However, the market outlook for the rest of this year is still uncertain, underpinned by continuing concerns as to the full impact on the real economy of ongoing credit difficulties.
Market sentiment has been badly damaged, not only by the uncertain implic-ations of the tighter credit environment but also by overly optimistic expectations for short-term profits growth across many sectors.
Additionally, the UK has not benefited from aggressive monetary easing, with the Bank of England exercising caution in the face of persistent, albeit relatively modest, inflationary pressures.
There is little doubt that these concerns are valid. However, the UK equity market has already taken a lot of pain and is currently pricing in a significant fall in earnings for 2008, even if analysts have been slow to adjust. While equities are likely to remain volatile for as long as credit and liquidity risks hang over the financial sector, the ratings accorded to UK equities are currently on the low side and long-term growth prospects generally remain strong.
Credit problems are unlikely to be resolved imminently, but in due course equities should benefit from several positive factors, including lower interest rates, new sources of finance, in particular sovereign wealth funds, healthy corporate balance sheets, decent dividend growth and sensible valuation levels.
Ratings in the UK market have compressed in recent years although they have now started to expand as companies with good earnings visibility are being rewarded with higher ratings and there is scope for this development to continue.
In this difficult environment, we remain cautious and focus on companies with good visibility of earnings, where ratings can expand further.
We also seek companies benefiting from internal change, irrespective of the economic environment.
Finally, we look for companies which are benefiting from an external change impacting on their industry.
Two areas where we currently see good visibility are support services and defence. Many support service companies such as Serco Group benefit from a continued drive to outsource non-core activities by private and public sectors alike. Defence companies such as BAE Systems benefit from Government spending.
There will always be companies which see their prospects improve on the back of internal changes. We believe Smiths Group is about to see a revival of fortunes following the appointment of Philip Bowman as chief executive. He has an excellent track record of turning round underperforming companies.
A recent example of external change has been the rapid industrialisation of emerging economies such as China and India, which has led to an enormous rise in the demand for (and the price of) many basic commodities.
Areas where we remain cautious include those sectors most affected by the credit crunch such as consumer services, house- builders, retail and financials.
Despite a recent rally in banks, financials remain under significant pressure and are unlikely to return to favour with investors just yet. That said, we continue to see some opportunities in the sector such as Intermediate Capital, a mezzanine finance group, alternative investments provider Man Group and insurer Royal & Sun Alliance, which have all been affected by negative market sentiment but have strong underlying businesses.
We believe it is appropriate to retain a cautious position in the near term, with an emphasis on visibility. In the medium term, we see a somewhat brighter outlook for equity markets.
Simon Murphy is manager of the Old Mutual UK select equity fund
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