Confidence in a falling market
Following the evaporation of initial gains in 2004, the outlook for UK equities for this year is brightening.
The likelihood of further rises in interest rates appears undiminished however. Robert Parkes, UK equities strategist at HSBC notes: “We think rates will be raised as an insurance policy against risk of deflation in the medium term arising from the downside risks in the housing market, the level of consumer debt and how that will respond in the higher rate environment. The overall debt burden just as it has held growth up over the last few years we think it will hold growth back over the next few years.”
He explains that while indicators pointed to a slowdown at the end of last year, since then we have seen an acceleration in consumer demand. “Given the starting point of very high debt levels and the acceleration in the housing market, rates will have to increase sooner rather than later. Our economists see rates reaching 5% by the end of the year.”
John Storkerson, portfolio manager, global core equity at Putnam Investments points to some dark clouds on the horizon: “I have seen figures that show that bankruptcies among home owners is the highest that it has been for a number of years.”
As for the markets, Parkes is cautiously optimistic. “We have a target for the FTSE of 4,700 for the end of the year, driven by continued good news on the corporate side,” he says. “Earnings growth will be in the region of 7% this year, and if you add in the dividend yields we forecast a market return 10% from this point to the end of the year.”
Storkerson, who selects UK stocks where they can contribute to a global portfolio, agrees that there are opportunities to be had in the market: “The market did well at the start of the year but since then it has lost all its gains. All the markets are below or at where we started the year in terms of index.” He adds: “We will not see the market gains of 2003 but I think a return of 10% is possible.”
The data is certainly encouraging. “Corporate profits are growing at record levels,” notes Storkerson. “Dividends are rising. They have ample cash to provide for this year’s spending and next year’s as well.”
Sectorwise, oil has emerged as favourite of the month. This is certainly the case for Parkes at HSBC. “At the start of the year people were talking about the price falling back,” he says. “That hasn’t happened so analysts have upgraded the profit forecasts for oil companies so that has driven the sector higher.”
Storkerson shares the enthusiasm. “We don’t see the price of oil going down to $26 a barrel in a hurry, in large part due to the increase in world demand,” he says.
Telecoms is another sector that is returning to favour. “People say the mobile side is returning to utility status but we think it is still a growth sector,” says Parkes.
There are also opportunities to be had in non-cyclical sectors, notably in pharmaceuticals. “We have recently shifted from underweight to neutral,” says Parkes. “This has been one of the most under-performing sectors over the last year. Now it is starting to look attractive and has been one of best performers over the current quarter.”
Consumer markets present contrasting scenarios. “We like consumer staples,” says Storkerson. “In the last six months people have been moving into the cyclical end of the market trying to get gearing and leverage of economic growth. In the process this has left a valuation vacuum for some of these companies.”
Parkes sees danger elsewhere in the consumer sector: “General retail is our least preferred sector given its exposure to discretionary consumer spending and the likelihood of a slowdown there,” he says. “We think there is further bad news to come and so we expect that sector to under-perform.”
He adds: “We also have an underweight stance on banks. There is concern over the potential slowdown in loan growth, an increase in the number of bad debts and a slowdown in refinancing activity. In addition, competition in the banking sector is intense so margins are under pressure.”
So what is the small cap / large cap view? Parkes notes that small and mid caps have had a tremendous run on the back of the recovery in the economy. “As they tend to be more cyclical in nature, and given that our current preferred sectors of telecoms and oil are in the FTSE 100, we think large caps will outperform this year.”