of such securities, bonds and savings certificates.

How are joint holdings taxed?
Each joint account holder will be treated as an individual holder. If you choose the exchange of information, the relevant form must be completed and signed by all joint holders.

What is the position with trusts?
Where payments to trusts are established, it will be dependent on the status of the trust under the law of the jurisdiction concerned.

In jurisdictions where a trust does not have a ‘legal personality’, payments will in most cases be made to the trustees.

In this situation where a professional trustee receives savings income and the beneficiary has for example a life interest the trustee may have to consider if the beneficiary is a relevant payee. In such a case, the trustees will be viewed as a paying agent in respect of that income. Accordingly, the trustees would need to consider if tax would need to be retained or information exchanged.

Where the beneficiary trust does not have such a life interest to part of that income then the trustee would be the relevant payee and not the paying agent. If the trustee is a corporate one or not resident in an EU Member state the payment of the savings income would not be subject to withholding /retention tax or exchange of information requirements.
Hilary Pack CTA TEP - Lutea Consultancy Ltd ms/summer-05-09

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For anyone who has read my previous articles, they will no doubt have sensed a strong scent of bear (which is probably better than a strong smell of bull!). Having warned readers in the Spring edition about too much gearing in hedge funds it gives me no great satisfaction to report that those concerns came to fruition within a matter of days after publication. The hedge fund world has its share of heroes as well as horrors and it is often difficult to determine which is which until a downturn appears. When interest rates are low, it does not take a genius to borrow several times the value of a fund’s assets and produce double digit returns (even from government bonds) while slicing off a healthy chunk in ‘performance fees’. For the majority of funds who climbed further up the risk ladder there were three combined factors that greatly helped them over the last few years. First, borrowing costs were exceptionally low which allowed funds to gear up and magnify returns, second, the Dollar weakened which favoured more aggressive overseas investment and third, high risk bond prices rose significantly as investors hunted for yield.

Just as three factors came together to help these funds, so they have joined in unison to hurt them. US interest rates have risen, thereby pushing up the cost of borrowing, which in turn has damaged many hedge fund performance numbers. As rates have gone up, the attractiveness of gearing has diminished. Also, when borrowing in Dollars it means that you are effectively ‘short’ of the currency. If the latter strengthens, you then start to make a loss on foreign investments. You must therefore buy back Dollars to reduce the gearing. A ‘short squeeze’ then follows which drives the currency higher still. At the same time, many funds rushed for the exits when the bonds of General Motors were downgraded yet again. Other high yield bonds were also ditched and the whole process created a self-fulfilling decline. It is rather like watching a horror film where the monster jumps out of the screen into a packed cinema audience who then rush out in the opposite direction; some are devoured by the beast itself while others are crushed underfoot by the stampede. One of the selling points of the funds is that they complement your portfolio by reducing the correlation of the different assets. However, because there are simply too many hedge funds and too few opportunities the selling of risky investments across the world meant that many asset classes started to correlate strongly. In other words they all fell together, although it has to be said that some fund losses have only been in the low single digits.

The purpose of this commentary is not to gloat but to point out that there could be a hidden and unexpected benefit for ‘long only’ investors following this episode. As any spin doctor or management consultant will tell you, every threat is an opportunity and for once I agree. The first benefit may come from an expansion in Price Earnings (P/E) ratios which is one factor that drove the markets higher in the late ‘90’s. Although major indices such as the Dow Jones Industrials are unchanged over 6 years, company earnings have since soared. P/E ratios in America are therefore at their lowest level in 8 years. In recent months, the combination of a strong Dollar and a weakening economy has helped to push down bond yields (or long term interest rates). Even if company earnings stabilise for the remainder of 2005, the fall in these long term interest rates should remove the downward pressure on share prices. Second, it appears that many hedge funds will be backing away from the stock market in the months ahead as they lick their wounds and keep a low risk profile.

Although it is hard to prove, one suspects that part of the reason for flat stock markets is that they have been trapped on either side by hedge funds. Every trend on both the upside and downside has been stopped dead in its tracks by the sheer number of these players who operate on both sides of the market. To use an analogy, it reminds you of a pride of lions around a herd of antelope. When the number of these predators is limited then the two species work in harmony. The lions are well fed and help to keep the antelope herd healthy by picking off the weaklings. In the meantime, the herd still has the freedom to move around and graze unhindered. However, when there are too many lions, the herd is surrounded and cannot move. Over time the lions kill all the antelope and they in turn die off because their large numbers are not sustainable. This is very similar to stock markets where the aggressive financial predators are too great in number so the opportunities disappear and the market itself becomes range-bound and listless. Perhaps now that hedge funds have been badly hurt then the markets will be free to move higher, albeit for a few months, in what is usually the quiet summer period.

As any one who knows me will testify, I have been bearish on stock markets for some time. The great yields and equity valuations that are normally seen at the bottom of a market downturn simply never materialised. This was due to the huge economic stimulus applied by America to stave off the combined effects of the burst Internet bubble and 9/11. I suspect that while the bear has been subdued, it is still very much alive and grumpy. Speaking of which, the word ‘berserk’ refers to the behaviour of rampaging Vikings who frequently wore bearskins to invoke the spirit of these ruthless animals. As the warm summer weather approaches, I for one will slip off the uncomfortable bearskin and swap it for the more comfortable but thick skin of the bull. Although it goes against the stock market adage of ‘sell in May and go away’ it appears that 2005 may be the exception. However, the cold winter of deflation is lurking in the background with the classic pre-cursor of all major downturns very much in evidence; namely, too much debt coupled with rising commodity prices. When Autumn approaches we should use any stock market rally or Dollar strength as a selling opportunity. I for one am accumulating Gold bullion and Gold shares in the expectation that central banks will print money like confetti in a bid to stave off deflation. My one concern is that during the Great Depression the American government confiscated all physical gold holdings when they devalued the Dollar. This action prevented the wealthy from preserving their purchasing power. We must therefore hope that history does not repeat itself, although nothing should come as a surprise where government intervention is concerned.
Toby Birch Vice President – Investment Manager. Bank Julius Baer & Co. Ltd. (Guernsey Branch) ms/summer-05-10

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