We are beginning to turn our attention to 2008. 2007 looks like proving solid enough for UK equity investors in the end, despite the usual hiccups along the way. For those investors prepared to tag along to the momentum enjoyed by Basic Materials in 2006, 2007 proved another year of thrilling outperformance.
Elsewhere, Telecoms, Utilities and Tobacco proved popular while the Banks struggled in the wake of the credit crisis and the apparent collapse in Northern Rock’s credibility. We forecast a rather different set of macro economic conditions in 2008 to those persisting throughout 2007. For that reason it is tempting to believe that sectoral performance may look very different this time next year.
Our starting position is that UK economic growth is going to slow. We are not envisaging a recession but we think it likely that both the Treasury and Bank of England forecasts for sub-trend growth of 2.0% – 2.5% next year could prove accurate or even a little optimistic. UK household spending is coming under pressure. Mortgage rates / rental rates have increased, council tax bills are set to rise by more than inflation and credit conditions are set to tighten further.
Recent data from Hometrack appears to show that average house prices have edged lower of late. This chimes with recent data on mortgage approvals (down c15% from their peak) and the latest downbeat conclusions from the Royal Institute of Chartered Surveyors and other industry watchers. We have already used a recent note to indicate that inflationary pressure is likely to remain quiescent and that the Bank of England will, in due course, begin the process of monetary easing. It’s going to need to as pressure on UK households is intensifying. Real disposable income has fallen sharply with most discretionary purchases being funded through a fall in the savings ratio (see charts below)
If that weren’t bad enough, employment conditions in the financial sector are tightening too. Clearly the pressure is increasing on those mortgage lenders regarded as being at the sharp end of the UK’s sub-prime market. More generally, fixed income related employment is under pressure and not just in the square mile.
This too could serve to pressurise discretionary spending and the residential property market further. To some extent this is showing up in the CBI’s latest survey of financial services where business optimism has swung aggressively into negative territory. The CBI survey also reflects increasing concern regarding the extent to which government spending will prop up overall demand in the future. The recent Pre-Budget Report and Comprehensive Spending Review make it very clear that the fiscal stimulus that has proved so supportive to UK growth over the past five years is at and end. Government spending is expected to fall sharply over the next three years, a reversal of the recent experience.
The Good News Is…
Against this swathe of negativity we can at least expect lower short-term interest rates. This and slowing growth, should remove the major props underpinning sterling and we expect the currency the fall markedly against both the euro and the dollar over 2008. The significance of this is that fully 70% of UK company revenues are derived from outside the UK and just as sterling’s strength has had a profoundly adverse effect on translation over 2007, the effect is expected to reverse over 2008. For anybody doubting the significance of this event the following chart should prove decisive.
The inverse nature of the relationship is clear cut. Sterling began to perform strongly against the dollar in early 2006. At the same point the FTSE All Share Index began markedly to underperform the S&P 500. Furthermore, the UK is regarded as a defensive market as far as global asset allocators are concerned. We suspect, therefore, that the UK’s relative outperformance will become even more pronounced in 2008, a year in which global growth comes under pressure (and as recognised in leading indicator data which already shows clear signs of rolling over)
Of course with around 25% of the FTSE 100 Index weighting now comprising Oil & Gas and Basic Resources the benchmark index of “blue chip” companies is perhaps less defensive than it was, however, we remain upbeat on prospects for emerging markets a view which should continue to favour Mining companies as well as other long-term favourites such as Diageo (DGE), SAB Miller (SAB), BAT (BATS) and Vodafone (VOD). Finally, turning to valuation, both in absolute and relative valuation terms the UK equity market looks pretty well underpinned. We see falling gilt-edged yields as providing a useful prop to relative equity valuations while price earnings ratios should receive some support from the less negative relative earnings outlook as sterling declines on the foreign exchanges. This is an important point as slowing growth is already having a negative impact on near-term earnings revisions.
Data for October shows the ratio of earnings upgrades to downgrades slumping to 0.79 (i.e. 79 upgrades for every 100 downgrades) from 1.05 (105 upgrades for every 100 downgrades) in September. The deteriorating trend in earnings prospects is a feature across all developed equity markets at present, so the UK’s ability to buck the global trend should prove an important support as global asset allocators consider weightings in the run-up to 2008.
Conclusion
Perhaps perversely, the worse global and domestic macro economic conditions are the more we like the outlook for the UK equity market. We see global growth coming under pressure next year, within which the UK is expected to play a full part. However, we expect domestic base rates to start to fall from Q1 2008 an event which we expect to help undermine sterling on the foreign exchanges.
Given that the UK equity market has greater exposure to overseas revenues and earnings than any other developed Western equity market, we believe that the translation effect, for so long a negative factor, is likely to turn positive in due course, underpinning absolute valuations which had become somewhat stretched in the wake of the strong stock market rebound following the July / August financial market turmoil. We expect that quality growth will remain the style preference of choice and that larger companies will continue to outperform their medium-sized and smaller counterparts.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley