UK equities have recovered some of the losses they suffered following 11 September and there are signs that the domestic economy is more robust than previously feared. But investors’ hopes for a more geographically widespread upturn in economic fortunes could paradoxically dent share index levels in the UK.
This is because the UK market is a defensive market in general, says Khuram Chaudhry, equities strategist at Merrill Lynch in London. If a European economic recovery appears to be on the cards, investors could favour continental European stocks over UK equities to take advantage of the expected upswing.
“If you believe the market is going to be quite cyclical, you may see money taken out of the UK market and put into Europe’s cyclical sectors such as chemicals and construction,” he says.

Early signs of a cyclical recovery would be a rise in bond yields, stabilisation of commodity prices and an increase in corporate bond spreads. “If all three factors materialise, then this would be positive for oils and mining, and construction should be another beneficiary,” says Chaudhry.
The market is already factoring in some kind of recovery for next year, he says. “If the European Central Bank cuts rates quite aggressively, you could see the UK giving up some of its gains because it has outperformed quite significantly,” says Chaudhry.
However, there is also a danger that European monetary policy will not have such a rapid effect on economic activity, he says.
On 8 November, the Bank of England’s Monetary Policy Committee cut interest rates by an unexpectedly large 50 basis points. This move followed the US Federal Reserve’s decision to ease the cost of borrowing by the same amount.
The UK market reacted positively to the rate cut, having factored in a reduction of just 25bps. The FTSE 100 index rose to a two-month high to stand at around 5,250.
Although easier credit is generally expected to nudge the economy back into growth mode, some economists are worried about the side-effects.

Richard Jeffrey, economist at Charterhouse Economics, is concerned that consumers in the UK have been encouraged to take on debt. Although borrowers might believe that debt is justified by a rise in wealth – where property prices have increased – in reality consumers are borrowing from their future income, he says.
“It is difficult to release capital gains in the housing_market unless you can sell your house outside the household sector,” he says.
If the Bank of England had to raise interest rates, servicing some of this new debt could prove unaffordable, says Jeffrey.
Even though the UK manufacturing sector is technically in recession, other counter-cyclical factors are cushioning the domestic economy. Nigel Lanning, director of Dresdner RCM UK, says it is the resilience of the UK consumer – and government spending – that has kept the economy pushing ahead.
Strong household demand remains the main feature of the current state of the UK economy, says Jeffrey.
“But there are other aspects of the economy that are quite worrying,” he says. “A rise in the trade deficit and an increase in inflationary pressure will be a cause for concern.” While there might be a small increase in unemployment figures, says Jeffrey, there still seems to be quite reasonable demand for labour, particularly in the public sector.
“I believe it is a rather unsound situation because the imbalances in the economy – which are evident in the gap between output and demand growth – will cause problems,” he warns.
For now, many UK market participants are reluctant to turn cash positions back into equities before there are more signals that demand for exports will become more robust.
Chaudhry said the market is now waiting to see if US consumer confidence continues to plunge. “One in five of all units purchased on this planet are purchased by a US consumer, so they are quite significant,” he says.
Lanning says although many resources are being thrown at the economy to restimulate it, it is still uncertain whether these efforts will prove successful. The FTSE 100 index has recovered around 1,000 points since the falls in the wake of the 11 September terrorist attacks in the US, but the situation is still hostile.
“We don’t know whether there will be further terror acts,” he says. And concerns remain that the military campaign against the Taliban in Afghanistan will lose its footing.
But Lanning is more optimistic than many about the current health of the UK economy. “With the economy picking up, I don’t think one can get too bearish from here,” he says.

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