Fund manager's comment/Steven Laidlaw
At the beginning of June, there were grounds for thinking economic recovery was on its way. Interest rates were coming down around the world and, in such a situation, the appropriate strategy is to reduce defensive sectors like pharmaceuticals, which, in any case, appeared to be fully valued, and concentrate on cyclical sectors that can be expected to benefit when the economy picks up.
However, during June, UK economic sentiment appeared to take a turn for the worse after some pessimistic market data. Inflation was higher than expected and employment figures were disappointing. This was accompanied by a number of high-profile profit warnings in other markets.
Market performance remains erratic and the FTSE All-Share fell around 2% during June.
Growth also remains weak and, although we should be close to the low point, the mix of growth is slightly different from previous expectations. Consumer spending and business investment has proven more robust than envisaged. As a result, the UK trade deficit is beginning to move into worrying territory. If this deterioration continues, the prospect of recovery in 2002 may be diminished.
We are close to the low point for inflation in the current cycle but we do not expect inflation pressure to increase significantly in the near future. We have one caveat: if the recent weakness in sterling persists, UK goods price inflation, currently at zero, is likely to pick up significantly. Service sector inflation is running close to 4% so the Bank of England's Monetary Policy Committee may be forced to consider interest rate rises sooner than the market anticipates.
Ordinarily, this might lead portfolio managers to refocus on defensive stocks, which normally demonstrate resilience as the economy slows.
So, do all signs point towards a slowdown? Not necessarily. The question investors have to ask themselves is which body exerts more influence on UK markets, the Bank of England or the US Federal Reserve?
Many signs point towards the latter. Sterling has been weakening steadily against the US dollar. Given the number of UK companies with high dollar earnings, this has been a major factor in our forecast for 2001 corporate profits rising from 6% to 9%.
Technology, media and telecoms continues to lead the way down. We think the sector is still overvalued with excessive earnings expectations. Within the old economy, we prefer lower-rated cyclical stocks and therefore continue to reduce exposure to defensive stocks, which we feel are fully valued.
The concerns over deteriorating economic conditions mean our stance in favour of cyclicals may appear unattractive. However, we believe the benefits of the interest rate cuts already implemented in the UK and US will start to filter through later on in 2001 and this will be reflected in a UK market upturn.
Near to low point of economic weakness.
Inflation unlikely to increase in near term.
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