The first quarter of 2008 has been a time of marked volatility across most asset classes, the collapse of short-term credit markets having created a great deal of uncertainty. The effect of the credit crisis has spread beyond US sub-prime mortgage lending in an uncontrollable manner affecting many of the darker corners of the world’s financial system, as well as some venerable names like Bear Sterns. Despite central banks?best efforts to inject capital and slash interest rates, it could be a long hard year or two ahead before stability can be restored.

The recent buyout of Bear Sterns by JP Morgan, with the aid of the US Federal government, made many realise the threat to the global financial system is serious. Massive de-leveraging has led to the sale of assets at any price, leading to substantial downward re-valuations of the collateral. Many financial institutions have already owned up to significant losses on their mortgage-related investments, but the worst is probably yet to come. Many banks have to patch up huge holes in their balance sheets as a result of excessive risk taking in an era of easy credit. Going forward, we are going to see consolidation among investment banks and significant changes in ownership and / or power in a number of banks over the next few years.

Moody’s are predicting that at best, global ‘speculative grade?corporate default rates will rise by more than four-fold in 2008 (up to ten-fold if the US moves into recession) from the current extremely low levels, as growth slows and finance dries up. Distress rates, where corporate bonds trade at more than 10% over government debt, have been rising sharply in recent months. Corporate profit margins have been on the decline for the last two quarters in the US and look likely to continue this downtrend for the present. Even stripping out the banking sector, a marked slowdown is evident. However, one must not get too bearish as much of the record earnings quarters over recent years have been led by the very same banking / financial sector.

Investors are desperately trying to find a safe haven in this chaotic environment. There have been huge capital flows into commodities as the deterioration of the US economy and plunging interest rates weaken its currency. Gold prices have been over USD1,000 per ounce and oil prices at over US$100 per barrel, a rate reached more quickly than analysts had anticipated. Even the Yen, the weakest of the major currencies (partly as a result of the continuing disappointing performance of the world’s second largest economy and partly as a result of the ‘carry trade?, had broken 1US$ to 100 Yen level - a level which had not been seen for the past 10 years due to the widening differential in interest rates with currencies like the Australian dollar. The negative emphasis shifted towards the US dollar in mid-year, as the credit crisis unfolded and has moved on to sterling in the latter few weeks of the year as the UK trade gap widened to a record level.

Outlook

As conditions in the US mortgage market worsen through the year, consumer sentiment is likely to remain weak. The UK will be especially vulnerable to negative impact from the credit market as debt is at an unsustainably high percentage of household wealth. Asia ex-Japan and the Emerging Markets will continue to be victims of financial institutions and investment banks?losses as they continue to unwind their leverage. Under this uncertainty, asset allocation is the key to capital preservation and reducing volatility. Despite their short-term volatility, we believe commodities will continue to benefit from this riot. Equity market returns are likely to be flat at best in the early part of 2008 and there is still a significant downside risk if events grow nastier. We continue to like the diversification and relative safety of low-volatility funds of hedge funds, plus bricks-and-mortar rent-collecting property funds.

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This commentary should not be seen as a recommendation or solicitation to invest. Anyone considering investing should first seek advice specific and appropriate for their own needs, objectives and risk appetite.