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Comment: London market unperturbed by bombings

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UK equities have lagged their counterparts elsewhere and are likely to continue to do so, according to Barclay’s Global Investors chief economist Haydn Davies.


Market background

The UK market reaches its highest level in three years. However, the UK has underperformed markets elsewhere and will continue to do so with sentiment so weak


A flurry of upbeat US indicators suggest the economic climate is improving, which should help Wall Street shake off its lethargy


Weak export orders continue to weigh on Japan‘s economic environment

An improvement in manufacturing orders signals a recovery in the euro zone, but only a tepid one


UK market undeterred by bombings

As news broke on 7 July of the four suicide bombings on the London Underground and a London bus, in which 52 commuters are known to have been killed, the UK market lurched sharply lower. However, within a day, the stock market had recovered the ground it had lost. Investors came to the conclusion that although  the bombings represented a terrible human tragedy, the impact on businesses would not be significant. Even the news of a failed, repeat series of suicide bombings two weeks later did not keep the market from touching a three-year high.


This apparent fortitude is explained by the fact that those industries likely to be most affected by the bombings – the transport, and leisure and hotels sectors – make up only 4 per cent of the capitalisation of the UK market. So although these sectors have underperformed, their small weighting means that they have failed to make much impression on the broader market.


The impact of the bombing on the UK economy is also likely to be small. The tourism sector is set to be the most affected, but for example, spending by overseas visitors amounts to only 1.5 per cent of the UK‘s annual economic output. As a result, even a sharp fall in the number of tourists visiting the UK would have only a small impact on growth.


The devastating outbreak of foot-and-mouth disease amongst livestock in February 2001 and the US terrorist attacks on 11 September, led to a 10 per cent fall in overseas visits to the UK over the course of that year. Therefore, even if the number of tourists visiting the UK were to fall twice as sharply as it did in 2001, UK economic growth would turn out around 0.25 per cent lower.


Nonetheless, with economic growth at its slowest rate since 1993 and the manufacturing sector officially in recession, the UK economy is not in the best shape to weather too much of a shock.


Economic indicators such as business confidence and retail sales have improved a little over the past few weeks, but it remains too early to gauge whether the consumer slowdown has run its course, particularly in the aftermath of the London bombings. Although the economic news has looked a little more upbeat and activity in the housing market in particular appears to have stabilised, the Bank of England looks increasingly poised to cut interest rates at its August meeting.


The last time the Monetary Policy Committee (MPC) met, four of the nine-strong committee voted for a cut. Moreover, the consumer slowdown has turned out to be more severe than even the most ardent hawks on the MPC, concerned about the overheating housing market and the ballooning of consumer debt, had expected.


The outlook for UK equities is boosted by the prospect of a cut in interest rates and the modest improvement in the economic climate. This helps to explain why the market has remained undaunted by the London bombings. Not surprisingly though, the UK market has been lagging markets elsewhere and although the bombings should have minimal impact on the earnings outlook for UK firms, this underperformance is likely to continue.


The modest improvement in the economic climate is outweighed by weak investor sentiment. Investment analysts, for example, have been downgrading profit forecasts over the past couple of months, while in most other markets they continue to raise them. Moreover, foreign investors continue to favour markets elsewhere.


The pound has also suffered from a sharp downturn in sentiment, partly as a result of the London bombings, but mostly because of the prospect of cuts to UK interest rates.  However, the interest-rate outlook does favour UK government bonds that continue to look better value than markets elsewhere.


Improvement in economic climate to help Wall Street

Over the past few months the US economic climate has looked a little patchy, but over the past few weeks a flurry of better-than-expected economic indicators have suggested that the outlook is a little brighter. An upward revision to the estimate of economic growth in the first quarter means that the US grew a little quicker than the annualised trend rate of 3.5 per cent, rather than a little slower as statisticians had first thought.


Business confidence has also stabilised and new manufacturing orders have surged, even ignoring Boeing’s best ever month for new aircraft orders following the Paris air show. Reassuringly, firms also appear to have trimmed their stocks of unsold goods more quickly than expected.


Although this inventory drawdown has detracted from growth over the past few months, the inventory overhang should be less of a drag on growth in the coming months. In addition, underlying retail sales – ignoring sales at petrol stations – have accelerated modestly. The better news does not suggest that the US is headed for another boom, but it does put to rest worries about growth for now.


