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Relative values

There is no doubt that this has been a challenging period for UK equities, particularly those which invest in smaller companies. Over the year to April 30, the total return for the FTSE 100 was -2 per cent compared with -19.3 per cent for the smaller companies market as measured by the Hoare Govett Smaller Companies index excluding investment trusts.

Volatility has been a key feature of the market and investors have been particularly concerned that the difficulties associated with US sub-prime lending will affect global growth prospects. As a result, risk-averse investors have taken shelter in the perceived safety of large-cap stocks as smaller companies have struggled to keep pace.

The other major impediment has been the credit crisis and its impact on the banking sector. Sentiment has inevitably been driven by events in the US, with concerns over the financial health of Bear Stearns precipitating a share price collapse in March.

The mood recovered somewhat in the wake of a hefty cut in US interest rates and encouraging news elsewhere within the sector but investors have retained a cautious outlook.

Deteriorating economic conditions have also affected the performance of smaller companies as they tend to rely more heavily than their bigger counterparts on a favourable economic environment. Those with earnings linked to the public sector have been adversely affected by an anticipated downturn in Government spending, announced in March’s Budget statement. Chancellor Alistair Darling was forced to admit that the UK economy is likely to grow more slowly than expected. This heralded a reduction in Government revenue and an increase in borrowing.

The Bank of England has been dealing with slower growth and tighter credit conditions while consumers struggle with escalating utility bills, mortgage payments and food prices. The Bank has been faced with the difficult task of balancing the risk to growth with that of domestic inflation which threatens to rise well above its targeted level.

The big stockmarket winners have been mining stocks, propelled not only by sustained growth in demand from emerging markets but by merger activity as well. The oil and gas sector, boosted by record prices for crude oil, has been another strong performer. Many sectors of the market where smaller companies play a prominent role, such as support services, have struggled.

We believe that the performance of smaller companies relative to their bigger counterparts depends to a large extent on how much further the credit crisis has to run. The key for many firms has been not only how prepared the monetary policy committee has been to reduce interest rates but the extent to which financial institutions are prepared to pass these cuts on to the corporate sector and consumers.

Growth in the UK looks likely to slow quite sharply this year as residential investment falls, consumers turn more cautious and business investment stops growing. The more competitive level of sterling may give some boost to exports but growth in GDP is likely to slow substantially. However, the negative effects on growth will not continue indefinitely. Lower interest rates, for example, will in time take some of the pressure off household finances.

In the short term, equities are likely to remain volatile amid continued uncertainty over the impact of the turmoil in financial markets. Investors will also be keeping an eye on the sustained strength of the emerging market economies.

The short-term economic outlook in the UK is far from favourable but many small and medium-sized firms are trading at their most attractive valuations in several years. As active managers, we aim to use our skills to identify these pricing anomalies to generate superior returns over the longer term.

Richard Dingwall-Smith is chief economist at Scottish Widows Investment Partnership

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