Confidence reigns for now
It may still be autumn, but players in the UK markets are acting as if spring has well and truly sprung - at least as far as the economic outlook goes.
The rout in share prices seen since July knocked about 20% off the FTSE 100 index, but equities have bounced back since then. Whereas merchants of doom were predicting the economy would contract next year, now some optimistic voices are saying the Bank of England has nipped any serious downturn in the bud.
I think the fears of a recession are exaggerated...the consumer has been thrown a lifeline," says Geoffrey Dicks, UK economist at Greenwich NatWest. At its October meeting, the Monetary Policy Committee of the Bank of England cut the cost of borrowing by 25 basis points, bringing the repurchase rate down to 7.25 %.
UK equities are now looking reasonably attractive, says Gareth Williams, UK strategist at ABN AMRO. "We were quite bearish in the first half; valuations were stretch-ed, profits were coming un-der pressure and the outlook for interest rates wasn't en-couraging...but all three things have got better."
Among shares, there may be some bargains to be had if worries about economic weakness really have been overblown. "The market is priced on the basis that the UK's going into a recession, which we don't think will happen," says Williams. Particularly stocks exposed to the UK consumer now look attractive, including retailers and builders, he says.
Until recently, commentators have been comparing this year's signs of economic weakness to the run up to the major recession in the late 1980s and early 1990s. But this degree of pessimism now appears unjustified, some say. "Household balances are nowhere near the level of the late eighties...and the housing market hasn't really had a big boom at all," says Williams.
Paul Turnbull, chief economist at Merrill Lynch agrees that domestic economic fundamentals do not appear to be as dire as many players say. The economy is obviously slowing, which will have some impact on corporate profits, but interest rates are now coming down, he says. Merrill Lynch forecasts 1-1/4% GDP growth next year compared with an estimated 2.7% growth rate for this year.
"The Bank of England Monetary Policy Committee has erred on the side of caution," says Dicks. "They're probably doing too little too late, but they are on the case," he says. Apart from the ef-fects that a credit easing should have on consumer spending, the move towards lower UK rates has also given exporters a helping hand by denting sterling's strength on the foreign exchanges.
Dicks expects another 25 basis point easing in November, though 50 basis points is possible. Turnbull also sees a quarter point cut with base rates down to 6% by next Spring.
The minutes of the Bank of England's October meeting reinforced expectations that UK rates will be cut again in November. Two members of the policy-setting committee had apparently called for rates to be cut by "at least" 50 basis points, instead of the 25 basis points by which rates were eventually cut that day.
However, though views on the economic outlook may have brightened, danger signs are all too apparent. Retailers in various sectors reported sharp drops in trading in September. There is weakness in the financial and manufacturing sector -together adding up to 30-40% of the UK economy, says Dicks.
For bonds, he says little change is likely in the next few months at the 10-year end of the yield curve. All the action will be in short-term rates following the anticipated rate cuts from the central bank.
But Andy Bevan, senior bond economist at Goldman Sachs sees 10-year gilt yields coming down to 4.5% in the next three months from around 5% now.
This forecast incorporates a fairly significant spread tightening relative to European markets, he says. "Interest rates are likely to come down by more than is currently discounted in the market, so bond rates would come down in line with that," he says.
Whereas the market has factored in short-term rates coming down to 6% and then stopping there, Goldman Sachs believes the Bank of England will ease credit much further that that, says Bevan.
In general, analysts see the FTSE 100 picking up to around 5,500 by the end of the year from around 5,200 now. While this may be positive, the market is set to remain volatile given the global backdrop, says Turnbull. Rachel Fixsen"