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Natural selection

The recent release of worse than expected first-quarter1 GDP data vindicates our cautious views on the economy – we expect UK GDP to contract by 3.5 per cent this year. Significant further deleveraging is required on the part of consumers and businesses.

Moreover, the brief consumer sweet spot created by falling oil prices and low mortgage rates is now passing, Government finances suggest that taxes will need to rise and unemployment is also increasing. We therefore think that talk of a V-shaped recovery is misguided – our forecast for 2010 is for GDP to be flat.

Subdued demand for consumer goods, excess capacity in many industries and minimal wage growth suggest that inflation is not going to be an issue in the short to medium term.

However, the amount of stimulus that has already been unleashed means that inflationary pressure is likely to build at some point.

Once prices start to rise, inflation readings may move quickly, especially given that the authorities may be sluggish in their response for fear of choking off growth.

We believe that the market will start to focus on this risk in late 2010. Until then, we do not see inflation as a major issue.

Despite the likelihood of below-trend growth over the medium term, there are reasons to be optimistic about the prospects for the market.

Equity investors are forward-looking creatures by nature and the prospect of an improvement in economic conditions has been taken well. Even at very muted levels of growth, companies can structure themselves to deliver attractive returns to shareholders, and there is much evidence of management teams taking sensible action in this regard.

Furthermore, fears of complete financial meltdown have receded. Strong gains seem unlikely in the short term but there is scope to make money in the months to come.

Following the outperformance of defensive sectors early in the year and the rotation into higher beta and more highly geared areas during the rally, sector themes are now less clear cut.

We are identifying good opportunities in defensive and cyclical areas and believe stock selection will be the key driver of performance from here.

Reflecting this view, the portfolio is now much more balanced. We still have a solid core of large-cap, defensive names representing the established themes of dividend sustainability and the strong getting stronger.

However, these defensive stocks no longer dominate the fund and recent purchases have tilted the portfolio towards new themes such as refinancing and cyclical value.

Despite the short-term pick- up in investor sentiment, we are still keen to focus our investments on companies where we believe in the business model and the management team. Conversely, we remain wary of companies with an over-reliance on cheap debt as, with banks seeking to repair their balance sheets, the cost of debt is likely to stay historically high.

Dividend cuts have been a key feature of the market over the past year and we expect this theme to continue into 2010. The taboo of cutting the dividend has been broken and, with trading conditions remaining tough, companies may prioritise rebuilding their balance sheets above distributing profits to shareholders.

However, there are also companies – notably some of the banks – that are clearly keen to resume paying dividends as soon as they can. The fund is yielding more than is required to qualify for the IMA sector and we hope to maintain the dividend close to its current level.

In summary, the economic background remains difficult but growth will return, the financial system has survived its recent stresses and companies are adjusting their costs bases to match reduced demand. This creates the scope for experienced managers to make money for investors.

We believe that the clear sector themes of the past 18 months are now giving way to a period in which stock selection will be the key driver of returns. Portfolio strategy is now more balanced, with a mixture of large-cap, defensive names, attractively valued cyclical companies and turn-round stories.

Leigh Harrison is head of UK equities at Threadneedle and manager of the Threadneedle UK equity alpha income fund

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