Let us enjoy the equity sweet spot for now. Interest rates are likely to remain low for some time as the recovery remains fragile.
Earnings upgrades abound as overly bearish analysts’ expectations are replaced with improving profit margins driven by cost-cutting, re-stocking and low capacity utilisation. M&A activity is on the agenda once more as management move from self-preservation to growth. The strong will get stronger. Despite the rally, the valuation of UK equities remains undemanding relative to other asset classes.
However, the market is clearly not without risks and the greatest of these is policy error. It is the very recovery in growth that now creates the dilemma. How can our heavily indebted Government withdraw from the tremendous stimuli without damaging this tentative recovery? Or should they keep the “taps-on” with the risk of stoking inflationary pressures?
The domestic economy already hindered by high unemployment is set to endure an uncertain general election, higher taxes, rising interest rates, fiscal spending cuts and greater government regulation and bureaucracy.
As the rate of economic surprises has peaked, the strong tailwind that has driven markets in 2009 is over. In anticipation of increased uncertainty, slowing momentum and monetary tightening, history suggests the market will rotate away from the cyclical winners of 2009.
Invest in the larger, more-resilient international companies where an attractive dividend yield and exposure to overseas earnings should prove supportive. Consistent companies such as pharmaceuticals, food producers and tobacco stocks offer attractive absolute valuations having been used as a source of cash for most of 2009. While upgrades are still likely in the more cyclical part of the portfolio, this will be more stock-specific than the beta-inspired rally of recent times.
While UK equities continue to offer attractive longer-term value, returns could prove both challenging and volatile in 2010.
Jamie Hooper is a portfolio manager at AXA Framlington
