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14 January 2008

Balance of investment moves from old guard to brave new world of growth

Early 2008 should see more of the same volatile stock market conditions as witnessed at the tail end of last year, even though a consensus of doom and gloom for the UK economy seems to have been reached.

The banking sector remains in turmoil with further write-downs expected. The knock-on effect of this financial crisis on the UK economy is still being assessed, but recent data suggest that the housing market has already slowed dramatically in response to past interest rate rises and the self-fulfilling negative press articles written over the past year.  With consumer sentiment deteriorating, the UK economy is set to slow significantly this year to sub-2% growth.

This is not a readjustment similar to that seen in 2005. The problems facing the financial markets will not be easily fixed and slowdowns in the housing market can go on longer than expected, like the current US situation.  Just how bad things get will depend on the labour market.

We positioned our portfolio more defensively over the second half of 2007. We have also been focusing on companies that can deliver good growth in this slower economic environment, as we expect such companies will command a higher rating as growth becomes increasingly scarce. This strategy should continue to do well until investors have some further visibility on the depth of the US slowdown and the impact globally.  Consensus suggests they are expecting the worst.

However all this negativity does not necessarily mean that stock markets have to fall over the next 12 months. Valuations suggest that much of the doom and gloom is already factored into share prices. Take the housing sector - we are only now seeing a fall in house prices, although share prices have been falling for over six months as the market has factored in this deterioration. Accordingly, estimates for the market in aggregate are too high but share prices already reflect this. The key determinant of 2008 performance is whether sector valuations remain attractive once city analysts’ forecasts catch up with the current economic environment.

On a more optimistic tone, corporate balance sheets are not stretched and an appetite for M&A remains, with the mining sector providing the most recent example. This, together with share buybacks and further cuts in interest rates, should provide some support for the stock market.

We do not think that the UK economy will fall into a recession. Unlike the US, we feel that the Bank of England has loosened monetary policy early enough to make a soft landing a strong possibility. It also has the scope to respond further if necessary.

Bull points

• Corporate balance sheets are not stretched
• Further interest rate cuts should provide some support to stock markets

Bear points

• The problems facing financial markets will not be easily fixed
• The UK economy is set to slow significantly

Hugh Duff
Senior Investment Manager, UK Equities
The Scottish Investment Trust PLC

Published in Investment Week

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