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Some grounds for optimism

Looking ahead to next year, prospects for the UK economy are hardly sparkling. While war with Iraq looms and the US economy appears unable to get back on its feet, UK investors feel well and truly rattled. But the doomsday scenario being priced in by the equities market may be exaggerated, say equity strategists.
“If you look at all the traditional measures, they basically say that what the equity market is pricing in is not a slow economic dip but a collapse,” says Peter Saacke, European equity strategist at Merrill Lynch in London. “In our view that is overdone.”
Assuming the stock market comes to realise this, he says, the scene could be set for an autumn bear market rally.
Bob Semple, UK equity strategist at Deutsche Bank, says there are some reasons for optimism. “In terms of factors that drive the UK market, it looks good value. What tempers that is that you can’t say the same about the US,” he says.
He sees the UK economy growing moderately from this point on, and is hopeful that this view will take hold in the market. “By the end of the year, the market should have seen some improvement.”
Neil Dwane, chief investment officer of Europe at Dresdner RCM Global Investors, agrees that prospects for the US economy are dismal. “Looking ahead into 2003, we are cautious of global economic improvement. We still think there is a high probability of a double-dip recession in the US.”
In Europe, the economic climate will be lacklustre, he says. “Companies will not have a buoyant environment into which to sell their products.”
Even assuming that the UK economy is set to improve, it may be some time before the domestic consumer actually feels the effects of this. Putting the current situation into a historical context, Dwane notes that when the economy pulled out of recession in the early 1990s, it was not until 1994 or 1995 that people in Britain saw things getting any better.
While Saacke sees some upside for UK share prices, he points out that this scope is very limited. Valuations are currently fair, but not extremely cheap. “Early growth expectations are still too high. Growth in earnings over the two-year period from 2001 to 2003 were expected to come in at around 40%, but the actual rate of growth is more likely to be 20%, he says.
The UK equities market has suffered an unforeseen degree of selling this year. Dwane says he was among the most downbeat stock market forecasters at the start of this year. “But even I was not pessimistic enough,” he says.
The main risks for the UK market currently are the extent to which market participants worry about the economic data coming through, and US President George Bush’s plans to go to war with Iraq, says Semple. The market is likely to remain unsettled as long as this potential military conflict is in the air, he says.
The prospect of another Gulf war also raises the spectre for investors of accelerating inflation, Dwane points out.
Semple sees the FTSE ending the year between 4,400 and 4,800. However, following this recovery, progress is unlikely to be inspiring. Concerns about US accounting practices continue to gnaw away at investor confidence, and this has a knock-on effect on the UK market, even though there are no major systemic doubts over UK accounts.
“In the UK, people feel reasonably happy with accounting standards,” he says. “The issue here is one of the economy.”
It will only be in 2003, when a clearer picture emerges of the state of the US and UK economies, that forecasters will be able to predict the shape the market will take, says Dwane.
“We could be in for another year of dull market returns,” he says. “The winners are going to get stronger and the losers will continue to find the going tough.”
In the choice between sectors, investors would be wise to stick to energy and autos. “We think that to benefit from a bear market rally, it makes sense to have cyclicals,” says Peter Saacke. Merrill Lynch remains sceptical about telecommunications and technology stocks, and continues to underweight insurance and pharmaceuticals.
UK consumer spending on housing, home improvements and leisure activities is one area where things appear well set, says Dwane. A perception that trade unions are becoming stronger in the UK fuels the view that pay for lower-paid employees could rise by more than expected. This will buttress UK consumer spending, says Dwane, with the gambling, leisure and pub retailing sectors in particular benefiting from increased turnover. Retailers such as Marks & Spencer and Next could gain too.
If war breaks out, then oil stocks could benefit, but on the other hand tourism and airlines would do poorly, he says.
Merrill Lynch expects to see the Bank of England to cut interest rates by 25 basis points in October – a move the securities house forecasts will be mirrored by the European Central Bank in November.
But with interest rates in the UK already so low, there is little room for further reductions.

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