After recovering much of their early year loss by mid-March, equities have lost ground again, slippi...
After recovering much of their early year loss by mid-March, equities have lost ground again, slipping back to levels not seen since October. Year-end record highs now seem a long time ago and despite recent volatility and techmania the overall index is not much more than it was two years ago. Nonetheless, we expect the FTSE 100 to reach 7,000 by the end of the year (equivalent to 3300 for the All-Share), a level broadly consistent with fair value as measured by the equity yield ratio, based on our expectations that bond yields will fall to 5% and corporate earnings will grow 10-12%.
In the near term, further volatility is likely. The market is comfortably supported at the 6,000 level and renewed progress towards our target level is expected when bond yields start to drift lower and corporate earnings grow. While we continue to favour growth over value on a 12-month view, in the short term cheaply-rated defensive stocks may enjoy a rally from oversold positions.
The economic environment is favourable, with the consensus GDP growth forecasts close to 3% for this year. The consumer sector is buoyant, unemployment is falling, real incomes are rising as inflation falls and house prices are rising. Services are strong, while manufacturing is under pressure.
Meanwhile we expect inflation to be below consensus this year and next. RPIX is likely to surprise on the downside, coming close to the 1.5% lower boundary of the MPC's target range, due to a combination of productivity gains, sterling strength keeping imported inflation low, fierce retail competition and the increasing influence of the internet, which is suppressing upward inflationary forces by offering greater price transparency. In addition, pay settlements are edging down. Along with the fact that input price rises are not being passed on, inflation should therefore remain close to 2% for the next two years.
We expect that base rates will peak at 6% in the summer as above trend growth and housing inflation encourages the MPC to tighten monetary policy.
Overcapacity remains a problem in a number of consumer cyclical and manufacturing sectors, which will restrict earnings growth for companies in these areas. Corporate activity is likely to remain at comparatively high levels, although the events surrounding some recent UK technology issues and volatility in the Nasdaq market may make investors more discriminating.
UK equities are now reasonably valued relative to bonds, as well as being rated more cheaply than other European markets. While we believe that the strategic longer term outlook for equities is positive, the likely continuation of recent volatility, allied with uncertainty over interest rates, suggests the market could experience some underperformance in the near term.
Ashton Bradbury is head of UK retail funds at Hill Samuel
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