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Optimists and pessimists vie over UK prospects

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There is good news ahead for investors in UK equities. Not only could corporate earnings show double-digit growth next year, say equity strategists, but in the middle of 2000 the market may be buoyed up by the notion that interest rates have peaked.
But none of this is happening just yet. In the next six months as the market waits for this rosy scenario to emerge, market participants may have to resign themselves to the blue chip index trading in a narrow range.
“In the next few months we may well see something of a rollercoaster ride for the equities market,” says David McBain, UK strategist for Deutsche Bank. “Everything is very much in the grip of the swings in the bond market and the gilts market in particular,” he says.
But in 2000, interest rates should peak at 6.5%, and earnings growth could bounce back into double figures, says McBain. However, so far there has been little in terms of positive corporate earnings to give the market a fillip. At the moment, earnings downgrades are continuing to show through, he says.
While sentiment is set to remain fairly upbeat in the last few weeks of this year and although the market is quite well underpinned in terms of valuations, inflation pressures are still thought to be lurking. There is still a risk that the next set of economic data could show stronger than expected economic growth, fuelling fears of a more severe monetary tightening, says McBain.
The FTSE 100 index, currently around 6,600, is likely to remain confined to a range between 6,000 and 6,600 until next summer, and reach 6,800 by the end of next year, he says. Philip Wolstencroft, UK equity strategist at Merrill Lynch says the institution is cautious on the UK equity market, and predicts the index will stand at just 6,200 in six months’ time.
“Our concerns are that we are in a world of strong growth where interest rates are rising… this is more of a global phenomenon than something that is happening in the UK,” he says.
Wolstencroft says globally, central banks are probably underestimating economic growth, so interest rates are likely to go up further than they have already. But this does not necessarily apply to the Bank of England, says Gareth Williams, UK equity strategist at ABN AMRO. “I think they have been pre-emptive in their actions and that is encouraging,” he says.
ABN AMRO takes a more positive view on the UK equities market. “There is a pretty benign economic backdrop where growth is picking up but inflation is not really there… and valuations are not particularly stretched,” says Williams.
Everyone is waiting to see when and at what level interest rates peak. Williams forecasts UK base rates will peak at six percent in the middle of next year, up from 5.5 percent now.
Recent outbreaks of ‘bid fever’ have helped the UK market recover, says Williams. These flurries of mergers and acquisitions are also a reflection of the difficult trading environment facing companies, he says. Low inflation has put pressure on companies to try to keep their returns high, and cost cutting is one of the few options open to them.
But Richard Jeffrey, group economist at Charterhouse, sees the latest M&A activity as a bad sign. It is the fact that valuations are too high which is forcing companies to cut costs, he says.. He is altogether more pessimistic about near-term prospects for UK equities, forecasting just 6,000 for the FTSE in six months’ time.
“I think the market is being valued on a hoped-for profits performance that will not
be achieved,” he says. The market has been driven ahead
by certain sectors – notably
the pharmaceuticals and telecommunications sectors – which now look seriously overvalued, says Jeffrey. But there is value in the market in some unfashionable areas, including companies with a strong exposure to overseas markets.
Williams sees market activity focusing on both consumer and industrial cyclical sectors which saw heavy selling in the wake of the first interest rate rise of this cycle two months ago.
Merrill Lynch favours the banks and the construction and engineering sectors of the market. It is neutral, however, on pharmaceuticals which have attracted a lot of attention from buyers this year. “But we are nervous about the telecoms sector, where ratings are abnormally high,” says Philip Wolstencroft. At BT and Cable & Wireless, for example, prices are falling faster than volumes are rising, he says.
Merrill Lynch is forecasting 10-year gilt yields will rise to 5.7% in six months from around 5.3% now. Charterhouse sees the whole yield curve shifting up by 50 to 100 basis points – more at the longer end than the shorter.
Longer-term gilt yields, says Jeffrey, are chronically bad value. “Anyone looking to set up a fixed-income component of a portfolio should be looking to invest in a mix of US, French and German bonds rather than UK bonds,” he says. While the UK 30-year gilt yields around 4.3% currently, the 30-year US government bond yields over 6%, he says.
The reason longer-term gilt yields are so low is the technical situation in the market, strategists say. Pension funds are having to increase their bond weightings and the resulting shortage in the bond market is all the more acute because of the budget surplus which means the Government is buying in debt.

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