The minds of UK investors have, for some months now, been firmly fixed on any signs of inflation cre...
The minds of UK investors have, for some months now, been firmly fixed on any signs of inflation creeping into the economy, and this collective worrying has been causing much stock market volatility. October saw data released which pointed towards a strong economic recovery, and this inevitably led to worries about increased pricing pressure and an eventual inflationary bust.
UK investors also have one eye concentrated intensely on the US economy. With a high percentage of UK-listed stocks dependent on the US for earnings, events across the Atlantic are of great interest. At present sentiment on Wall Street is extremely nervous with investors reacting with euphoric glee or depressive pessimism to every economic release. The Fed, for its part, seems determined to slow the economy and strike inflation dead by raising interest rates before it can take hold.
But there is no doubt that economic recovery in the UK is for real. Industrial production continues to increase, retail sales are on an upward trend and the CBI has reported manufacturing confidence as rising at its fastest rate for four years, citing robust consumer spending as a contributing factor.
However inflation, in both the US and the UK, is striking by its apparent absence and has put the MPC in a quandary over the scale of future rises in UK rates. It is still too early to say with any conviction, but the UK may well follow the US model of the last few years where robust economic growth has been accompanied by benign inflation. There is ample evidence in this direction from the consumer-sensitive sectors of the stock market, where intense price competition has seen an apparent inability on the part of many companies to translate increased consumer demand into profits growth.
The spectre of a boom in the housing market and a tightening labour market have so far seen the MPC err on the side of caution, and this has resulted in the two recent interest rate rises. We anticipate this cycle of rising interest rates will peak at 6% to 6.25% at the end of next year, below where many investors expect. This is because we believe the potential threat of inflation is exaggerated.
Intense international competition and problems of overcapacity are affecting pricing power in many cyclical industries from airlines to brewing. The advent of new technology and the internet is further eroding margins and this will also keep a cap on price inflation. When this becomes clear the interest rate expectations of the market, which has been particularly pessimistic recently, will have considerable scope to strengthen and by doing so, this will provide good support for equities.
Equity income investors will benefit from this scenario by carefully selecting the best stocks, many of which are now on a significant yield premium to the market. Earnings momentum and stronger GDP growth, combined with support from the bond market as inflationary fears recede, could see a positive effect on equities over the next six months.
Another area where we are positive at the moment is in financials. We have increased our holdings in domestic banks and insurance as these sectors offer attractive valuations and have strong potential for further consolidation in the future.
The biggest threat to this positive picture, other than an unforeseen source of inflation or the MPC raising rates too far and snuffing out economic recovery, is from New York. UK stocks have a high correlation with those on Wall Street, where valuations continue to look stretched.
Andrew Spencer is fund manager at Fleming Asset Management
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