The UK equity market performed well during the second quarter of 2005; the FTSE 100 Index marginally outperformed the All-Share Index, returning 5.3% against 5.0% over the period. A key feature in the market over the quarter has been the relative weakness of sterling against the dollar; the pound has fallen by over 5.0% relative to the dollar since the end of March, although it has appreciated a little against the euro. The other major development in world markets over the past three months has been the heady rise in the world price of oil to a peak of a little over $60 per barrel – a rise of over 50% on the position at the beginning of the year.

Fixed interest markets have performed better than had been anticipated over the period, with the Government All Stocks Index returning 4.7% over the quarter. At the end of March, it was generally felt that interest rates had not yet peaked and that one or two quarter-point increases were to be expected during the remainder of 2005. The current view, which we share, is that rates may now begin to fall over the summer and that a rate of 4¾% will mark the peak of the current cycle. It is the combination of these changed expectations on the UK rate cycle and the continuing slow increases in US interest rates that have engendered the relative strength of the dollar against sterling since the spring.

We have been somewhat surprised by the resilience of the gilt market recently, although the changed expectations for the direction of UK interest rates have been a positive factor. We continue to see little long-term value in conventional fixed interest stocks at current levels, particularly as we envisage a substantial increase in gilt issuance over the next few years to fund an increasingly large Public Sector Borrowing Requirement.

In our past two reviews we anticipated that 2005 would, in market terms, be ‘a year of two halves’. Most of the returns for investors would come in the first half of the year and the second half would be more pedestrian. Looking forward from the current vantage point we remain of this view. Whilst dividend growth, particularly from FTSE 100 companies, has been highly satisfactory and major companies have continued programmes to repurchase their own stock – the so-called ‘de-equitisation’ strategy – recent economic news from the UK has shown a marked deterioration.

There has recently been a radical downward revision in actual economic growth for the first quarter of 2005, which on an annualised basis makes it increasingly unlikely that the Chancellor’s ambitious target of 3-3½% growth for the year will be realised; a more realistic figure is now little more than 2% and some commentators are forecasting a figure as low as 1¾%. Falling economic growth implies a shortfall in tax receipts and, given the Government’s highly ambitious expenditure plans, there is an increasing likelihood of tax increases to come in the short term to compensate for a sharply widening fiscal deficit.

Consumers are now becoming concerned about this eventuality and this concern is being reflected in a sharp slow-down in retail expenditure and a cooling housing market. We feel that the equity market will reflect these concerns in the latter half of 2005 and, indeed, would not be surprised to see the overall market only a little higher at the end of the year.

Many hedge funds have also encountered difficult trading conditions during the first half of 2005; there is some evidence to suggest that this is because too many funds are pursuing similar strategies, thus limiting the scope for absolute investment returns.

The economic renaissance of China, which has been a key recent investment ‘theme’ at Taylor Young is showing some signs of cooling down, although data are sometimes conflicting and perhaps not as reliable as most commentators would wish. Nevertheless, it remains undeniable that China continues to be a major influence in global energy and commodity markets and is also under substantial pressure to allow a revaluation of its currency, currently pegged against the dollar. So far, the Chinese authorities have resisted this pressure but it is our view that such a move is likely in the medium term. We also anticipate that such a move would result in an appreciation against sterling of currencies such as the yen, Taiwanese dollar, South Korean won and Singapore dollar, enhancing returns for sterling-based investors for stocks with exposure to this area. India, too, is experiencing strong economic growth and we are currently evaluating investment opportunities in this area.

One factor in markets which would render us more upbeat on future prospects would be an increase in corporate merger and takeover activity. We have already seen one FTSE 100 company, Allied Domecq, being the subject of a foreign bid and domestically there has been enhanced activity in the real estate sector with cash bids for companies such as Pillar Property and Tops Estates. Although many pension funds and insurance companies are still reducing their exposure to the UK equity market and increasing exposure to bonds for actuarial reasons, foreign investment interest in the UK equity market is now at an all-time high. The prospect of gently falling interest rates also enhances the attraction of the UK equity market to cash rich private equity companies, and in particular a rising dollar increases the attraction of sterling denominated companies to potential US predators. Fresh activity from both of these groups would make us more enthusiastic about equity valuations, but historically the summer has not been a period of activity in this area.

In conclusion, we envisage a period of some market consolidation after a satisfactory first half and the recent terrorist outrage in London, a sombre warning of the dangers posed to society by militant political groups. Resources stocks, particularly in the oil and gas area, may continue to perform well, particularly if there is further strength in global oil prices, although this would necessarily have a negative impact, through rising input costs, on other sectors of the equity market such as airlines, transportation and consumer stocks. As we have indicated, we remain nervous of the prospects for consumer-related areas and are also keeping under review stocks such as the mortgage banks, like HBOS, which could start to come under pressure if unemployment and personal bankruptcies begin to increase against a background of weakening economic growth. If there are any further significant developments in this area over the summer, we will comment further in the next edition of our newsletter, ‘A View From The Bridge’, which will be published towards the end of August.



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