In the UK, the liquidity environment remains bullish with growth in the money supply continuing to o...
In the UK, the liquidity environment remains bullish with growth in the money supply continuing to outpace the growth in industrial output. The excess cash has to find a home and for the past couple of years this has spurred a rise in asset prices, whether equities, bonds or property.
For the equity market to progress the positive liquidity conditions need to be accompanied by positive sentiment. In the last few months there has been a spate of weak economic figures. Most of the gloom has centred on the consumer, with retail sales coming under pressure as households rein in their spending. This has caused investors to reassess their outlook for the economy, with most revising down their expectations for economic growth.
Since the equity market is forward looking any downward revision to economic growth translates into lower future corporate profit growth and this helps explain the current hiatus in the equity bull market. Along with weaker investor confidence equity markets are also having to contend with a loss of momentum in earnings.
For the past couple of years analysts have been upgrading their earnings numbers, with the cycle extended by a seemingly insatiable Chinese demand for commodities. Given that most of the cost cuts by companies a few years ago have washed through and economic growth appears to be slowing it is reasonable to assume that we are near the peak in the profit cycle. Consequently, we are likely to see fewer earnings upgrades and an increase in profit warnings, something that has already been confirmed by Ernst & Young in its quarterly analysis of UK company announcements.
In this mixed environment, where liquidity conditions are encouraging but investor confidence may struggle to provide fresh impetus to the market, we are choosing to tread cautiously. Investors are likely to be rewarded by focusing on companies with defensive earnings growth. Aerospace is a sector which should exhibit this quality given that air travel is becoming increasingly frequent and government spending on defence is unlikely to fall. With strong order books providing visible earnings Rolls Royce and BAE Systems look attractive in our view.
We also believe that out-of-favour sectors may prove attractive. The pharmaceutical sector has been unloved for some time on account of a potential change in pricing in the US and negative stories surrounding several high profile drugs. Glaxo SmithKline, the pharmaceutical giant, however, has a strong product pipeline and demographic changes, particularly an ageing population, should prove supportive.
Provision for old age is also something that should help the life assurance sector. The British Government is currently reviewing pension provision. Whatever proposals are agreed, the life assurers should benefit from increased revenues as workers are encouraged to save more. In contrast, banks are likely to be affected by the current decline in consumer confidence. Growth in lending is likely to slacken and credit quality may deteriorate.
Move to unloved sectors such as pharmaceuticals.
Demographics favour life assurance sector.
Banks vulnerable to falling consumer confidence.
Moves to overweight equities and fixed income
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