After two years of negative returns, equity investors are hoping the expected global economic recovery will help break this unwelcome pattern
Despite two years of broadly trend growth in the UK economy, investors entered 2002 having suffered a second successive year of negative returns from domestic equities. As the UK economy is forecast to continue growing robustly this year, investors will be forgiven for hoping that this rather unusual relationship between equity returns and economic growth will not be maintained for a third year.
Among the G7, the UK appears well placed in 2002 and forecasts of growth of over 2% look realistic unless global influences deteriorate markedly. Consumers have responded to the lower interest rates and earlier government spending promises that, according to the Chancellor, are 'complementing and supporting monetary policy', are starting to support overall growth.
At times, it is still hard to believe that the UK has enjoyed nearly a decade of continuous growth without igniting inflationary pressures. Given the lack of pricing power, both domestically and globally, it is still highly unlikely that the current expansion will end as a result of renewed inflationary pressures. Indeed, there are valid concerns that the deflationary pressures seen in Japan could spread to other economies.
However, despite our understandable interest in the health of the UK economy, the reality is that the fate of equity investors has more to do with the outlook for the US economy.
Evidence of either continued economic difficulties or renewed economic growth in the US should, in the first instance, give clear direction to Wall Street and other equity markets. The US economy is clearly struggling against severe headwinds in the form of reduced business investment and optimism, high debt levels, reduced pricing power, weak global demand and low domestic savings rates. Despite these weaknesses, the combination of lower interest rates, tax cuts, increased government expenditure and lower oil prices should succeed in promoting economic growth in the US.
While I am reasonably hopeful that this recovery will be evident in the early part of the year, I am less sure about the speed of the upturn as many of the headwinds currently suppressing demand will persist. In particular, private consumption has not suffered any discernible weakness and has benefited from mortgage refinancing and zero-interest incentives in the auto industry, the latter suggesting some sales have been brought forward.
As an investment house, we place considerable emphasis on the short and long-term technical and liquidity factors driving markets. For example, the rating of the UK equity market may compare favourably with other major markets but this would be of limited support if the technical position turned decisively negative.
Pension funds, particularly in light of the move by Boots, and life offices, constrained by free asset ratio considerations, will remain under pressure to rethink their asset allocation strategies. Even if there is not a wholesale move away from equities as an asset class, the long-term growth in equity ownership by these institutional funds, a trend that has acted as a technical support for the market generally, looks set to end.
The risk is that the large mature defined benefit schemes, in adjusting their equity weightings, will swamp the natural demand from other investors such as defined contribution schemes. It would appear to be a case of when and not if, although as with the oil market where fears of supply shortages have regularly surfaced over the past thirty years, the answer may still be not yet.
When economic recovery is anticipated, equity remains the asset of choice to play this trend although given the length of the bear market and the earlier unjustified optimism, it would be understandable if investors chose to await clear evidence, possibly in the form of an improving corporate earnings picture.
But what kind of growth in corporate earnings should investors expect? Over the long run, there has been a pretty strong correlation between the growth in corporate earnings, money supply and nominal GDP. With growth in nominal GDP set to remain around 4% to 5%, it is not surprising that many are expecting only a subdued recovery in corporate profits leaving the consensus forecast for total shareholder returns across the market struggling to rise above 8%. With long dated gilts yielding around 4%, corporate paper slightly less than 6% and commercial property yields of 7%, is the implied equity premium sufficient to justify the existing equity weighting?
Of course, the market may be too pessimistic in assuming a recovery to only trend growth in profits. Labour market pressures appear to be weakening and the US in particular appears to be shedding labour quickly. If this is combined with a reduction in wage growth, the impact on reported profits could be substantial.
In addition, the inventory position should turn positive and, having avoided the investment excesses of the late 1990s in the US, businesses in the UK should feel more comfortable with future capital expenditure plans. Lower oil prices should also feed through to the profit line although the size of the oil sector within the UK market, where earnings would come under significant pressure under the same oil price scenario, would unfortunately negate this positive influence at the market level.
The relatively undemanding rating of the UK equity market sits more comfortably with the consensus view of a muted profit recovery. If, unlike myself, you are comfortable with the validity of the bond and equity earnings yield ratio, equities are currently attractive. This affords scope for an expansion of multiples within the broad market, increasing total shareholder returns.
Personally I do not read too much into this oft mentioned ratio, noting the recent breakdown in the relationship. Instead I believe any multiple expansion or contraction will reflect the degree of confidence among investors about the extent and sustainability of the recovery.
The growth/value and cyclical/defensive arguments are likely to continue attracting some attention in the market. The strong recovery in long duration growth stocks since the end of September possibly reflects continued deep-seated optimism for this type of stock, despite their overall performance since March 2000, given the limited opportunities for strong revenue growth in a low inflation environment.
While the technology sectors have displayed strong relative earnings growth in recent decades, as an equity income fund manager I remain somewhat sceptical about future prospects. As capacity has increased substantially, pricing power should remain weak, arguing for a much more stock-selective approach.
While I might be expected to trumpet the merits and outlook for equity income funds, I note with some concern, given past experience, the number of commentators recommending such products, especially after such a strong run over the past eighteen months. However, if there is merit in the idea of secularly low profit growth, dividends will constitute a larger part of the total return.
I also struggle to get too excited about the relative merits of either large-cap or small-cap stocks. The latter are often regarded as more economically sensitive but this partly reflects their historic domestic bias. If the UK is no longer the most volatile of the major economies, this influence may be more muted. Large-cap stocks would normally be expected to benefit from technical and liquidity factors but at the global level, the relatively defensive structure of the FTSE 100 index could limit enthusiasm for the UK market.
The lesson to learn from this is that in any segment of the market there are some companies with better or worse prospects than others. The same distinction is rightly made between fund managers and we have to strive to stay on the right side of that divide. Once again, I feel more comfortable maintaining a stock selective approach and will continue to apply this going into 2002 rather than blindly adhering to a broad theme.
The fate of UK equity investors depends to a large extent on the US economy.
Pension funds remain under pressure to rethink their asset allocation strategies in favour of bonds.
Having avoided the excesses of the US, business in the UK should be comfortable with future capital expenditure.
Underperformance still present – for now
Regtech or fintech
15% increase in number of claims paid
Open architecture philosophy
Inflation above 2% for first this this year