Navigating rough seas May 2008

This document is for Professional Clients only and is not for consumer use

Investment Topics
Navigating rough seas The turbulence in financial markets which started last summer has shown few signs of abating. However, we do not think this paints a gloomy picture for the outlook for equity and credit markets: quite the contrary. In credit markets, we think that Problems which were initially very attractive opportunities centred on US subprime have been generated by recent mortgage markets have spread developments, and we are to credit markets more generally, seeking to take advantage of the banking sector and equity these in our fixed income funds. markets. Indeed, if an equity bear In the UK equity market, the market is defined as a 20% drop generally defensive stance we in the level of the stockmarket, have adopted especially in we have just seen the ninth such our income funds has not UK bear market in the last forty worked well in the first quarter years. These turbulent conditions of 2008. However, the sell-off in financial markets are now in the market has been quite spreading to the real economy, indiscriminate and we see most notably the tightening in many companies trading at credit conditions. valuations which we consider very attractive, especially when Indeed, we do think there is a judged on a three- to five-year good chance of the UK entering a investment time horizon. period of recession.
01 Investment Topics Navigating rough seas May 2008

UK equity bear markets What constitutes a bear market in equities? One conventional definition is that a bear market is a period in which the overall equity market falls by 20% or more from peak to trough. In the UK, the FTSE All Share Index, reflecting the performance of the overall equity market, has been calculated daily since 1969. On the basis of that daily data, there have been nine bear markets since then, shown in Figures 1 and 2. The most recent one can be dated from the peak of the market on 15 June 2007 to the most recent low point on 17 March 2008, a period in which the overall index fell by 20%. Of course, we cannot be sure that the bear market has finished. It could be that a renewed decline occurs and that the FTSE All Share Index falls back below the 17 March 2008 low point. A look at the nine bear markets shows there were six quite short ones lasting a year or less; and three long ones lasting over a year. The economic and financial market characteristics of each of these varied enormously. The one we have just experienced shares some of the characteristics of the short, sharp bear markets of 1987 and 1998. That is, the problems triggering the sell-off the subprime mortgage problems and the credit crisis were centred in the financial sector itself. The 1987 bear market was triggered by the stockmarket crash on Black Monday, 19 October 1987; and the 1998 bear market by Russias default and the collapse of Long Term Capital Management (LTCM a hedge fund). Some may see the current problems as more like those of the early 1990s, when the housing market was particularly weak. However, the bear market in 1990 was similar in magnitude but shorter in duration than that from June 2007 to March 2008.

1. FTSE All Share Index & bear markets 1 January 1969 - 21 April 2008
FTSE All Share Index Bear markets falls of 20% or more Index 10,000

1,000

100

10

69

74

79

84

89

94

99

04

09

Source: Reuters Ecowin. Data to 21 April 2008

2. Nine UK equity bear markets 1 January 1969 - 21 April 2008

FTSE All Share Index fall (%) 0 -20 -40 -60 -80
Jan-69 May-72 May-76 May-79 Jul-87 Jan-90 Jul-98 Sep-00 Jun-07 Jun-70 Dec-74 Oct-76 Nov-79 Nov-87 Sep-90 Oct-98 Mar-03 Mar-08*

Duration of bear market (months) 30 20 10 0

Jan-69 May-72 May-76 May-79 Jul-87 Jan-90 Jul-98 Sep-00 Jun-07 Jun-70 Dec-74 Oct-76 Nov-79 Nov-87 Sep-90 Oct-98 Mar-03 Mar-08*

*Recent low point: 17 March 2008 Source: Reuters Ecowin. Data to 21 April 2008

3. UK GDP and recessions 1 January 1969 - 21 April 2008

Change in GDP cf. previous quarter, annual rate Recessions % 25.0

Bear markets and recessions Some see the behaviour of the equity market as a leading indicator of the economy. In particular, weakness in the equity market is thought to signal the likelihood of a recession, but the imperfect linkage between the stockmarket and the economy has long been recognised by economists. Paul Samuelson, Americas first Nobel Prize winner in economics, famously commented the stockmarket has predicted nine out of the last five recessions. His remark was made in 1965 and related to the US, but little seems to have changed since then. Indeed, the UKs experience bears a similarity to the pattern identified by Paul Samuelson. There have been nine bear markets in the last forty years; but only four recessions (defined as periods in which GDP has fallen by two or more consecutive quarters, see Figure 3).
02 Investment Topics Navigating rough seas May 2008

