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Happy medium

Medium-sized companies put in a remarkable performance last year and the prospects remain good

Last year was not bad for UK equities. After losing some ground in March and April, equities rose steadily through the summer. October saw some profit-taking as concerns about the possible effect on inflation of higher oil prices and other commodity prices came to the fore but markets regained their poise and are reaching new highs again.

Although smaller firms and the biggest blue-chip names generally performed well last year, the main driving force was a remark-able performance from many medium-sized companies. This reflects both a more supportive operating environment and a high level of acquisition and merger activity. But will the strong market environment persist this year or will this be a good time for investors to start thinking about taking profits. We firmly believe there is potential for more market upside in 2006 and have identified a number of areas of the market and companies we believe have the potential to deliver excellent investment returns over the next 12 months.

The key global debate this year among participants in the major equity and bond markets is likely to continue to be whether we are approaching the end of the economic cycle or if we are still in the midst of a very elongated cycle, with the peak in interest rates still some years off. We are firmly in the latter camp. It seems to us that there are strong structural forces at work which are keeping inflation under control.

We believe the world is still awash with spare industrial capacity and labour markets are still adapting to the shock of several hundred million new workers joining the global economy. Add the fact that major central banks are operating with a greater degree of transparency and it seems that latent infla- tionary forces should remain under control for longer this cycle than the market would normally expect.

We expect the UK economy to turn in a respectable performance this year. Monetary policy is likely to be eased, although only slightly now that the economy is close to full employment, and we expect pretty healthy economic expansion of 1.5-2 per cent. Add in what remains an attractive valuation level even after recent performance, the prospect of continued merger and acquisition activity and what should be an attractive level of overseas earnings against the supportive global backdrop and we believe the UK equity market could see further upside, perhaps as much as 10 per cent.

We are favouring financials and engineering stocks and are also looking very closely at niche retail operators which should continue growing earnings at a healthy pace.

We are upbeat on the insurance sector, where companies have had success in driving through rate increases in the wake of the hurricanes in the US last year, and have also identified a number of investment opportunities in the “other financials” sector, including investment managers Rathbones and Aberdeen Asset Management.

Another area of the market which we believe should perform well is the engin-eering sector. Capital spending has been under tight control since the collapse of the technology bubble and, as the labour market tightens, we believe more companies will invest in capital projects to raise productivity levels and maintain their competitive edge. We believe this will benefit firms such as engin-eering conglomerate Tomkins, foundry product provider Foseco and material handling equipment maker FKI.

We also feel the prospects for selected support services companies, in the aerospace and defence sector for obvious reasons at the moment, and even for selected niche retailers should prove rewarding for investors. The going might be heavy on the high street but remains good to firm for many medium-sized operators such as car part distributor Halfords and catalogue retailer Findel.

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