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Global backdrop

How events on the world stage are likely to affect the movement of UK equities in 2007

UK equities have amply rewarded investors for taking risk this year but will it be the same in 2007?

The first thing to consider is that UK equity returns depend more on global economic trends than merely what happens in the UK. There has been a rather dull economic environment in Britain over the last year.

The housing market has recovered and consumer spending has picked up but growth has struggled to reach trend. Some slowdown in domestic demand is expected in the next year as interest rate rises affect the housing market and the consumer.

Don’t expect the retail sector to be a star performer against that backdrop.

The global economy is also set to be softer in 2007. The US is slowing and recent data from Europe has been disappointing. The German economy, for example, has to deal with a significant VAT increase in 2007 and the European Central Bank seems certain to raise interest rates again. With the euro strong against the dollar and the yen, there are more downside risks to European growth. In Asia, China appears to be growing strongly still but the extent to which it can continue to do so when the US is slowing is questionable.

Certain sectors of the UK equity market have been beneficiaries of the global economic expansion. These include oil and gas, mining and other basic materials and some industrials. Rising demand for commodities in Asia and the impact this has had on prices have boosted share prices in some of these sectors. Industrials have benefited from the boom in world trade. If global growth slows next year, some of the potential drivers of UK equity prices will not be so strong.

The cyclical backdrop is set to be less supportive. Leading global indicators have turneddown which usually signalsa period when equity returnsare less robust. However,a global recession is not onthe cards for 2007. Moreover,when we think about otherinfluences on equity markets,the outlook is far from gloomy.

Liquidity remains ample. Globally, interest rate levels are hardly restrictive. In the UK, M4 growth is running between 12 and 15 per cent. This is boosting housing and also stock prices as much of his liquidity is generated in the corporate sector. It manifests itself in private equity bids for listed companies and other merger and acquisition activity. This has boosted shares in some sectors andwill continue to do so in 2007.

Second, valuations are attractive. The UK market is on a forward price/earnings multiple of 12. The dividend yield remains a major source of attraction for UK stocks and certainly the implied risk premium in equities relative to bonds remains very high. Some may argue that equity markets are not particularly cheap but, equally, the case can be put that bond markets remain very expensive.

The level of the equity market would only be a problem if we saw a major earnings’ downturn next year. There is little sign of that. Where it might happen – in oil and gas, for example – share prices have already retreated. If earnings do slow, the sectors most at risk are some of the lower value cyclicals like chemicals and general industrials. The more cautious investor might prefer to avoid the more cyclical parts of the market and look to higher-yielding,less globally influenced parts of the market. Banks, insurance and telecoms look attractive on that basis.

The consensus is for slower global economic growth in 2007. It will mean slower profits and sales but also lower interest rates and the prospect of a recovery in 2008. A harder landing would require more of a retrenchment in the corporate sector but that remains a low-probability outcome at this stage.

Chris Iggo is UK senior investment strategist at Axa Investment Managers


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