As We See It, the Current Equity Outlook ...                     Third Quarter 2007

The third quarter of 2007 will be remembered as a period of tremendous volatility in financial markets. The US housing bubble finally burst and consumers pulled their horns in a little, but not enough to quell all fears of inflation. Markets overseas remained strong, but fear of global contagion prompted central banks outside the US to either ease or cease tightening their benchmark interest rates for the time being. Business spending appears to be holding up reasonably well, but can be expected to soften over the near term.

Stocks in the financial sector were hardest hit, either through their direct or indirect association with the "sub prime" mortgage market. While this is not a comfortable situation, it was predictable and ultimately healthy, as lenders and borrowers who engaged in risky behavior, wittingly or not, are experiencing the consequences of imprudent decision making. Our exposure to these markets is minimal, and while the financial stocks we do own corrected sharply due to their guilt by association, they were strong companies going into the crisis and are emerging with improved competitive positions on the other side. They will have renewed growth opportunities as financial and housing markets normalize.

We are getting our first real autumn weather here in Connecticut, after an unusually warm September. The change is welcome, but brings us closer to heating season, and energy prices remain near record highs. Our belief is that high energy costs are an additional drag on the consumer, and that combined with the housing issue, they will dampen consumer spending for the foreseeable future. Our outlook for the markets in general is similarly cautious; we think that there is relatively little upside this year to the gains we have seen so far.

We are pleased to announce that Henry Woo has joined Johnston Asset Management. Henry was formerly with Trainer Wortham & Company in their New York offices, where he covered technology stocks. He will be broadening his coverage horizons here and is fitting in nicely with the rest of the team. He is a graduate of M.I.T., and holds masters degrees in both computer science and business from Penn/Wharton. Henry is an engaging and energetic individual whose impact is already being felt in our research. Thanks to you, the firm has experienced handsome growth over the last few years, and we are being very careful about hiring the right people to give you both the investment results and high levels of individual attention that you have come to expect.

Sticker Shock!

The first sign was the difficulty I had boarding my recent flight to London. I was jostled repeatedly by jolly Brits laden with large, overstuffed shopping bags. As I was wacked yet again by one of my fellow passengers as she swung her bags up in the air to shove them into the overhead bin, I realized that these shopping bags weren’t filled with high-end merchandise, they were from the likes of H&M, Gap, etc. After she apologized, "Oh, I’m ever so sorry!" I seized the opportunity to ask her about her trip. Yes, it was a "Bargain Shopping Trip to New York" one of many that are heavily promoted by U.K. tour companies these days. It was so cheap, the whole family, even Grandmum, had come!

The fact that the US dollar is weak is old news, yet it was still surprising to experience firsthand just how weak it has become. A tube ticket cost $9 compared to a $4 subway ride in NYC, and the wireless internet connection in my room set me back more than $30 per day. Let’s not even get into the cost of that hotel room which truly made me ill upon checkout, which unfortunately coincided with sterling’s rally to 2.10. There was a relative bargain though: my Grande coffee at Starbucks was only $3.60 vs. $1.95 in New York.

The dollar was historically high in 1984, when I was lucky enough to travel to Paris on business and came home with my own overstuffed shopping bags. Post the 1985 Plaza Accord, the greenback weakened sharply, and then continued to depreciate more gradually through the early ’90s, then strengthened again. It peaked around 2002 and has been declining since then. Right now it’s about where it was in the late ’80s and early ’90s. The structural problems of the US trade and current account deficits remain, and speculation that the Fed will continue to reduce interest rates further dims the allure of US assets. There are already signs that China and perhaps some other Asian central banks have begun reducing their purchases of US government securities.

Despite the clear undervaluation on the basis of purchasing power parity, the dollar has not yet shown any sign of bottoming out. For our clients with non-US portfolios, the weak dollar has provided a nice performance boost. It’s a double-edged sword though, as many of our investments have US$ exposure and are feeling the translation effects. Some of the company managements I visited with on my trip bemoaned the pain, including Diageo and Roche Holdings. It seems as if the weakness will never end, but it will, perhaps relatively soon if European central banks begin to ease. That strength may prove short-lived, as the 2005 rally was, but it could be significant. We may never see the 1984 highs again, but there will again come a time when currency hedging will be a valuable tool in the international portfolio manager’s arsenal.