This summer has seen a gradual deterioration in sentiment, as it becomes more apparent that the grad...
This summer has seen a gradual deterioration in sentiment, as it becomes more apparent that the gradual tightening of policy has begun to have an impact in the real economy.
Leading indicators are suggesting consensus forecasts for economic growth in 2005 are too high, while current evidence of economic activity shows that both the housing market and consumer spending are beginning to slow down.
Sentiment has responded by swinging from the optimism seen in the first quarter of 2004, to a growing concern about the outlook for corporate profits in 2005.
Reinforcing this nervousness has been the continuing instability in the Middle East and Iraq, the sustained strength of the oil price and the unexpected fall in bond yields in response to rising interest rates. However, the valuation of the UK stock market remains undemanding, even if only modest growth is expected in 2005 and beyond. Indeed, the FTSE All-Share yields over 3% and dividend growth, excluding share buybacks, is running at over 5%.
Our view has been for some time that the credit-financed expansion that followed the technology bubble was unsustainable and that the rebalancing of the economy would constrain growth for some time and have the potential to destabilise the stock market in the process.
At the same time, as evidence of slower growth has been accumulating, the price of raw materials and energy have also been rising sharply, principally due to the strength of demand from China. This has reinforced concerns about profits growth in 2005, as output prices remain highly competitive and margins are being squeezed by the rises in input prices. However, it is clear UK firms have gone to considerable lengths to maintain profits growth and strengthen their balance sheets through reining in capital expenditure, continued cost cutting and productivity improvements.
So the finances of UK firms look to have recovered while the Government and consumers have continued to borrow.
The recent signs of a slow down in the housing market and slower spending on the high street have suggested that a higher cost of money is starting to bite and that loan demand from consumers may begin to fall signaling the start of the next phase of this cycle - where growth continues but becomes harder to sustain in the face of reduced stimulus from cheap money, Government spending and consumer borrowing.
Corporate profits will continue to move ahead but at a much slower rate and the emphasis will shift to boosting growth through further cost reductions and the acquisition or demise of weaker competitors.
The positive aspect to the weakening economy is that it is clear the top of the interest rate cycle is at hand and investors can begin to assess the prospects in a low growth/low inflation environment where low investment returns are the norm.
In this environment, both dividend income and growth potential are likely to become more important as a driver of total return, as underlying earnings growth will be modest and a re-rating of equities in this attritional world will be unlikely.
This suggests stocks with good cashflow characteristics can be revalued, recognising their superior ability to return cash to shareholders.
Equity valuations modest.
Rates are peaking.
Rising input costs.
House prices too high.