The view of the UK economy is upbeat as the Bank of England keeps the lid on inflationary pressures.
Andrew Milligan, head of global strategy at Standard Life believes that the Bank of England is going to be going slow in terms of rate rises. “We have seen some weakness in the housing market,” he says. “We expect the bank to move again in November. Rates will reach a peak of 5.5% by the middle of next year.
“At the moment it looks as though the bank has been wanting to see a better balanced economy and so far that seems to have been happening.”
In its most recent Strategy Paper AXA Investment Managers UK agrees: “the trend in retail-sales growth has shown few signs of weakening recently.”
It adds: “At the same time, consumer confidence fell in June to its lowest point in six months reflecting reaction to the two consecutive rates hikes and speculation of further increases.”
However, it notes that inflationary pressures building on various fronts. “First, energy prices have remained high for a prolonged period, and this strength is likely to put pressures on production prices. In addition, as the manufacturing sector gathers strength, so does its pricing power. The strong producer price index will begin to be passed through to consumer price index inflation. Secondly, the labour market is tightening and pay settlements are accelerating significantly. Against this background, we expect wage pressures to grow in strength and weigh on inflation.”
This means that the output gap will narrow and inflationary pressures will build, offering grounds for further monetary-policy tightening. AXA IM notes that the level and pace of recent GDP growth has been revised upward to 3.4%. It states: “Against this background, inflationary pressures could be exacerbated, raising the possibility that the BoE is behind the curve.” But it provides some reassurance: “solid income growth should offer a solid cushion to consumption.”
AXA IM also believes that the slight depreciation in Sterling is likely; “this could lead to further deterioration in the price picture, bringing in imported inflation.”
In terms of sectors, there is some consensus on banks and utilities. Milligan of Standard Life says: “We still have a cyclical bias. We remain heavy in the mining sector; supply is still relatively constrained and China is continuing to show moderate growth.”
He adds: “We remain heavy in telecom stocks because of valuations and because of the free cash flow that some of these companies are generating. Because of the shift in interest rates we also like a number of the financial stocks, but that view could change quickly depending on how we see the interest rate cycles altering over the next few months.”
Meanwhile Merrill Lynch in its August UK Chart Book has similar preferences. The basis for this is that three out of five macro indicators are falling: 12-month change in UK bond yields, OECD’s UK leading indicator and UK producer price inflation. “Rising oil prices, higher interest rates and a peak in profit revisions – suggests bond yields may edge down further. Historically, both utilities and banks have risen vs. the market – when bond prices rise and yields fall.”
Retail provides a more mixed picture. “We are taking it on a stock by stock basis,” says Milligan. “There are a number of retailers that are doing very well, like Next; others look like they're losing market share. Stock analysis applies to the consumer leisure sector in general.
Meanwhile small caps are favoured over large cap. “One of the reasons is a structural,” notes Milligan. “We see a lot of the FTSE100 companies constrained by legacy, pension-type issues. Small cap are more free in this respect.”
He concludes: “We are still relatively upbeat about the UK economy into 2005 and 2006. Undoubtedly there are issues surrounding the housing market and consumer debt but the triggers for those to be brought down are a sharp rise in interest rates and a sharp rise in unemployment, and neither looks likely in the foreseeable future.”