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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