September 2011

Economy

Economic growth in the UK is anaemic. Forecasts continue to drift downwards as fears of a European debt crisis brew. GDP growth estimates stand at 1.1% for 2011.

The housing market is stagnant with prices flat since the beginning of the year. Mortgage approvals remain at depressed levels despite low borrowing costs. UK consumer confidence has deteriorated further in the last few months according to the Nationwide index and high unemployment remains a concern.

With the UK base rate already very low, it is possible that to stimulate the economy the Monetary Policy Committee will re-introduce quantitative easing at some stage. This should reduce downside risks to growth but at the cost of higher inflation. Consensus expects CPI to be 4.4% in 2011, significantly above target.

Equity Market

Global growth forecasts are deteriorating. The Greek debt crisis and fear of contagion throughout the rest of Europe has affected investor confidence. A default is becoming increasingly likely and a solution to the problem is not immediately apparent. This along with fears of slower growth in China has made for extremely volatile equity market conditions. In the last quarter, the FTSE 100 has fallen 15%.

Panic has gripped markets with the highest risk sectors falling aggressively. Slowing global industrial production expectations have hit commodities and the mining sector. Miners are down almost 30% since the beginning of the quarter.

The banking sector has also performed poorly this quarter, down 25%. Concerns regarding exposure to risky European sovereign debt and possible recapitalisation requirements have been detrimental.

Unsurprisingly, defensive sectors have held up well in the current market conditions. Tobacco (-0.5%), Mobile telecoms (-2.6%) and Utilities
(-2.9%) have all outperformed the market quarter to date.

Following the recent market correction, the FTSE 100 now trades on just over 8 times next year’s earnings with a current yield of 4%. This appears to offer good value when compared to historic valuations although earnings estimates could come under pressure next year given the macroeconomic backdrop.

Strategy & Outlook

We remain of the view that the current economic lull is more likely to be a mid-cycle slowdown rather than a double dip. As the European debt crisis continues to escalate however, the probability of recession increases. Aggressive European policy action would be beneficial for equity markets.

We continue to favour quality companies with strong balance sheets and little exposure to Europe. We fear banks are returning to difficulties and remain underweight.  In an environment where the real return on UK government debt is zero we stay cautiously optimistic on the relative merits of equities.

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