Against the backdrop of a number of downbeat forecasts, 2004 proved to be a relatively positive year for UK equities. The FTSE All-Share enjoyed a rise of over 9%, which, combined with a dividend yield of 3% or so, provided a total return of over 12%, comfortably ahead of returns from both in fixed interest and cash.

It was, however, a year where stock selection was of unusually high importance. Smaller companies again outperformed larger companies and whilst some smaller industrial sectors such as tobacco and real estate enjoyed significant gains, some larger sectors such as pharmaceuticals suffered substantial falls. One prediction we would feel confident of making is that 2005 will be a year where active stock selection will again prove key in outperforming market indices.

A good example of this is to examine the trading performance of some of the largest stocks in the FTSE index. HSBC and Vodafone both ended the year broadly unchanged in price terms. GlaxoSmithKline fell by over 5% and only BP of the giant FTSE constituents rose meaningfully by some 12%. The 9% rise (in capital terms) over the year was, therefore, clearly the result of significantly better performance from many medium-sized and smaller companies.

In the UK, the outlook for growth in 2005 is relatively positive when evaluated against other major European economies. However, at a macroeconomic level, the balance of payments has deteriorated sharply over recent months, particularly in manufactured goods. The Government’s own financial balance sheet is also looking less robust as a result of a significant increase in public expenditure and dwindling projected tax receipts. At some stage during 2005 these factors, in our opinion, will result either in a further rise in domestic interest rates, a fall in the trade-weighted value of sterling, or both. The major political issue is whether these factors become more obvious before the General Election, universally assumed to be on 5 May.

What does this mean for markets and the various asset classes in which we invest? Our view is that the current outlook is unhelpful for fixed interest investments, both gilts and corporate bonds. Although these investments can merit a weighting in most portfolios, we tend to feel that returns over the year will be lacklustre and would prefer to hold cash as a strategic non-equity allocation decision. One small exception could be index-linked gilts, which could be worth considering, both due to their relative scarcity and the continued appetite of pension funds and insurance companies for liability matched assets. Commercial Property, both in funds and particularly in the quoted sector has been a good performer. We feel that this trend will continue into 2005, although overall returns, from the current base, are expected to be more muted than in 2004.

This leaves equities, which we still feel is the asset class of choice for most investors in 2005. In sporting parlance, our current estimation for 2005 is that it could be ‘a game of two halves’. There is a certain amount of momentum behind markets generally at the moment, spurred by a sharp fall in the level of world oil prices from the peaks seen in the late autumn. Provided that the weather in the US remains, as it has been, seasonably somewhat better than average and that the elections in Iraq fixed for the end of January actually happen, then there is a good chance that for world equity markets the first quarter of 2005 could be quite positive. Thereafter, the outlook is much cloudier. America will most likely experience further increases in interest rates as both fiscal and trade deficits continue to rise and the dollar comes under further pressure. In the UK, the domestic property market will anxiously await the traditional pick up in interest at Easter, which is particularly early this year. However, the threat of looming tax increases and also the prospect of further interest rate rises, latest Bank of England minutes notwithstanding, is not an especially positive background for equities. At this stage, we would be looking to move a little more defensively in terms of raising a little cash here and there from equities in the run up to an Election.

Looking a little more closely at the UK equity market, what will be the major themes in driving equity performance? Chinese economic growth, a dominant theme in 2004, will again feature highly. This year the questions will focus on how the economy will adjust to a controlled slowing in the breakneck pace of growth in the last eighteen months, and whether the yuan/remnimbi will be revalued against the dollar. Our thoughts at this stage are that China will peg rates but some other economies such as Taiwan, Singapore and South Korea will facilitate a small revaluation of their currencies. This factor, combined with the relatively positive growth rates experienced throughout the Pacific Rim economies, provides a favourable outlook for sterling investors. The other major theme we see developing in 2005 is for a continuation of merger and acquisition activity and further ‘de-equitisation’, by which we mean the return to shareholders of cash and the repurchase by companies of their own equity.

Two major companies have returned cash recently, Marks & Spencer through a capital rationalisation exercise, and Banco Santander due to the takeover of Abbey National. Additionally, companies such as BP, Vodafone, AstraZeneca and BAT have been buying back their own stock in the markets, thus shrinking their equity base and enhancing earnings for ongoing shareholders. Levels of corporate cash are at historically high levels and further corporate restructuring is certainly to be expected. This activity, though, could be concentrated in the first few months of the year and, as indicated, the post-Election environment in the corporate sector could prove less benign. One small structural positive for the equity market is that if interest rates and long bond yields rise a little, as we expect, this will offset (through a complicated actuarial valuation technique) some of the prospective pension fund deficits that due to a recent legislative change, are being seen more prominently featured on balance sheets. The pressure to switch assets away from equities and into fixed interest, so pressing during the first quarter of 2004, is thus somewhat abated.

So, in conclusion, 2005 looks to be another year in which equities may be the best performing major asset class, but perhaps with returns skewed towards the first half. Fixed interest appears unappealing and cash, as ever, the safe haven. Stock selection, as in 2004, will be the key to generating returns and a focussed approach on both owning successful companies, and also – something that is not so often fully appreciated – not owning unsuccessful ones, will again be our major endeavour on our clients’ behalf.



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