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Domestic science

Being an investor in UK equities is not much fun at the moment. The credit crunch is having a real impact on the domestic economy and people are becoming more cautious.

This effect is seen most painfully in the mortgage market and house prices are now falling. In the long term, this is probably no bad thing but there is a cost to be paid in the impact on the economy and consumer confidence.

The UK equity market has suffered. The FTSE All-Share Index was down by 15 per cent from its peak last year to the end of June. For many investors, life feels signi- ficantly worse due to the huge variation in returns across sectors.

Largely, the extent of one’s misery will be a function of your exposure to resource stocks, with the oil and mining sectors now represen-ting 30 per cent of the FTSE All-Share Index. The main reason the mining compan-ies have outperformed in the last few years has been because of a massive rise in profitability, not an upward re-rating of their earnings, so these companies still look reasonably valued.

If you strip out the oil and mining sectors, the FTSE All-Share index fell by 26 per cent in the year to the end of June.

Investors who are underweight in resource stocks and overweight in more UK-centric cyclical stocks will feel like they are in a fully fledged bear market.

This time last year, there was a suspicion that life was about to get tougher. Investors were starting to worry about inflation and long-dated gilt yields were moving up as a result. A number of companies started to become a bit more cautious about near-term prospects.

My conclusion at the time was that those sectors exposed to the consumer would struggle as the impact of a slowing economy was not yet priced into analysts’ expectations.

Conversely, we believed that the outlook for companies exposed to continued growth in the global economy remained positive and was probably better than most analysts believed.

In simple terms, this view has proved correct. Most of our winners, which have positive earnings’ revisions and improving fundamental newsflow, are exposed to these growing overseas economies, benefiting in particular from the continued spend on global infrastructure, and have been largely immune to the impact of the credit crunch.

The temptation is to switch one’s resource stocks into the underperforming cyclical stocks. Our investment process will not let this happen at the moment. Prospects continue to improve in the oil, mining and related industrial sectors (where we hold many of our winners) while the outlook for companies exposed to the UK economy remains poor.

There is no sign that the impact of the credit crunch is over yet and most stocks in the consumer-cyclical sectors continue to suffer from earnings’ downgrades.

We suspect that, in terms of the domestic economy, life is going to get worse before it gets better.

Despite the slowdown in the economy, inflation is moving upwards. The Bank of England is clearly hoping inflation will come back to more manageable levels later in the year but the risks are increasing. A good proxy in the UK for investors’ expectations of inflation is provided by long-dated conventional gilts.

Since 1998, bond yields have been remarkably stable, averaging about 4.5 per cent, implying an expectation of around 2 per cent inflation with a real return of 2.5 per cent. Over this time, inflation, on a variety of measures, has averaged, conveniently, about 2 per cent.

There is now very little margin for error. Any increase in inflation from here is likely to feed through to higher gilt yields.

This would be bad news for the economy since real growth would be subdued while inflation is brought back under control.

William Pattisson is manager of the Liontrust First large cap and Liontrust Focus 350 funds

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