Still in pretty good shape
Despite the battering suffered by UK share prices so far this year, strategists says that the country’s economy is fundamentally still in good shape. Worries about economic weakness in the US and Europe have dragged London prices down, they say.
The UK economy could be even fitter than official figures suggest. Darren Winder, UK economist and strategist at UBS Warburg, argues that at least one traditional barometer of the economy is underestimating the strength of the domestic economy.
“The economy should continue to enjoy steady growth coupled with low inflation,” he says. Consumer confidence and growth in money supply all seem very robust, and this seems to contradict output-based indicators, he says. On the basis of production figures, it looks as if the UK economy grew at just 0.3%, he says, but in reality the growth figure is probably between 3 and 4%.
This indicator is failing to reflect domestic growth at its full rate, says Winder, because the measure’s weightings are simply out of date. They were last set in 1995. The true industrial mix of the UK economy has changed a lot since then, but despite this, the indicator will not be realigned for another 18 months, he says.
“I think there’s a definite possibility it could be understating growth,” he says. A similar situation happened in the late 1980s, he says, where the UK economy later turned out to be growing more rapidly than the indicator was showing.
Winder says it is unlikely GDP growth will be less than 2% this year. And there is still the opportunity for the Bank of England to lower interest rates – another reason for the stock market to reverse its downwards trend.
The bank’s monetary policy-makers cut interest rates by a quarter point in early April but this move was made mainly as an insurance policy against the global backdrop, says Khuram Chaudhry, UK strategist at Merrill Lynch. The state of the domestic economy cannot have been a concern, he says, with consumer spending, house prices and other indicators all higher.
But as long as foreign market indices stay under pressure, the FTSE 100 will find it hard to break away from the depressed trend just yet, says Chaudhry. “The FTSE is unlikely to de-couple from the US or European indices because company earnings are derived from a number of countries,” he says.
Small and mid caps, however, should perform well, he says. Their valuations are looking attractive right now.
While the market as a whole is now trading on a price/earnings ratio of 17 looking ahead to this year’s profits, medium-sized and smaller companies are trading on PE ratios of between 11 and 12 – representing a 30% discount to the broader market, says Chaudhry.
The Dow Jones Industrial Average and the CAC 40 have fallen by around 7% so far this year. And there is still no sign of brighter news coming from the US and European markets. Companies across Europe are downgrading expected earnings figures, he says.
“The US has had its biggest growth shock for 10 years,” he says. “In September last year, economists were on average looking at growth of 3.7% for this year, but today some economists are now forecasting 1.9% growth.”
In the UK, on the other hand, GDP predictions for this year have remained relatively steady over the past six months at 2.5%, according to Chaudhry.
“The UK market is very cheap relative to other markets... On a six-month view, mid caps should outperform large caps, and I would put my money into stocks which benefit from lower interest rates, such as retailers, construction, transport, leisure and banks,” he says.
The FTSE 100 should reach around 6,600 by the end of the year, he predicts.
Deutsche Bank UK equity strategist Bob Semple sees domestic growth at 2% this year, picking up next year. Market valuations do not seem over-demanding at the moment, he says. The UK market benefits from having a defensive market structure, he says.
Though he forecasts the FTSE 100 will rise from the current doldrums to between 6,500 and 6,750 at the end of the year, he says recovery is not imminent. “Next month it will probably still be flat on its back,” he says. It will take some time for the economic medicine of tax cuts to come through, he says.
The crisis in the UK’s farming industry brought on by the spread of foot-and-mouth disease among sheep and cattle will not leave the economy as a whole unscathed, say RBS Financial Markets economists Ross Walker and Geoffrey Dicks.
“The macroeconomic costs in terms of output, the balance of payments and the public finances are not insignificant; the costs to some sectors and regions are much greater,” the two economists said in a research note.
Walker and Dicks said that according to their rough estimates, the crisis would lower UK GDP this year by 0.3 percentage points and help push the public sector back into deficit in 2002/03.