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Strength in numbers

Economic data suggests the fundamentals remain supportive for the UK economy.

The UK stockmarket has made strong gains over the past four years and performance remains positive so far in 2007. The FTSE All Share index is up by 2.9 per cent in the year to the end of March, having gained 3.3 per cent last month after bouncing back from the correction at the end of February.

Two related factors have helped the UK market’s resilience. First, UK equities are supported by cheap valuations which are attractive relative to bonds and to their own history. They are attractively valued in their own right, particularly given the sustained growth in corporate earnings. For example, compared with the exalted valuations of the late 1990s when the UK market traded on a price/earnings ratio in the mid 20s, UK stocks now look inexpensive, trading on P/Es in the low teens.

The second key factor behind the UK market’s continued strength has been merger and acquisition activity. Attracted by reasonable valuations and strong earnings potential, foreign buyers and private equity groups continue to target UK companies this year.

Such corporate activity has been a feature of the mid-cap index and, more recently, the large-cap index, with a buyout offer for Boots and a rumoured private equity deal for Sainsbury as well as the plan by Barclays to merge with ABN Amro.

We would expect M&A activity to continue supporting UK share prices this year. Share buybacks and M&A activity together accounted for a net 3 per cent reduction in shares outstanding for the UK market in 2006, cutting supply and helping to underpin the market. This trend is material and likely to continue in 2007, given the attractive valuations still afforded to UK companies.

The UK market remains well supported at the moment and our central assumption remains for UK equities to produce positive returns through the remainder of 2007. However, as the sharp correction of late February showed, risks remain and periods of heightened volatility can be expected over the coming months.

One of the current perceived risks to equity markets comes from concerns over the slump in the US housing market and associated crisis in the US sub-prime mortgage sector.

Investors are worried about the wider impact of the house price reversal on the US economy, particularly on the US consumer. With a number of UK companies now dependent on international demand, there is some concern over the impact of any significant weakness in US growth on UK corporate profits.

The US economy should benefit from continued strength in the labour market and any incipient weakness could be countered by lower interest rates from the Federal Reserve. The US should therefore avoid recession, even if it grows below trend this year.

With global GDP growth likely to be reasonably strong during 2007 and with the UK economy also expected to deliver robust GDP growth this year, the domestic economic outlook looks relatively benign.

UK corporates are forecast to deliver continued positive earnings growth, with consensus forecasts of high single-digit earnings per share growth for 2007 and 2008, while also delivering good dividend growth. These expectations leave the UK equity market trading on an attractive P/E ratio of around 13x for 2007 and 12x for 2008.

Further volatility may be seen over the coming months, perhaps sparked by renewed geopolitical tensions or announcements of weaker than expected economic data, but the fundamentals are likely to remain supportive for UK equities.

James Illsley co-manages the JPMF Claverhouse investment trust.


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