Now the conflict in Iraq has ended and oil and house prices have started dropping, UK investor...
Now the conflict in Iraq has ended and oil and house prices have started dropping, UK investors appear to have rediscovered their optimism. The market is carrying an air of confidence that has been absent for a long time.
At the moment, investors seem happy to take on smaller, riskier names in return for potentially greater rewards. Meanwhile, defensive stocks ' for so long the staple diet of the bear market ' are lagging behind. The breadth of the latest rally has seen small and medium-sized companies' valuations rising healthily along with their larger counterparts. But is this buoyancy misplaced, or do the figures back up the bravado?
Recent economic data is mixed. First quarter economic growth was 0.2%, much as anticipated. However, the growth mix was different from market expectations. Consumer spending was just 0.4% for the quarter ' and, while the slowdown was expected, this was the weakest quarterly showing in six years. Business investment and net trade were also marginally weaker than consensus. This was offset by high government spending, but this represents little more than a catch-up of the previous quarter's underspend. It is unlikely the government will be taking up the slack for much longer.
The latest GDP figures reveal whole economy investment fell by 0.1% during the first quarter, but rose 1.0% year-on-year. After a positive number in the final quarter of 2002, this suggests we have reached the turning point in the cycle of capital spending. However, any re-emergence of business investment is likely to be more muted than in previous cycles, simply because the origins of the current global weakness stem from the excessive investment of the late 1990s. Global demand should remain subdued.
Although the slowdown in consumer spending has been widely anticipated, the landing should be soft. Employment continues to grow, albeit slowly. Consumer spending looks set to start picking up again at the start of 2004, when the impact of this year's rises in direct taxes drops out of the annual comparisons. That said, a return to the +4% growth rates of the past few years is unlikely.
Now the euro debate has ended for the moment, interest rates are expected to stay low. The Monetary Policy Committee left rates unchanged this month, hardly surprising given the recent weakness in sterling. We expect interest rates to be cut once more by 0.25% before September, and they will not return to 4% until late 2004.
The main drivers of higher inflation concerns up to now have been rising oil prices and house prices, both which are expected to slow this year. Against that, recent sterling weakness is now clearly feeding through to goods prices, and public sector wage inflation is running at 5.1%. On balance, however, we still believe the outlook for inflation will improve as the year progresses, simply due to the weaker growth outlook.
So messages are mixed and the jury is still out. Certainly, there are 'buy' signals. The corporate profits outlook is improving. GDP data shows a rise of 7.6% ' the fifth consecutive quarterly increase. Positive corporate cashflow is providing scope for a recovery in FTSE profits during 2003, even against the ongoing backdrop of weak growth. The ratio of profit upgrades versus downgrades has improved, and earnings forecasts look realistic.
Even so, one might have thought a three-year bear market had taught investors that irrational exuberance and misplaced optimism can be costly. Caution is likely to remain the watchword, and it could take an awful lot of good news before investors are convinced the latest upturn is sustainable.
Our portfolios currently favour large capitalisation stocks, an uncomfortable position given that the huge bias towards small- and mid-cap stocks over the last quarter. This presents a dilemma. Is it safer to follow the herd, increasing exposure to the smaller end of the market, or should you wait for larger stocks to come back into favour?
Both alternatives offer opportunities and risks. If you presume the small/ mid-cap sector will continue outperforming, then you have to bite the bullet and invest heavily in the sector, although in doing this you may lock in underperformance versus the market. This strategy could prove unfortunate if profit-taking started and the focus moved back to large-caps.
Smaller companies tend to outperform if investors believe that economic recovery is on its way. Smaller companies tend to exist further down the economic food chain and, as a result, are the first to see any pick-up in orders. The main problem is at the moment there is scant evidence of such a recovery and the market is pricing for a growth in earnings that is not as yet discernible.
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