20.0 15.0 10.0 5.0 0.0 -5.0 -10.0 69 72 75 78 81 84 87 90 93 96 99 02 05 07

Source: Reuters Ecowin. Data to 21 April 2008

So, is the recent stockmarket weakness giving us an indication of a coming recession neatly conforming to Paul Samuelsons ratio of bear markets to recessions or is it another false alarm? The main reason for expecting the stockmarket to be right is that a common factor the credit crunch is behind both the stockmarket weakness and the economic weakness which many anticipate. In the financial markets, banks previous willingness, indeed enthusiasm, to lend to each other and to other financial institutions, such as hedge funds and private equity firms, has been transformed into equally marked reluctance to do so. Just as easy access to bank finance was an important driver of the rise in stockmarkets in the period leading up to the summer of 2007; so the tightening up of finance has seen that process reversed. For example, the share prices of many medium-sized companies were driven up in 2006 and early 2007 because they were expected to be taken over, typically by companies financing themselves with debt. The credit crunch has meant that many deals that were being considered failed to materialise and few seem to be in the pipeline. Many financial institutions borrow in order to leverage their positions in financial markets. For example, a hedge fund may borrow a multiple of the capital it has available in order to increase the size of its investments. One hedge fund that collapsed recently, Carlyle Capital Corporation, had $31 of debt for every $1 of its own money. It had hoped to use its massive borrowings to generate higher returns from investments in highlyrated mortgage securities. The strategy failed when the value of those mortgage securities fell, quickly eroding the capital in the fund. But it is not just in these areas that credit conditions have changed. Particularly in the US and the UK, households have been borrowing heavily for some years, with a large part of their borrowing secured on the value of their home. In recent years a virtuous circle has been in place whereby home prices have risen, credit has been easily available and cheap, leading to a further rise in home prices, which in turn has facilitated more borrowing. In those circumstances, it was easier to secure mortgages which were high both in relation to income and the house value on which it was secured. That may now turn into a vicious circle whereby tighter credit, higher interest rates and lower house prices feed on each other. That interaction

is already evident in the US economy; and there are concerns that a similar situation is developing in the UK. Lower house prices, tighter credit conditions and higher interest rates produce a potent mix, capable of impacting consumer spending to such an extent that the economy tips into recession. Neil Woodford, Head of Investment at Invesco Perpetual takes the view that the US economy probably is in recession now and the UK economy will, he thinks, be in recession later this year.

4. UK stockmarket in recessions
FTSE All Share Index fall (%) 40 20 0 -20 -40
1 Jul 7331 Mar 74 1 Apr 7530 Sep 75 31 Jan 8031 Mar 81 1 Jul 9030 Sep 91

Duration of recession (months) 16 12

Markets and recessions Recessions are not, however, necessarily bad for equity markets. Indeed, the UK equity market rose in three of the last four recessions (see Figure 4). Often, equity market valuations such as the price to earnings ratio rise in periods of weaker economic growth as investors see through a temporary period of weaker corporate earnings. However, that is notably not the case at the moment. The price/earnings ratio on the UK equity market is close to historic lows (see Figure 5) as is the gap between the earnings yield on equities (the inverse of the price/earnings ratio) and the gilt yield (see Figure 6). It is not just those aggregate valuations, but also the extraordinary behaviour of different sectors of the market which makes Neil Woodford optimistic about his ability to generate attractive returns for investors on a three- to five-year view, despite the concerns about the tightening of credit and the possibility of a recession. He comments that good quality defensive businesses have been dragged down with everything else in the stockmarket sell-off and therein lies the opportunity. Businesses that have the potential to perform very well from a profit, cash flow and dividend perspective, even in a difficult economic environment, now have share prices which really are at a rockbottom level.

8 4 0
1 Jul 7331 Mar 74 1 Apr 7530 Sep 75 31 Jan 8031 Mar 81 1 Jul 9030 Sep 91

Source: Reuters Ecowin. Data to 21 April 2008

5. FTSE price/earnings (P/E) ratio 29 January 1993 - 21 April 2008

P/E ratio on FTSE All Share index Ratio 30 26 22 18 14 10

93

94

95

96

97

98

99

01 03 05 07 00 02 04 06 08

Source: Reuters Ecowin. Data to 21 April 2008

6. FTSE earnings yield vs. 10-year gilts 29 January 1993 - 21 April 2008
Earnings yield on FTSE All Share index Yield on 10-year gilts % 10

