In recent weeks, we have seen falling house prices, slowing growth, inflation exceeding expectations and high oil prices hitting consumer stocks. Coupled with this dire background is a UK policy response that has been tepid by the standards of the US.
The Bank of England has reduced the base rate by 0.75 per cent in recent months while the Federal Reserve has cut the Fed funds rate by 3.25 per cent. The UK Government spent billions of pounds nationalising Northern Rock while the US government has spent billions of dollars mailing tax rebates to every household in the US.
There is no doubt that the US housing market is further through the correction than the UK, where prices have only just started to fall. Mortgage approvals in the UK dropped to around 28,000 in May, the lowest for over a decade.
At the end of June, the UK’s biggest housebuilder, Taylor Wimpey, announced it was conducting talks with a number of major shareholders to repair its weak balance sheet through an emergency share issue. The company also announced £660m of planned write-downs in its land holdings.
It is a gloomy picture but it is not necessarily a complete one. To begin with, it is important to remember that the UK economy is not reflective of the UK equity market as a whole. Consumer sectors are suffering but we are also witnessing what many investors have termed a super-cycle in commodities.
This is having a markedly positive effect on many UK companies. For example, the mining sector makes little direct contribution to the UK economy but mining companies account for 12 per cent of the UK stockmarket. Energy production is only 4 per cent of the economy but the oil and gas sector accounts for 19 per cent of the market. These sectors have benefited from the recent commodity boom and the positive earnings of these companies have been a welcome contrast to the underperforming financials and domestic-facing companies in the UK.
I retain my long-held enthusiasm for metals and mining stocks. On the demand side, it is estimated that $21.7trn of emerging market infrastructure spend will take place in the next 10 years (source: Morgan Stanley) as the process of urbanising an emerging market population of around 3.5 billion gathers pace.
However, it is the supply side that should provide greatest support to an extended cycle. After shortages of equipment, infrastructure and people, falling grades, strikes and windfall taxes, the critical problems for mining companies are now growing global shortages of power and water. China, South Africa, Zambia and Chile all face severe power problems.
Overall, we remain cautious on the outlook for the UK economy and anticipate further earnings downgrades for the consumer-related sectors. However, valuations seem reasonable and equities still look attractive relative to bonds.
We continue to prefer stocks with earnings resilience and international diversification. Therefore, we expect mining and oil services stocks to continue to thrive. Getting the sector calls right was all-important in 2007 as the market came to terms with the macroeconomic outlook and started to price in relative earnings risk. In 2008, stock-picking within sectors has returned to the fore as the winners and losers emerge.
Innes McKeand is head of equities at Aegon Asset Management