Taking an informed view regarding the direction of investment markets over both the short and long term is fundamental to the effective management of investors’ money.  The view is arrived at by analysing external informed opinion or research and used by professional investment managers to construct and/or adjust the asset allocation of their investors’ portfolios.  So what is the current state of the UK market and where might it go from here?

In the recent past the UK’s financial markets have shown a high degree of stability against a backdrop of rising interest rates, high oil prices and uncertainty surrounding global political events.  This period of stability could, however be brought to an end, and equity prices, bond yields (which means an increase in prices) and the sterling exchange rate could all fall.
 
Short-Term Interest Rates

UK interest rates have been rising and are likely to continue upwards peaking at around 5.25% by the end to this year.  Once rates have peaked, provided house price inflation is reducing and no other inflationary dangers appear; interest rates could start to fall reducing to around 4.75% by the end of 2005.

Contrary to the above view the market implied 3-month inter-bank interest rates, which indicates rates continuing to rise to around 5.5% by the end to 2005.  Only time will tell which view is correct – however, markets are often slow to see top of a cycle so, maybe this time is no different to any other.

Bonds

Short-term bond yields share a close relationship with interest rate movements, therefore in the near future yields may rise and values fall.  Despite the implied 3 month inter-bank rate, however, the short-term bond market movements indicate that we are close to the top of the interest rate cycle. 

Equities

The biggest short term danger for equities prices are the twin treats of sky high oil prices and rising interest rates, despite the strengthening of the UK’s economic outlook.  These fears are reflected in the fact that the FTSE 100 index has moved sideways for most of this year, despite increasing consensus estimates of Gross Domestic Product (GDP) growth for 2004, which were 2.4% at the start of 2003 rising to 3.2% now.  This said, consensus estimates for 2005 are lower at 2.6%.

While short term uncertainties remain and confidence continues to be fragile, any bad news is likely to result in a disproportionate downward market movement.  Despite this, the market looks fair value on a historical Price Earnings (P/E) and dividend yield basis.  The P/E ratio of the FTSE All Share index stands at around 13.3% compared to an average of 18.6 over the past ten years and 13.2 over the last thirty years.

The dividend yield of the FTSE All Share index is 3.8%, compared to an average yield of 3.3% over the last ten years, and 4.5% over the past thirty years.

Looking at year-on-year earnings growth for UK companies the latest figures show a figure of 24% compared to ten-year average of 6.1% and 10.3% for the thirty-year average.         

Property

Property has been the best performing asset class with total returns of 17% year on year in June, compared to 11% on the FTSE All Share index and 4% on 5-15 year Gilts.   The performance is due to a recovery in rental demand and continued sharp falls in property yields, which on a gross (nominal) yield basis are at all-time lows at 7.25%.  Despite this, and taking into account inflation, real UK commercial rental yields have been very stable over the past ten years at around 5%.  This could change, however, if there is further capital growth on the back of UK institutions spending as their earnings recovery.

Currencies

Sterling has remained strong over recent months due to successive interest rate rises and strong UK economic data relative to the US.  Whilst sterling has had a good run, if markets start to discount future UK interest rate falls, then sterling could soften against other leading currencies.

Whilst short-term interest rate movements have supported sterling, in the longer term this looks fundamentally overvalued and could easily lose 10% on a trade-weighted basis by the end of 2005.  Clearly this should be taken into account by euro investors with a high percentage exposure to sterling. 

Please note this article provides a guide to some of the relevant areas that individual investors’ should consider discussing with an authorised adviser in relation to their specific circumstances.  If readers have any questions relating to this article please contact Mark Davies 902 887 100 or e-mail mark.davies@brooksmacdonald.com