93

94

95

96

97

98

99 01 03 05 07 00 02 04 06 08

Source: Reuters Ecowin. Data to 21 April 2008

03

Investment Topics Navigating rough seas May 2008

Our approach to asset management In this context although Neil is not happy with the poor relative performance of his funds in comparison to the peer group during the first quarter of 2008, he is optimistic about future prospects. In that quarter the Invesco Perpetual Income Fund lagged its peer group (the IMA UK Equity Income sector) by 2.62%. Such weak relative performance has been seen before. Most notably, this happened in the fourth quarter of 1999 when the technology and telecommunications boom was at its peak but such stocks were not held in Neils funds. In the eight quarters following that, however, as the tech boom deflated, the Income Funds performance exceeded that of the peer group in every quarter (see Figure 7). That, of course, was an extreme episode. Looking instead at all previous quarters in which the Invesco Perpetual Income Funds performance has lagged the peer group by the same margin as in the first quarter of 2008, that is 2.62%, and then tracking subsequent relative performance we see the pattern in Figure 7. That is, the Invesco Perpetual Income Fund outperformed the peer group in seven of the eight subsequent quarters. However, past performance is not a guide to future returns.

7. Invesco Perpetual Income Fund Performance relative to sector

Performance in 1999 Q4 and subsequent 8 quarters Performance for all quarters in last 20 years when performance has been 2.62% or worse than peer group and subsequent performance % 10 8 6 4 2 0 -2 -4 -6 -8 -10 +1 +2 +3 +4 +5 +6 +7 Subsequent quarters +8 Underperforming quarter

Source: Lipper. Data to 21 April 2008

Past performance is not a guide to future returns.

8. Invesco Perpetual Corporate Bond Performance relative to sector

Performance in 1998 Q3 and subsequent 8 quarters Performance in 2001 Q3 and subsequent 8 quarters % 4 3 2 Underperforming quarter

Similarly, our fixed income funds have 1 also experienced periods of poor 0 relative performance when bond market -1 conditions have been unusual. In both the third quarter of 1998 and the third quarter -2 of 2002 the Invesco Perpetual Corporate -3 Bond Fund had quite large exposure to -4 credit compared to other funds in the +1 +2 +3 +4 +5 +6 +7 +8 Subsequent quarters IMA UK Corporate Bond sector. The funds relative performance was adversely Source: Lipper. Data to 21 April 2008 affected by this exposure. The team could Past performance is not a guide to have cut their credit exposure at those future returns. times but decided that was not the right strategy. Broadly, they maintained a relatively high exposure to credit risk and this was well rewarded in the subsequent eight quarters, as shown in Figure 8. Conclusions The UK equity bear market may well, In recent circumstances, the fixed income this time, be accurately predicting that teams performance has not been behind the UK enters a recession. However, in that of the peer group. But bond market both the UK equity market and in fixed conditions have been unusual and they income markets we see very attractive find themselves in a situation where they opportunities. In large part, these have are seeing value in many areas of the been generated by the somewhat market which are being shunned by other indiscriminate behaviour of the market investors. In many cases this is because during its sell-off. In our UK income there are forced sellers in the market. funds, performance relative to the peer But Paul Read, co-head of Fixed Income group has been adversely affected, but at Invesco Perpetual, describes the as this has been driven by the unusual opportunities available in credit markets as market dynamics we see no reason for a of the type which occur only once or twice fundamental change of strategy. in a fund managers career. In managing fixed income funds, the team has been able to take advantage of those opportunities both because of the high levels of cash and liquid bonds which were held in their funds as the credit crisis unfolded from August 2007 onwards as well as because of continued inflows into their funds.
04 Investment Topics Navigating rough seas May 2008

Further Information
Contact us Invesco Perpetual Broker Services Telephone 0800 028 2121 www.invescoperpetual.co.uk

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. As one of the key objectives of the Invesco Pereptual Income Fund is to provide income, the annual management charge is taken from capital rather than income. This can erode capital and reduce the potential for capital growth. Past performance is not a guide to future returns. Where Neil Woodford and Paul Read have expressed views and opinions, these may change and are not necessarily representative of Invesco Perpetual views. Please refer to the latest Full Prospectus, Simplified Prospectuses and relevant Key Features and latest Annual or Interim Short Reports for more information on our funds. This document is for Professionals Clients only and is not for consumer use. Telephone calls may be recorded.
Invesco Perpetual is a business name of Invesco Asset Management Limited Authorised and regulated by the Financial Services Authority Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK
37729/PDF/010508

05

Investment Topics Navigating rough seas May 2008