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The pressure is rising

Volatility has continued to be a feature of the UK equity market since the start of the year and is presenting a major challenge for seasoned investors.

Conditions are uncertain with regards to the extent and magnitude of the US slowdown, and any uncertainty breeds volatility.

Moreover, a number of lead indicators are contradicting each other, which means the market tends to over-react to any news that it receives. Heavy selling has become a common occurrence and is frequently indiscriminate.

Thus, even quality stocks can see their prices fall.

It is almost three years since the FTSE 100 index first broke through the 6,100 barrier.

We have been through several bull and bear phases since then but the UK market has effectively been treading water for the past three years.

If history has shown us anything about economic cycles it is that the market will look through and beyond the trough into the next phase of growth. Moreover, hindsight reminds us that where the market eventually reaches the bottom of the trough, it usually feels like there is still further to fall.

Reasons to be cheerful

Given that fundamentals remain sound in the UK and global growth is expected to recover by the end of the year, we are optimistic on the market&#39s prospects despite the near term volatility. We see 2001 as a year of positive returns for the UK equity market and there are several key reasons for this:

l The domestic economy is soundly based and should be relatively insulated from the turmoil in the US.

l Equities are cheaply valued in relation to bonds. In fact, excluding the Asian crisis of 1998, equities are at their cheapest for 10 years or so.

l Falling interest rates should re-energise growth.

l Active stockpickers such as us can take advantage of indiscriminate selling.

Key concern

Of course, the outlook for the US economy still remains the key concern.

Corporate earnings in the UK and the rest of the world are seriously dependent on the world&#39s biggest economy. To quote the former chairman of the Federal Reserve: “Everyone suffers when the 800lb gorilla on the block catches cold.”

UK stocks with a large amount of US exposure are therefore more at risk.

Last autumn, earnings&#39 forecasts were too optimistic in the UK. At the time, most commentators were talking about US inflation risks being on the upside and even the Fed was maintaining a tightening policy bias. The debate at that time was about controlling rather than generating growth.

Since then, the speed and magnitude of the US slowdown has taken everyone by surprise. For example, consumer confidence has collapsed in a very short period of time and the NAPM has similarly deteriorated.

However, we now believe that forecasts are much more realistic, having adjusted to the slowing economy.

If these top-down estimates of growth are to be trusted, now would probably be a good time to start buying into growth/ selected cyclicals.

But, as ever, any forecast is only as good as the assumptions on which it is based and right now there simply is not enough hard evidence to say with certainty that the US recovery will be swift (a so-called “V-shaped” recovery).

The degree of reversal in US economic fortunes to date suggests that those who still maintain there is little possibility of a recession may be in denial.

On the positive side, the positive action taken by the Fed has reassured investors that the strategy being implemented will prove effective.

This suggests that any further negative economic news may well be largely dismissed unless it is prolonged into the latter half of this year.

Our house view, however, is that the recovery will begin later this year but that it will not be as rapid as many commentators are suggesting.

We still feel that 2002 estimates of earnings&#39 growth are too optimistic and will be subject to further downgrades in order to reflect reality.

Favoured market

The UK is our favoured equity market at present due to its attractive valuation and the prospect of further interest rate cuts. While global economic growth remains under pressure, our approach is to run relatively balanced sector exposures and the market&#39s defensive nature is not a major drawback.

This said, the UK market will continue to be volatile until we have enough information to determine the global economic outlook. Such conditions are challenging but they can also provide a number of opportunities for actively managed funds.

Stockpicking managers are able to capitalise on price changes, trading stocks when the market sentiment swings wildly from one day to the next, taking gains, and picking up some bargains along the way.

On a six-month view, the UK market could produce impressive returns for those funds willing to back their views.


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