What a summer we had. Aside from the deluge of rain that dropped from the skies, the somewhat unpleasant storm in the financial markets sent many investors scrambling for cover. Yet even with all the volatility we have seen over the past few months, the fact remains that UK equities are still resolutely ahead in the year to date.
It seems that the overall script has been playing out much as we anticipated, albeit with the advent of some rather unexpected events in recent months. For example, US interest rates have begun to come down in the wake of the credit crunch but we believe the Federal Reserve would have begun to ease its hand by this point in any event. With the US economy having slowed for over 12 months, recent tightening in lending conditions would simply appear to have amplified the degree of Fed response.
The key thing now, as far as we are concerned, is that US policy is likely to be massively reflationary over the next 12 to 18 months as the Fed attempts to stimulate economic activity by making borrowing cheaper. There is still likely to be some poor economic data coming out of the US over the next few months but we are fully expecting the Fed to react with sufficient conviction to stave off any possibility of recession. With further cuts liable to be on the cards, we do not believe it would be impossible to see interest rates down as far as 4 per cent within quite a short order.
What is particularly important for equities is that this significant easing of policy will take place against a backdrop in which the rest of the world is still in pretty good shape. There may still be further tests for investors’ nerves over the next few months, particularly given the possibility of further revelations about the damage caused to banks, but we believe there is now a pretty positive picture being painted for global equities.
As the Fed response starts to kick in, the credit markets should begin to function again, the interbank market should gradually reopen and, as fear subsides, we believe we could see significant upside in UK equities over the next 12 months.
The question about interest rates in the UK is not quite as clear cut. Prior to the summer shenanigans, the market had factored in the possibility of two more quarter-point hikes. We believed that the doves on the monetary policy committee would hold off until they could see what effect the previous hikes were having. Given what has been happening in recent months, however, the market’s expectations have clearly made a U-turn. With no prospect of further hikes on the cards, the question now is when will rates actually come down?
We think the market could be surprised by the speed of the Bank of England’s response. With evidence of a slowdown in the UK housing market and the consumer coming through, we believe we could see a downward move in UK interest rates as soon as this year. Either way, it seems the Bank of England will find it difficult to abstain for too long from the global reflation trend that looks likely to take place.
With all these factors in mind, the next 12 months look set to be very favourable for UK equities. From an opportunistic point of view, we also believe there are now some great chances to pick up stocks that seem to have been unfairly punished in the recent volatility. For example, with financials one of the hardest hit areas over the past few months, we have been seeing some strong opportunities cropping up in stocks like Barclays and Royal Bank of Scotland.
The succession of rate increases and abnormally wet weather have also put pressure on retailers, leading to setbacks in shares such as Marks & Spencer, Next and Home Retail Group. Consumer demand may continue to fall but the anticipated level of slowdown seems to be more than priced in to these names. Given their strong business models and healthy balance sheets, as well as the prospect for lower interest rates, we believe companies like these offer some great returns for investors in the coming year.
Richard Buxton is manager of Schroder UK alpha plus fund and head of UK equities