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Long and the short of it

Uncertainty over interest rates is causing volatility in the market but future prospects look promising

After a strong start to 2006, the UK equity market suffered a sharp sell-off during May, which saw much of the gains eroded.

Since then, the market has experienced volatility. This is often the case during the summer months but the present lack of direction is symptomatic of the fact that we may be approaching a turning point in the economic cycle.

The market sell-off was initially triggered by a reappraisal of the risks facing the global economy. Central banks have been using monetary policy to put the brakes on growth gently during the past couple of years, and it seemed that this tightening cycle was nearing an end. But inflationary pressures have continued to build in recent months and this has made the outlook for the future direction of interest rates less clear. The risk of a policy mistake from the world’s central banks has increased, particularly and most critically in the US. Central banks themselves have suggested that their decisions on interest rates will be based on emerging macroeconomic data, so it is no surprise that the market is responding with volatility, as it digests new data in an attempt to predict the future direction of interest rates.

This volatility may well continue in the short term until the macroeconomic picture becomes clearer.

We are not expecting a drastic correction because valuations remain attractive, particularly when we look to the longer term. There are many reasons to be optimistic about the longer-term prospects for UK equities. The outlook for many UK companies is encouraging, balance sheets are healthier than they have been for some time and there are interesting valuation opportunities in the market. Many large-cap companies, for instance, are looking particularly attractive with strong cashflows allowing good levels of dividend growth.

As a long-term investor, my investment approach is primarily bottom-up. I believe a long-term view is critical but it is notable that the market overall is becoming increasingly short-term in its focus. Annual turnover in the UK market has risen from 60 per cent in 1998 to 125 per cent this year, implying an average holding period of less than nine months. By contrast, the turnover on my funds is about 20 per cent, implying an average holding period of five years.

The market’s increasingly short-term focus can lead to exaggerated share price movements. Take Wolseley, for example. As a plumbing and building equipment distributor, Wolseley’s shares have come under pressure in the past few months as the market has focused on its exposure to a slowing US housing market. This recent performance highlights the market’s tendency to place emphasis on short-term factors, often at the expense of a company’s longer-term attractions. It also illustrates the market’s discounting nature, where it is trying to forecast the impact of events before they have happened. Both of these market characteristics can lead to opportunities for the long-term investor.

A slowing US housing market will undoubtedly be making life difficult for Wolseley in the current financial year but when looking at the company with the long term in mind, I see a great deal of growth potential at an attractive valuation. Wolseley has an excellent record of achieving long-term growth, both organically and through acquisition. Its exposure to the US and European housing markets makes it more cyclical than many of my holdings but it does share some of the core characteristics that I look for.

In summary, for the patient investor with the fortitude to endure recent volatility, the outlook for the UK stock market remains encouraging.

Ciaran Mallon is manager of the Invesco Perpetual income and growth fund


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