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01 March 2004

Growth to support UK equity market

Aggregate UK company profits are estimated to have increased by 14% during 2003

Stimulated by strong growth in the US and recovery in Europe, UK GDP is expected to advance by at least 3% during 2004. Although sharply higher exports to the US and Asia have begun to close the considerable trade gap, sterling strength against the dollar has diminished the benefit of these to UK companies on translation of overseas profits.

In both 2002 and 2003 domestic growth was driven by strong consumer spending while the contribution from industry was weak.

The Bank of England MPC has been concerned about this imbalance and the concurrent rise in levels of personal debt. Confidence was undoubtedly buoyed by house price inflation (15% in 2003 following 23% in 2002) which is now moderating.

The primary role of the MPC is to control inflation which is presently well below target. However, taking a long-range view that inflation will gradually rise, the committee has taken preventative action to subdue the consumer by implementing two 0.25% increases, bringing the base rate back to 4.0%.

Average earnings for the record 28m adults in employment grew by 3.6% in 2003, faster than whichever inflation measure (RPI, RPIX or CPI) one chooses, and so spending momentum is likely to slow rather than halt completely. With personal indebtedness at historically high levels, any rise in the cost of servicing that debt will create difficulties for some borrowers.

Deterioration in loan books would be negative for the banking sector, which constitutes 20% of the UK market. However, initial 2003 results reported did not reveal any problems with loan quality.

After several years of rebuilding balance sheets, 2004 may be the year when companies step up capital expenditure on new facilities and systems. In leaner times the goals were streamlining of costs and efficient use of assets but genuine volume growth now may bring a need to create additional capacity. Commercial construction, machinery and software system suppliers would be the obvious sectors to benefit and these have performed in anticipation.

Aggregate UK company profits are estimated to have increased by 14% during 2003 and the first results reported have confirmed that expectation although those accounting in dollars have suffered from the translation of their profits into sterling.

If US interest rates remain at very low levels, as we expect during this presidential election year, and UK rates gently rise then the dollar may slip a little further against sterling.

The FTSE All-Share has risen 26% over the past 12 months. Much of this strength has been in mid-cap and small-cap shares which tend to be more closely linked to the economic cycle. Larger but traditionally more defensive companies have appreciated more modestly.

With slower earnings growth forecasts in 2004 around 10%, plus the tightening of monetary policy, it is unrealistic to expect such a positive move in the market. In the context of more modest capital progression, the market’s prospective yield of 3.3% becomes more significant in terms of total return.

Hugh Duff
Senior Investment Manager
UK equities
The Scottish Investment Trust PLC