After a firm rise in April, the FTSE All-Share dropped slightly in May and June as the macro outlook globally became less certain. There is great potential for stocks to make further progress in the second half of the year, but there are some issues that require clarity.
Performance of index over 3-months
Source: FE Analytics
Some weaker data from the UK, US and China continued to unnerve investors in recent months. We believe this reflects a mid-cycle slowing of growth, rather than a symptom of something more serious. The market is seeking direction at present and reactions to newsflow seem to be a little exaggerated.
For example, the news that the US Federal Reserve amended its GDP forecast from 2.9 per cent to 2.7 per cent brought widespread concerns about slowing growth. But 2.7 per cent is still firmly in positive territory and not much below the long-run average rate. The end of QE2 in the US also suggests that the Fed is less concerned about the need for continued stimulus than the wider market.
The latest instalment in the Greek sovereign debt saga was clearly an obstacle in the second quarter, as evidenced by the sharp increase in equities once new austerity measures were passed and funds secured to avoid immediate default. This development should bring a degree of stability to the eurozone and its banks.
However, concerns over the pan-European banking sector are not only the results of Greece’s woes. In the UK there is unease over the actions of the Independent Commission on Banking (ICB), as investors wait for clarity on its proposals.
Potential ringfencing of certain activities is creating a general sense of uncertainty over the future of the larger UK banks. Although downside risk remains and uncertainty is high, much of this is factored into share prices, and valuations in some cases are beginning to look interesting.
Inflation has been a key macroeconomic concern this year across many regions. We believe it may be nearing its peak, especially as many one-off effects (such as VAT in the UK) start to roll over.
Chinese tightening in response to inflation also appears to be reaching an end, with premier Wen Jiabao publicly stating that inflation is under control. An end to Chinese tightening would be supportive of commodity prices and therefore mining companies.
Over recent months we have reduced our underweight exposure to miners. A parallel story can be seen in the UK, where the latest minutes from the Bank of England’s Monetary Policy Committee showed less support for rate increases.
Market consensus has changed too over the course of 2011, as expectations have experienced a significant shift. Only a few months ago the market anticipated that the base rate would start to increase in May; now the first rate-rise isn’t expected until 2012.
Warm weather, bank holidays and the general feel-good factor around the royal wedding gave the UK consumer a lift in April, although since then the picture has been less rosy.
Regional differences are stark, with London and the South East proving resilient while other parts of the country struggle with austerity measures, unemployment and weak property markets. As we might expect, there have been some high-profile difficulties and failures in the retail sector, with Thorntons, TJ Hughes and Marks & Spencer all reporting negative news.
Although it may seem that consumer-oriented stocks would be best avoided at this time, there are some good opportunities to be found. For example, the recent closure of Focus DIY stores should benefit its competitors (such as B&Q) as they pick up some of the market share.
We think Kingfisher, B&Q’s parent company, is attractively valued at the moment. It appears its share price is being held back by its exposure to the consumer and fails to reflect the strong underlying performance. At times like this, a focus on stock fundamentals becomes particularly important.
Valuations remain appealing on many metrics, but we believe a key attraction of UK equities at present is their cash flows. With 10-year gilt yields of around 3.2 per cent, the forward dividend yield on the UK equity market of 3.6 per cent is compelling.
The positive second-quarter performance of the UK equity market despite challenging conditions suggests that the market is more resilient than is widely perceived. While we acknowledge that there are a number of macro risks yet to be resolved in the coming months, attractive valuations, strong cash flows and continued economic growth are all positive influences.
There has been some weaker data during the past quarter, but we believe this is typical of a mid-cycle slowdown and not indicative of a return to recession. Although the outlook for the domestic environment also appears lacklustre, it is important to remember that the UK equity market generates much of its earnings in other regions.
In an environment heavily influenced by macro newsflow, investors can be distracted by the noise of volatile data points. We prefer to maintain our focus on stock specifics, particularly where a company’s association with a certain sector or region has resulted in valuations that do not reflect the business reality.
Alan Custis is portfolio manager on the Lazard UK equity team. The views expressed here are his own.