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Season of mists

This time of year has a habit of being difficult for investors. In recent years, we have had the aftermath of September 11, the Russian sovereign debt default and ensuing LTCM collapse of August/September 1998 and the 1997 Asia crisis – not to mention Black Monday in October 1987 and the Wall Street Crash of October 1929.

Fortunately, the outlook for the remainder of 2006 is not quite so bleak but there is plenty of uncertainty holding back investors. The focus at the moment is inevitably on the health of the US economy, where a few worrying cracks are appearing.

As has been widely documented, the mainstay of US consumer confidence in recent years has been the surge in property prices to the extent that people have stopped bothering to save money. Savings rates fell into negative territory last year for the first time since records began in 1959. However, the housing market is now cooling rapidly, with the level of unsold houses at record levels and prices falling sharply.

A further complication is that millions of homeowners switched to cheap introductory variable-rate mortgages when rates were low a couple of years ago and are now facing the prospect of a huge increase in repayments once they switch back to rates of 7 per cent or so. The veneer of prosperity created by high house prices is likely to wear thin in the months to come, not least as the housing industry has been responsible for a significant part of new job creation in recent years.

The problem runs deeper than just housing. The most recent evidence suggests that inflation in the US is being driven by more than just petrol at $3 a gallon. For example, the minutes of the Federal Open Market Committee meeting in August show that the Fed is getting worried about the effect that a rise in unit labour costs is having on inflation. During the Greenspan era, it was taken for granted that steady rises in productivity – of which Chancellor Gordon Brown was so jealous – were helping to hold back inflation but now it appears that wage bills are increasing rapidly and productivity growth has stalled. As the Fed warns, energy prices are expected to moderate a little in the months to come but there is still a significant risk that inflation might remain at uncomfortable levels.

This presents a quandary. The Fed’s mandate is to ensure price stability, maximum employment and moderate long-term interest rates. If GDP growth is falling and inflation is not responding to interest rate rises, then the Fed will have to decide whether to risk further inflation or to inflict more pain on consumers. Neither scenario is desirable but the hope is that the imbalances can unwind in a sufficiently orderly fashion so as to avoid any major shocks.

For investors, including us, the sensible course has been to let cash build up and wait and see. This is not a luxury afforded to more constrained (or index) investors.

Active asset allocation can help. Weaker US growth will be felt in many markets but this does not mean that there is no room for manoeuvre. Our prognosis for markets is somewhat cautious but we are confident with the various overweight positions in our portfolios, which continue to be Japan, emerging Europe and the energy sector.

Japan’s recovery is the result of a long process of unwinding imbalances in their own economy, even if exporters there are sensitive to the US consumer. Emerging markets are certainly reliant on US demand but not to the extent that they used to be, as domestic consumption is soaring. Energy prices are high because global supply is still having trouble meeting demand.

These are themes – and no doubt there are numerous others – that asset allocators are free to exploit and, indeed, should exploit if they want to provide good returns for their clients. The outlook may be murky but this does not mean that there are not ways to make the most of the situation.

John Chatfield-Roberts is head of the Jupiter independent funds team

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