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How much further to go?

The UK equity market is likely to underperform its main rivals in 2004. The UK economy has weathered the storm relatively well and as such scope for large gains is limited.
The UK equity market one of the most expensive equity markets in the world having participated in the rally that started in March last year,” explains Haydn Davies, chief economist at Barclays Global Investors. Director dealings are weak in the UK market indicating that their shares are not attractively priced.”
He adds: “Additionally it is a fairly low growth market given that it’s dominated by pharmaceuticals, banks and oil companies which are fairly mature industries. Furthermore it will have to compete against a headwind of rising interest rates.”
So Davies’ prognosis for the FTSE-100 is modest: “we think the index will end the year at 4,600. The markets have factored in a lot of good news on the economy front with the rally that we have seen over the last nine months. In last couple of months investment analysts in aggregate have been downgrading their profits forecasts.”
Nigel Richardson, senior strategist at AXA Invesment Managers UK Ltd. expects the FTSE to increase in line with nominal growth in the underlying economy which he expects to be between 5 and 7%. “Cyclical sectors – consumer durables, industrials, materials – will do well,” he says. He adds: “in general we will expect small caps to catch up the large caps.”
Rick Lacaille, chief investment officer at State Street Global Advisors’ London Office is generally more optimistic: “I expect the index to reach 4,800,” he says. “There is some good earnings growth coming in countering negative so the market won’t look stretched.”
A lot will depend on the prospects for economic growth and interest rates. On the latter there seems to be some consensus: “We expect a series of moderate, modest tempered interest rate rises to 4.75% by the end of the year,” says Richardson. “Our outlook has not changed at all. Davies agrees: “We’ve been saying about 4.75 for a little while. Household debt is at record levels and that increases the sensitivity of borrowers to a change in interest rates.”
The outlook for economic growth varies. The positive prognosis for world growth gives Richardson cause for optimism: “While the demand for consumer credit is slowing and the housing market has reached a cyclical peak, we remain upbeat,” he says. “Export-led growth in the US will stimulate the world economy and UK manufacturing will benefit in terms of firmer exports; financial services will benefit too.”
However, Davies at BGI is sceptical about the impact of world growth on the UK economy: “That’s a fairly optimistic view,” he says. “Although world trade has picked up in the last 18 months UK exports have been flat at best. UK’s main trading partner is the Euro-zone and that where growth is weakest. Consumer spending which accounts for about 60% of demand is falling in Germany and Italy and won’t be long before it is falling in France too. That’s not helpful for the UK.”
He adds: “In terms of the biggest growth regions in the world US and Asia, sterling has appreciated against the US dollar and against the Asian currencies like the Chinese ramimbi that are tied to the US dollar. Furthermore the banking sector in UK very domestic focus. In addition the Bank of England is concerned about the growing household debt. So UK banks are not going to benefit from global growth.”
He adds: “Furthermore the economic outlook is not promising. Even though sales has been booming the demand has not benefited UK companies. Moreover retailers only way sustaining strong sales growth is by discounting very savagely. Some firms are going to find it harder still as taxes and interest rates rise.”
Lacaille highlights the contribution of public sector expansion: “The government continues to spend at an awesome rate which fills the gap left by the consumer slowdown. The rate of increase is quite substantial.”
The negative impact of the weak US dollar on the UK economy makes observers of the UK market that much more excited about the prospect for a rise in the historically low interest rates. “The Fed will raise rates early in the second half this year although doesn’t like to raise rates during an election campaign,” says Davies. However, the most recent data shows only modest employment growth.
Overall, sentiments about the prospects for UK equities have changed over the past year. “Weaker sterling has boosted the outlook for profits,” says Davies of BGI. “However, companies are still looking expensive.”
Lacaille notes increasing optimism: “Twelve months ago we were in a trough because we thought that there might be a physical interruption of the oil supply. There was a small chance there would be a disaster so it was right that equities should carry a risk premium. Circumstances have obviously changed since then.”
A fall in sterling would do much to improve the outlook, but while rates are likely to remain ahead of the US and Euro-zone for the coming year investors would be well advised to look elsewhere for now.

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