After strong returns in 2003 and 2004, the UK market looks set to make further gains in 2005, with the FTSE All-Share index rising by 16 per cent so far this year. But we believe the reasons for these gains are less clear-cut than in the past two years and have implications for investment decisions in 2006.It is often said that the stockmarket is a reflection of the economic situation and outlook. The global picture appears positive, with US growth still above trend and even Europe and Japan showing signs of recovery. But there are headwinds to growth, notably due to rising US interest rates and commodity prices which are still near recent highs. The UK environment has been more mixed. After several positive years, growth has been below-trend for the last five quarters and few are predicting a major upturn in 2006. The swing factor behind this change has been the consumer. UK consumers have seen cashflow reducing for the past three years, as rising utilities costs and taxes have eroded disposable income. For much of this period, consumers compensated through housing equity withdrawal, made possible by low mortgage rates and rising house prices. This has not been the case this year as mortgage costs have risen and house prices stabilised. Despite this uncertain background, the market is significantly higher. Corporate earnings growth has been healthy, driven by tight cost controls and low levels of investment. At a sector level, strong commodity prices have led to gains for both mining and oil stocks while classic yield sectors such as beverages, electricity and tobacco have also performed well. These positives have been partially offset by weakness in consumer-related sectors such as banks, general retail and media. While problems for retailers have been well-documented, it is notable that even those seen as higher quality have struggled, including Tesco and Next. We believe it is takeover activity and speculation which has added impetus to the market move recently. The key to this trend has been equity valuations, especially relative to bonds. Financing costs have been very low, leading to a raft of arbitrage opportunities. Private equity funds were the first to take advantage of this but we have increasingly seen traditional corporate buyers becoming active in the UK market, with O2, BPB and Allied Domecq all targets for European companies. There have been two clear themes driving bids. The first was private equity funds, funded by cheap money, looking to buy undervalued assets with strong cashflows. This was effectively a valuation-driven arbitrage trade. There has been increased caution for these bids, particularly in the retail sector, as buyers have realised that operational gearing can quickly erode profits and thereby destroy the investment case for such purchases. The second trend has been the purchase of higher quality companies – ones with strong strategic positions or whose assets are relatively rare. Two factors will influence whether takeover activity continues. The first is equity valuations. Valuations may become expensive if the market continues to rise or if economic forecasts – and therefore earnings forecasts – are downgraded. Either way, when valuations are more stretched, takeovers become less attractive. The second factor is financing costs. A general rise in interest rates and bond yields or a more difficult corporate environment resulting in higher credit spreads would both increase the hurdles for acquisitions. Several holdings in our funds have had bids in 2005. The likelihood of a bid is not a specific consideration when we select stocks but the reason for holding so many bid targets is quite logical when you consider the nature of bidders as outlined above: many acquirers have been looking at companies in the same way as us.