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Your Money > Investing Comment Articles > Market View: Worse still to come
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By Leigh Harrison, Head of UK Equities at Threadneedle
More sleepless nights worrying about your investments? Here's a few insights from one of the UK's largest fund management firms. Economy to remain weak
We have made further downward revisions to our economic forecasts and now expect UK GDP to contract by 3% in 2009. Although activity is likely to be on an improving trend by the year-end, we do not expect growth to return to positive territory until well into 2010. There will also be a sharp increase in unemployment this year as companies shed excess capacity built up during the boom years. Inflation is likely to be around zero and interest rates will also fall towards zero with the distinct possibility of more unconventional measures such as quantitative easing being unveiled in the coming months.
Difficult environment for earnings This environment is clearly a tough one for corporate earnings and we expect the forthcoming reporting season to be one of the most difficult in recent memory. Over 2009 as a whole we are forecasting earnings at the aggregate level to fall by around 15%. Dividends, too, are under severe pressure and are likely to fall by a similar amount. We are aiming to maintain the dividend payments on our equity income funds, but this will be a challenge.
Valuations discount a lot of bad news The volatile environment for earnings and dividends reduces the usefulness of many of the valuation measures traditionally used. However, the market has clearly absorbed an awful lot of bad news and, based on return-on-equity and long-term earnings trends, equities represent reasonable value at current levels.
Short-term direction hard to call Over the next few months we expect sentiment to oscillate between a pessimistic outlook, characterised by concerns about the government’s ability to fund the support packages it has unveiled, and a more optimistic view that the authorities have acted promptly and that economic recovery is around the corner. This ebb and flow is likely to leave the market trading in a fairly wide range. But if we fast-forward twelve months, 2010 is likely to feel better than 2009 and, at some point, investor sentiment will start to factor this in. Using the market’s likely short-term range to add periodically to equity weightings is likely to be a fruitful long-term strategy.
Little change to themes There has been little change to the themes underpinning our portfolios in recent months. The funds continue to be built around a collection of strongly financed household names, sustainable growth stocks and industry leaders. This defensive approach has served the funds very well but we are aware that caution will not always be the right strategy. We are looking for opportunities to move from a capital preservation stance to more of an outright money-making footing and have already incorporated a number of good value cyclical stocks into the portfolios.
Strong to get stronger We continue to believe that the current environment is one in which the strong will get stronger. This is not a market in which companies want to be saddled with debt and there is certainly a trend for management to replace debt with equity. The demand for the resulting equity will be a key mechanism by which the market sorts the wheat from the chaff as discerning investors allocate capital to long-term winners. Recent examples of successful capital raisings include Tullow Oil and Scottish & Southern. For more distressed companies, the cost of capital will be much higher.
Overseas earnings theme has further to run With data showing the UK economy to be one of the weakest on the world stage and interest rates approaching zero, sterling is likely to remain weak. This is good news for companies with significant overseas earnings, of which there are many in the UK – around 50% of the market’s earnings are derived from overseas. We believe that this theme has further to run and have a number of positions, in areas such as healthcare and tobacco for example, that are designed to take advantage.
Remain cautious on banks Underweighting banks has been a very profitable strategy for the funds and we remain wary of the sector. Balance sheet leverage remains too high and the cyclical deterioration in loan book quality is only just beginning. There is a good chance that one of the major high street banks will be fully nationalised and our holdings remain very selective and focused on the financially strongest players.
Conclusion The economic outlook remains very difficult and is likely to remain so for the rest of the year. However, the market is discounting a lot of bad news and is currently providing excellent long-term opportunities to make money. We remain defensively positioned at present, reflecting likely poor news flow around the forthcoming reporting season. However, on a three year view we are very positive, and we are looking for the opportunity to move portfolios to a more aggressive stance in the coming months.”
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