Warning despite record returns Following a dip in investment income in the fourth quarter, Hong Kong's de facto central banker has sounded a note of caution on the outlook for reserve returns for this year, even as the Hong Kong Exchange Fund he oversees reported record earnings of HK$142.2 billion for last year. Reflecting volatility in global financial markets, investment income attributable to the exchange fund - a pool of reserves that backs the Hong Kong dollar - fell nearly 46 per cent to HK$33.4 billion in the fourth quarter from the third quarter. For the full year, however, the fund posted its best performance ever, with income surging nearly 37 per cent over the 2006 level. It made a return of 11.8 per cent, the highest since 1998, surpassing the Exchange Fund Advisory Committee benchmark of 10.6 per cent. However, 'only one word can describe the investment outlook for this year, and it's difficult', Monetary Authority chief executive Joseph Yam Chi-kwong said. 'I am not too optimistic that the record-high earnings in the past two years can be sustained [this year].' Earnings from Hong Kong stocks shrank to HK$5.7 billion in the fourth quarter from HK$35 billion in the third, while investment in other equities widened losses to HK$4.4 billion from HK$1 billion during the quarter. The government received an investment return of HK$27.6 billion for the year from its fiscal reserves deposited with the fund, slightly higher than its budgeted investment income of HK$25.8 billion. Meanwhile, the investment income of the government's 5.88 per cent stake in Hong Kong Exchanges and Clearing amounted to HK$4.7 billion, making a total return of HK$146.9 billion. Bonds were the major contributor, making up HK$61 billion or 42.89 per cent of total investment income, having soared 91.2 per cent in value from 2006 levels. Hong Kong equities followed, accounting for HK$55.8 billion or 39.2 per cent of investment income, having risen in value by 55.4 per cent. Income from other equities fell, however, to HK$6.7 billion from HK$18.7 billion a year ago. 'We are very prudent in bond investment and didn't hold any subprime investment,' Mr Yam said, while attributing the strong performance of bonds to the intensifying US subprime mortgage crisis, which sent more investors to the bond market in a bid to avert risks. On the other hand, equity markets were extremely volatile, particularly in the second half, Mr Yam said. 'Gains in foreign equities markets in the first half were partly reversed in the second half because of concerns about money market tightness and corporate profits,' he said. The investment environment this year would be even more challenging as financial markets have dipped in the first two weeks of the year on deepening concern over subprime woes. 'Market sentiment could deteriorate even further,' Mr Yam said. 'There could even be a doomsday mentality. I hope that won't happen.' He warned investors to be prudent. Billy Mak Sui-choi, an associate professor at the department of finance and decision sciences at Hong Kong Baptist University, said: 'I wouldn't be surprised to see the Exchange Fund make only a single-digit return this year.' The fund's investments could make a loss if stock markets continued to weaken, he said.