Another tumultuous week for developed equity markets is coming to a close. There aren't many weeks, even in the world's fifth most developed economy, which start with pictures of the first run on a UK bank for 140 years, slip seamlessly past an aggressive US base rate cut and end with the governor of one of the world's most powerful central banks on the parliamentary rack answering questions straight out of Watergate ("who knew what and when"?).
The Bank of England's "Special One" looks increasingly ordinary and despite a robust defence of his actions in parliament it remains to be seen whether he might, in due course, do "a Nixon" or, in a more contemporary setting, "a Mourinho"! The purpose of this note is to reassure equity investors that the UK stockmarket remains attractive, despite all the background noise and the increasingly obvious fact that Northern Rock, like an exhausted England rugby player, hasn't the energy left to hurl a television set out of a Trianon hotel room window!
UK consumer spending set to slide
Perhaps oddly, one of the central foundation stones for our positive stance on the UK equity market is that the UK economy looks increasingly wobbly. For now, household spending appears to be holding up nicely, however, it remains to be seen how long the ebullient consumer will continue to do the retail equivalent of riding a large motorbike aggressively up and down hotel corridors. The UK's household liability to income ratio has risen to more than 150%, higher even than that of the United States (135%) while the servicing of that debt has risen to more than 15% of disposable income (from below 10% less than six years ago). In the meantime the residential property market appears just about secure, although furtive whispers are becoming more audible as the price to wage ratio increases to in excess of 140% (again considerably higher than in the US where the ratio currently stands at 120%) and where part of the almost inevitable fall-out from the Northern Rock crisis is likely to be a tightening of lending criteria.
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Consumer spending accounts for around two thirds of Gross Domestic Product here in the UK. But the combination of higher taxation, higher interest rates, a residential property market which shows signs of rolling over and a highly volatile equity market which appears to have got stuck on its seemingly inexorable march higher, does not make for a particularly propitious outlook. Real household disposable income growth has been in steady decline since the peaks (in excess of 6%) of Q3 1999 and is now at zero. Furthermore, the savings ratio has slipped to a decade low at just 2%.
Why a rate cut could be on the agenda
So what does the Bank of England do? Answer, it continues to fret about capacity constraints and the strength of the money supply even at a time when the targeted measure of inflation fell back to just 1.8% in August, its lowest level sine March 2006 and continuing a steady five month decline from the March 2007 spike at 3.1%. The inutes of the early September Monetary Policy Committee meeting reveal a 9 0 vote to keep UK base rates at 5.75% but clearly events since that meeting have been
moving very fast. The Bank has been forced into more about turns than an exuberant dancer at a summer music festival and has now ended up in a knot, in a heap and on the floor. Who is to say that UK base rates, which appear clearly to have peaked, may not shortly be on the way down again in a more decisive attempt to shift the shape of the bond yield curve and get the credit markets moving again.
The dramatic move on the part of the US Federal Reserve should act as an important template for the Bank of England and the European Central Bank. A deliberate attempt to "getahead of the curve" and stay there is essential if money market premiums are not to resurface again at the end of the year. This means that developed market central banks need to act now, they need to act aggressively, they need to act decisively and they need to stand prepared to act again if necessary. The time for hiding behind growth in the money supply has gone. Three cheers for the Federal Reserve for taking the action it did. Sorry Dr Bernanke (may your children live for ever), we take back any doubts we may have had about you!
At the time of writing it is still unclear what Northern Rock's fate will be. What we do know is that pictures of queues outside branches up and down the country are hardly likely to send consumers out with members of the England cricket team on a wild "celebratory" bender. It is noteworthy that whilst consumer spending accounts for around two thirds of economic output growth, fully one third of that spending has been discretionary over the past year and animal spirits, as keynes noted, are amongst the first to be brought to heel when confidence is lost. The consequence is that UK economic output growth is likely seriously to disappoint over the months and years ahead. Consensus GDP growth is forecast at 2.1% for 2008. In all likelihood that number is vulnerable to possibly significant downward revision.
Such an environment is not exactly propitious as far as the outlook for corporate earnings is concerned and we might be persuaded to be pretty negative on the valuation argument for UK equities, often touted as the base reason why shares appear cheap at prevailing levels. What encourages us to take another look is the fact that 61% of UK corporate earnings are derived from outside the UK, a significantly higher proportion than that enjoyed by the US (28%), Continental Europe (33%) and Japan (31%).
Were sterling to hold its own on the foreign exchanges we might expect that the translation of overseas earnings into sterling might act as a drag, however, the fundamental weakness of the domestic economy inherent in the above analysis does not exactly indicate that the currency can throw away its zimmer frame! Indeed, whilst we continue to forecast dollar weakness, we suspect that sterling will coattail that currency lower.
What may limit the pace at which the pound heads south is the substantial amount of foreign direct investment in the UK over the past six months. Hot money is certainly having another look at UK PLC. Not only does the domestic equity market benefit from a relatively high and reliable dividend yield (given the relatively under-geared corporate balance sheet), but historical back testing indicates that UK equities tend to outperform their global counterparts when global leading indicators roll over, as they are beginning to show clear signs of doing. We make two further observations on this point. Firstly, the heavyweight integrated oil sector is likely to continue to benefit from the high oil price and secondly, the seemingly inexorable rise in the Mining / Raw Materials sector shows few signs of abating as demand for basic resources remains robust. These global sectors are likely to prove particularly popular with global investors at this time.
Conclusion - be selective with stocks
In the wake of a week in the UK equity market that would make even the most hard bitten visitor to Alton Towers' hair stand on end share prices are still likely to emerge on top. Whilst we have some reservations regarding the valuation argument on which absolute support for the equity market can be derived, there is no denying that, taken at face value, a forward sector-adjusted 12-month forward price earnings ratio of just 12.4x (against Continental Europe's 13.1x) does make equities worth having at prevailing levels. That being said, investors should continue to sift through the bucket to see what the sea leaves when the tide goes out.
It is extremely tempting to take the plunge and dive back into the banks on the basis that the switch from an inverted bond yield curve to a positive slope is often the trigger for outperformance, however, on this occasion we sense that professional investors are still shorting the sector in anticipation of further trouble, either specifically at another bank or more generally in the context of increased provisioning levels and inevitable squeeze on margins and for these reasons we remain wary. It goes without saying that the above analysis hardly bodes well for the retail or consumer cyclical sectors generally. Note that even a cut in base rates may be insufficient. Historically, every 1% point off base rates only adds c0.5% to consumption and in an environment characterised by a marked deterioration in economic conditions we cannot be certain that the historical trend will be maintained this time. By contrast we are increasingly warming to the Utility sectors.
The above analysis points strongly towards further falls in gilt-edged yields and the sectors with the highest correlation coefficient with falling bond yields are Telecoms and Utilities. The catalyst for revived interest in the latter is likely to be the sale by Royal Bank of Scotland of Southern Water. A sale at or above a 25% premium to its regulatory asset base would provide a clear indication of investor appetite for high visibility, highly stable companies and investors should be positioning themselves accordingly. Elsewhere the message supports selective stock picking, largely on the basis of those companies whose earnings are relatively immune to a downturn in either the domestic or US economies. BAT, Diageo, SABMiller, a number of mining companies and Vodafone might fit into this category amongst others.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley
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