Hopes for a recovery in UK equity prices have been dashed more than once this year. But fund managers are still cautiously optimistic that the market could yet push through key barriers to end the year higher than its summer lows.
Over recent months, the market just about managed to break its long cycle of decline. The FTSE 100 finished the second quarter with a wafer-thin gain of just nine points, but this fact gave a welcome lift to sentiment after five consecutive quarters of falling prices.
Nigel Lanning, director at Dresdner RCM, notes that at the end of July the market had shed almost 10% of its value in just two months. “Clearly, we are sitting in a very depressed situation.”
However, there was still no sign in the US or in the UK that the markets were falling off a cliff, he says.
“And it doesn’t appear that we are about to see a genuine recession,” he adds.
Although the market in the UK looks weak in absolute terms, fund managers point out that, relative to the US, Europe and Japan, UK equities appear quite resilient.
“If you are a relative investor, then the UK is a good place to be,” says Theodore Varelas, European strategist at ABN Amro.
Equities in the UK have outperformed European stocks by 8% this year so far. The erosion seen in the UK market this year was not likely to worsen. Compared to bonds, equity valuations are not demanding at all, he says.
The market has been weighed down by bad news from companies.
Technology and telecommunications companies have had to revise down their earnings forecasts due to falling demand. Manufacturers, meanwhile, have been hit by the effects of the strong pound coupled with a slowing global economy.
Manufacturing is virtually in recession, showing a 0.6% fall in the first quarter followed by “disturbing” figures in April and May, says Mike Taylor, UK economist at Merrill Lynch, based in London.
But he points out that it is not uncommon for the UK to experience a manufacturing recession without having the economy as a whole dragged down. In the past 30 years, there have been nine manufacturing recessions, but only three GDP recessions in that period. “Consumers are always willing to borrow,” he says.
Market observers still say prospects for a UK recovery are heavily dependent on a rally happening in the US. With Japan sliding back into recession and European economies slowing, there is little prospect of a boost emerging in any other major market.
Varelas says ABN Amro is expecting US sentiment to rebound in the third or fourth quarters this year.
Taylor sees the prospect of a cut in UK interest rates – a move which could boost shares in housebuilding companies and domestic banks. “We think there’s a chance of another rate cut – which will obviously be supportive of the market – if the global picture deteriorates further,” he says.
But once the global outlook has improved, the Bank of England’s Monetary Policy Committee will start to focus on the domestic inflation indicator, and will try to cool activity, says Taylor.
Right now, however, the Bank of England does still have room to move rates lower. “The UK doesn’t have the inflation complaint that the ECB European Central_Bank has. It is still below target and there are no significant inflationary pressures around,” says Taylor.
Earlier in the summer, unexpectedly high retail price data unsettled the market. But Lanning says Dresdner RCM believes this was nothing more than a blip, reflecting seasonal food and oil prices, and as such will not deter the Bank of England from easing credit if such a cut is warranted by other factors.
David McBain, UK equity strategist at Deutsche Bank says that, in the short term, life will remain reasonably difficult for the UK market. But a rebound is in sight, given that the Bank of England has enough in its armoury to improve the situation, and that consumers are benefiting from tax handed back in this year’s budget.
“In the fourth quarter, there is room for sentiment to improve and the market will accordingly be in a position to test and break through the 6,000 barrier,” he says. “But it may be a little while before the market generates any real momentum.”

Though construction stocks should benefit from the prospect of falling interest rates, growth in the financial services sector is likely to be slow, strategists said. And the telecommunications sector is grappling with structural issues, says Varelas. Companies in the sector are suffering from the effects of having overinvested, and consequently they are now dealing with depressed returns on capital.
ABN Amro’s strategists prefer oils, mining and consumer-related stocks in the current environment, he says.

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