Quarter Ended 30 June 2008

In Q2, global equity markets initially experienced a bounce from their mid-March lows.  There was a perception that the Federal Reserve would prove a lender of last resort for investment banks as exemplified by the bail-out of Bear Stearns.  However, for the second half of the quarter, global equity markets experienced significant falls.  Inflationary pressures and the consequences of such pressures came to the forefront of investors’ concerns.  Global monetary authorities became more vocal with regard to their priorities and it was felt that inflation was their primary concern

Appian believes in Q2 ’08 there will be continued write-downs of financial instruments and that banks will see further re-capitalisation of their balance sheets via rights issues, sale of non-core assets and issuance of convertible bonds.  Whilst banks and monetary authorities are perceived to be constructing an effective solution to the sub-prime woes, money market rates continue to spike and offer further evidence that banks have little confidence in the strength of the balance sheets of their peer group.

Federal Reserve

The Fed, fearful of the widening effects of the credit crises have cut rates dramatically this quarter to 2.25% and some commentators suggest they may reach levels of 1%.  In addition, the Fed has indicated that they are willing to use mortgage-backed securities as collateral on any loans taken by commercial banks.

One structure of particular concern to global investors is credit default swaps.  Essentially, this structure insures the counterparty against default of a corporate loan.  Spreads on these structures have widened in line with a lack of confidence in the strength of balance sheet of the borrower.  It is this massive market that is of most concern to monetary authorities and is one of the reasons why the Federal Reserve guaranteed a significant amount of potential losses from Bear Stearns as it was taken over by JP Morgan.

In essence, the Federal Reserve has used taxpayer’s money to bail out Wall Street.  There have been contrasting arguments as to whether this is the appropriate thing to do.  Advocates suggest it was necessary, based on Bear Stearns inter-linkages within the financial sector.  Critics believe the Fed has created moral hazard for future risk taking by investments banks.  At this stage, Appian would suggest that the Federal Reserve, by aiding the bail out of Bear Stearns, will seek greater transparency and regulation with regard to the risks undertaken by investment banks in the US.

US Economy

It is widely believed that the US, if not already in recession, is experiencing a severe slowdown.  Three months of poor unemployment figures, falling home values and tighter lending standards are likely to ensure a significant slowdown in US consumer spending.  As of yet, this has not materialised, hence analysts’ expectations for earnings growth for the first quarter for the S&P500 is 10.7%.  Appian would suggest from a GDP perspective, the US economy will show a significant slowdown in Quarters 1 and 2 with a moderate recovery expected in the second half of the year as the fiscal stimulus and the lagged effect of interest rate cuts bear fruit.

USD

The US Dollar has weakened significantly over the first quarter against the euro.  This is as a reflection of the dramatic interest rate cuts enacted by the Fed and slowing or expected slowing growth.  A weak Dollar, whilst benefiting US denominated exporting companies, has the negative effect of importing inflation.  As a hedge against weakening US dollar, investors have continued to focus on oil and agricultural commodities.  In Appian, we continue to remain long-term bears of the US Dollar.  However, there may be short-term strength experienced, based on dramatic over-reaction or movement in the rate over the first three months of the year.

Inflation

The ECB continue to have rates on hold and remain hawkish with regard to future interest rate movements.  The ECB focus remains centered on inflation.  2008 seems to be the year where German union workers are rewarded for the relative strength of the German economy and it is these secondary effects that the ECB have indicated to be their most pressing concern.  Outside of the ECB, global monetary authorities have prioritised slowing economic growth as the most pressing concern.

PAT KILDUFF
June 2008