Concern about the outlook for US growth has meant that US equities have struggled to make much headway this year and although the economic climate has still been much more upbeat than in Europe, Wall Street has lagged well behind European markets. However, the better-than-expected news on the economic climate should boost the outlook for the US market.


Despite the improved economic news, the 10-year government bond yield at 4.2 per cent remains almost 0.5 per cent lower than the level at which it stood when the Federal Reserve first began raising interest rates in June last year. With bond yields remaining very depressed, equities continue to look better value, as do government bond markets elsewhere.  Nevertheless, sentiment towards equities is still a little soft with company directors in particular still preferring to sell shares in their own companies.


The US dollar has seen a dramatic turnaround in its fortunes since the beginning of the year. With the Federal Reserve expected to continue raising interest rates to at least 4 per cent by the end of the year, the currency should continue to rally, especially given the current strength of sentiment.


Japanese exporters struggling

A little unusually for Japan, it has been the export sector that has looked a little downbeat in recent months, while household spending has been surprisingly upbeat. Industrial production, for example, is lower than its level a year ago while retail sales have grown 3 per cent over the past year, their strongest rate since 1998.


Over the course of 2003 and 2004, Japan‘s exports to China grew by almost half, but a more recent slump in orders means that Japanese exports to China have fallen so far this year. Moreover, with foreign machinery orders still fairly soft there is little sign of any imminent recovery in export orders. China‘s modest 2 per cent revaluation of its currency, the renminbi, is also unlikely to have much impact on Japan‘s exporters as China‘s demand for heavy machinery will be unaffected. The revaluation only restores the value of the renminbi on a trade-weighted basis to its average level over the course of 2004.


The bright spot continues to be household spending. It has been bolstered by an improvement in the labour market as employment reached its highest level in three-and-a-half years.  However, with industrial production now shrinking, employment growth is likely to wane. Of course, if export orders were to pick up sharply, employment growth could accelerate still further.


For the moment the economic climate still looks a little patchy, although the Tokyo market should continue to make gradual progress. The prospects for government bonds look a little better with underlying inflation still negative. The 1.3 per cent 10-year yield still looks attractive compared to markets elsewhere with higher yields, but also with higher inflation. In contrast, the omens do not look good for the Japanese yen, which has been sliding since the beginning of the year. The 0 per cent yield makes the currency unattractive, sentiment is soft and the patchy economic climate continues to deter investors.


Euro zone poised for uninspiring recovery

The euro zone recovery has never really taken hold. Last year the euro zone grew by 1.7 per cent and this year economists, on average, expect the region to grow by a meagre 1.3 per cent.


French and German unemployment, at 10.2 per cent and 11.7 per cent of the workforce respectively, is the highest in more than five years. Despite the weak climate, the European Central Bank (ECB) has kept interest rates unchanged since May 2003. One reason for the ECB’s reluctance to lower rates has been the extent to which inflation remains stubbornly above its 2.0 per cent target.


Nevertheless, underlying inflation ignoring energy prices is only 1.3 per cent, suggesting that inflationary pressures across the region are not a great threat and that policymakers at least have no pressing need to raise interest rates.However, there are signs that activity is beginning to pick up.


French and German business confidence, for example, has been recovering from its trough in May.  Export orders in particular are beginning to improve, suggesting the euro’s fall is helping to ease at least some of the region’s woes. The weak link continues to be household spending.


French household spending, for example, has begun to fall and business surveys across the region suggest confidence amongst retailers has not matched the recovery in confidence amongst manufacturers. Therefore, although the economic environment appears to be improving across the region, the recovery looks set to remain half-hearted for the time being.


Nevertheless, the prospect of a fairly tepid recovery should not be too much of an encumbrance to European stock markets.  After all, the weak economic climate has not kept the region’s markets from rallying strongly so far this year. The French and German markets have risen by 15 per cent, and even Italy‘s market, with the economy having slipped into recession, has risen by around 9 per cent this year.


Despite their out-performance in 2005 — the US market has risen by just 2 per cent and the Japanese market by 5 per cent — European markets remain good value given the strong profit growth that firms have been able to engineer.


The main factor in their favour, though, is the strength of sentiment. Investment analysts are for the most part revising profit forecasts higher and foreign investors continue to invest heavily in euro zone equity markets.


While sentiment towards European stock markets is very upbeat, the same cannot be said of the euro. Moreover, the likelihood that euro zone interest rates will remain stuck at 2 per cent even as US interest rates reach 4 per cent, means that the interest-rate outlook continues to weigh on the currency.

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