Financial Management (Scotland) Ltd

April 2010

Although the recovery in developed economies has been relatively modest so far, stock markets continue to experience a 'V' shaped recovery and - despite fears about lasting structural imbalances - the pattern is proving remarkably similar to previous cycles.

Policy measures combined with liquidity from central banks remain supportive even if much of the stimulus in the developed world has been targeted on the financial sector. Unlike increasingly indebted governments, companies were quick to cut costs and - with the obvious exception of banks - their strengthening financial position means corporate profits are expected to rise 30% this year with record margins maintained and large cash reserves built up.

So what happens next? Clearly, withdrawing the stimulus prematurely might result in another downward lurch but, conversely, excessive liquidity could cause inflation to pick up. While governments in developed economies are reluctant to bring expenditure more into line with sustainable output, repeated stimulus reduces the long-term trend rate of economic growth and global competitiveness. The most likely outcome is therefore 'muddling through' with the option of renewed measures in 2011 if the recovery suffers a serious setback.

Recent economic data has been mixed but there have been more upgrades than downgrades to growth forecasts. Those for Asia and the US continue to improve with Europe remaining the laggard. Overall, the 3.5% estimate for global GDP in 2010 (2.3% for the developed world) is usefully higher than expectations of 3% and 1.9% respectively six months ago. The inflation outlook for the developed world is relatively benign although there is a divergence between declining expectations for the US and an increase for the UK. Currency rather than wages appears to be the major influence which means that CPI and RPI in the UK will rise as a result of the lagged impact of the 25% depreciation in trade-weighted Sterling since mid-2007. It seems probable that the economic uptrend will continue - perhaps even gather pace – as unemployment peaks, consumer confidence rises and inventory destocking nears an end.

Uncertainties, however, remain – notably the liquidity cycle given the frequent incremental reversals in policy stimulus albeit the authorities are treading warily even in the higher growth economies. China compensated for the global export downturn by implementing a four pronged package encompassing monetary, credit, exchange rate and fiscal policy but, with this starting to create growth 'problems', bank reserve requirements have been raised and lending reined in. The latter could still rise 15%-20% this year as part of longer term plans to invest in infrastructure and facilitate urbanisation which raises concerns about asset 'bubbles'. Residential property is an obvious example because if China is to achieve an urbanisation rate similar to other developing economy models over the next decade, this will require new housing for an additional 200m. India, with near double-digit inflation, faces rather different growth problems and here interest rates are rising. Moderate growth in the developed world means that forward interest rates have barely moved in recent months. Some emergency stimulus measures are either expiring (Federal Reserve and Bank of England bond repurchases) or being withdrawn (ECB repo facilities) but these moves are largely symbolic. Overall, liquidity is declining very gradually and remains supportive.

Another uncertainty is the impact fiscal deterioration in the developed world will have on funding. While attention has focused on the volume of debt, other factors such as the private/public split, maturity profile, currency denomination, foreign versus domestic ownership and the proportion indexed to inflation are also important. Although there are substantial amounts of private and public sector debt to be rolled over, a financial crisis followed by deleveraging usually proves disinflationary. One of the key issues is therefore the 'price' demanded by investors and the impact this has onthe cost of capital in general. Where there is perceived to be policy weakness - as in the case of Greece - investors seek higher compensation so it is interesting that 10 year UK gilt yields remain at the lower end of our estimated 3.75%-4.75% range. Companies are also active issuers of bonds but corporate spreads – in particular on non-financials - are close to a cyclical low which suggests that further outperformance against sovereign debt is less likely.

There are also tensions in currency markets - especially between the US and China with the latter being 'accused' of refusing to allow a revaluation of the Yuan. Currency movements in free market economies reflect an amalgam of economic and transactional factors. During the recession, the currencies of countries which 'printed' money (such as

the Dollar and Sterling) experienced a relative decline in value particularly against 'hard' commodity currencies. Now that growth is returning and cracks have emerged in the Euro, there should be some reversal in this trend.

Equities are clearly no longer the bargain they were a year ago and have anticipated much of the forecast improvement in profitability but, with commodities again looking overextended, commercial property grappling with funding issues and bonds marking time at best, shareholders should be adequately rewarded for the risks.

Glossary

Bear Market: A market in which prices decline sharply against a background of widespread pessimism

Dow Jones: A set of indices compiled daily from New York Stock Exchange closing prices. The averages are unweighted arithmetic indices, useful for showing general price movements. The Industrial Average consists of 30 industrial stocks. Referred to as the 'Dow Jones' and is probably the most widely quoted US index.

FTSE 100: An index of the Share prices of the 100 largest companies (by market capitalisation) in the UK.

G8: The world's major financial nations –Britain, Canada, France, Germany, Italy, Japan, Russia & United States

GDP: Gross Domestic Product – A measurement of the aggregate goods produced and services provided within an economy over a year and excluding income earned outside the country. Considered one of the main yardsticks of the health and vitality of an economy. See also Gross National Product.

RPI: Retail Price Index - A monthly indication of the average price changes to a particular ‘basket’ of consumer goods, and used as a general indicator of price inflation.

S&P 500: A United States stockmarket index, maintained by Standard & Poors.

Volatility: is a statistical method that measures how much a series of values move up and down around its average. The higher the volatility number, the less consistent the historical performance has been.