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Impact Investing

IPE special report May 2018

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Market stuck in a rut

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Hopes for a significant recovery in the UK equity markets this year have all but disappeared. Investor responses to negative news in the telecommunications sector have been surprisingly bearish, say strategists. If this attitude persists, market levels are bound to stay depressed, they say.
Shares of companies in old economy sectors have picked up, they note, but current prices of shares in many new economy businesses are still higher than warranted.
Darren Winder, UK Strategist at UBS Warburg, says the outlook for the coming six months is pretty tough: “It’s quite hard for the market to make progress given some of the valuations,” he says.
In the first half of this year, some of the hidden value in more traditional industrial sectors – such as construction and manufacturing – has started to show through in share prices. But capital spending plans are still at a low ebb, and this has had a knock-on effect on new economy companies, say strategists.
Though the market is anxiously looking to economic data for indications as to when domestic business activity will pick up, the picture is far from clear. “There seems to be a contrast between survey data and official data,” says Khuram Choudhry, equity strategist at Merrill Lynch in London. “A recovery does appear to be happening, even though GDP for the first quarter was fairly flat.”
Winder says the FTSE 100 index is currently at the lower end of a trading range between 5200 and 6200. It is likely to stay within this range for the next six to 12 months. “Earnings are likely to grow overall in the next 12 months, but we’re not going to see rapid growth in earnings,” he says.
News in the technology sector has been worse than anticipated. But this negative factor has been compounded by the way investors have reacted to the news, says Winder. These reactions have been more aggressive than imagined, he says.
Even though the prospects for blue chips are muted in the near term, Choudhry says Merrrill Lynch favours mid and small cap companies. “Valuations in these segments of the market are comparatively good,” he says. “Mid caps are currently trading at a discount of around 10% relative to large caps, while for small caps the relative discount is greater at between 15 and 20%.
“But within those sectors, we still believe some aspects of the market will continue to be under pressure,” he says, referring to the technology and telecommunications sector. As a whole, the telecommunications sector is still trading on an earnings multiple of 30 compared to the average multiple for the market of 19, even though telecoms profits are not expected to grow faster than the market.

Stocks in the construction sector
Nigel Lanning, director of European equities at Dresdner RCM Global Investors, says index levels indicate a weaker market than is actually the case. “The market has calmed down, but this is a bit of an illusion. If you take TMT out, the market is only just under its all-time highs,” he says. “Everyone feels gloomy, but there is a distortion to what’s really going on.”
The fact that growth is now stronger in the US and Far East is positive for the UK stock market he says, pointing out that half of UK profits in total come from overseas sales.
Even if there are some fundamental reasons to buy stock, strategists say the market needs to overcome its bearish mood before any real lift in index levels is possible.
Choudhry says Merrill Lynch’s latest fund manager survey showed that cash levels are low, leaving little room for new investment. Winder forecasts interest rates will remain at their current levels throughout the summer. The Bank of England’s policy setters are unlikely to raise the cost of borrowing unless they see an improvement in economic conditions, he says.
Choudhry says recent comments from the Bank of England suggest that interest rates are not likely to rise before the fourth quarter of the year – rather than in the second or third quarter of this year as had been expected.
James Knightley, economist at ING Financial Markets, predicts the UK base rate will rise by just 50 basis points by the end of this year – slightly less than the 75 basis point hike being factored in by the futures market. Despite the fact that surveys are pointing to strong growth, harder data – such as retail sales – are still pretty soft, he says, and this is something the Bank of England is aware of.
In the Bank’s latest quarterly report, central bankers said inflation is expected to stay below target over the next 18 months before moving above it as the two-year horizon approaches. Overall risks, the report said, were moderately on the upside.
Comparing the UK market to its international counterparts, Noel Mills, asset allocation strategist at Barclays Global Investors says UK equity value is not quite as alluring as in continental Europe. But it is certainly better than in the US, he says. “It is the economic impact of a persistently strong currency that still gives cause for concern,” he adds.

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