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Time to worry about the UK stock market?

Cherry Reynard
Written By:
Cherry Reynard
Posted:
Updated:
25/11/2014

The UK stock market is still riding high, but fund managers are increasingly warning of a ‘Black Monday’ style crash.

Certainly, clouds are gathering for the UK economy. The deficit remains unyielding. The Eurozone economy appears to be losing momentum and with its weakness comes risks to the UK. Even David Cameron is taking a more cautious tone. Should investors be shipping out of the UK stock market?

It is relatively easy to make a bearish case for the UK economy. On the one hand, the debt burden remains in place: Despite the Coalition’s talk of austerity, only limited progress has been made on tackling the deficit. The UK has a potentially disruptive election coming up, with no clear favourite and an opposition keen to tackle the perceived ills of ‘big business’.

The UK still has one of the highest level of government borrowing relative to GDP of any developed market. It remains higher than that of France, Italy and Greece. While deficit plans remain largely on track, tax revenues have not been rising as fast as hoped. Ian Stewart, chief economist at Deloitte, says: “The best way of shrinking public deficits is to grow the economy. Yet, while the UK has easily outpaced its peers this year, progress in reducing the deficit has gone into reverse….the long squeeze on public expenditure is actually on track. The problem is that tax revenues have lagged well behind expectations.”

He says that much of the growth in employment has been in low wage work, which doesn’t generate significant tax revenues for the exchequer. This means young and unskilled people are getting back to work, but that is not doing public finances much good – at least in the short-term.

There is also the problem of the Eurozone. Richard Jeffries, chief investment officer at Cazenove Capital, recently said that he believed the Eurozone to be a ‘deflationary construct’ and so it has proved. Each time the global economy appears to move higher, trouble in the Eurozone drags it lower once again. Deflation continues to be a threat in the weaker Eurozone economies, but even in Germany, a combination of weak demand on its doorstep and lacklustre Chinese growth is exerting a negative influence.

But it is not all gloomy. The UK, for the time being at least, has growth on its side. Jeffries believes that the UK growth rate will be a little lower than official figures suggest, at around 2.5% for 2014, but still robust. Ruth Lea, economic adviser to the Arbuthnot Banking Group, says: “The economic background to the Autumn Statement, due on 3 December, is very satisfactory. Growth remains good, despite the Eurozone’s travails, and inflation is benign.”

Recent data from research group Markit found that business sentiment in the UK is far stronger than that in the Eurozone, and even somewhat higher than in the US. Corporate spending – one of the key pieces of the economic recovery puzzle – is improving.

This is being seen in an improvement in wage growth. Steve Davies, co-manager of the Jupiter UK Growth Fund, says: “We have seen a continued increase in private sector jobs and we expect that growth to continue. We have thought for a while that official statistics were underestimating the rate of growth in wages. Talking to a selection of the companies we are invested in, the vast majority have awarded pay increases of 2-3% in 2014 and the latest official data gives additional support to this view…This may well improve in the New Year.”

But stock markets do not slavishly track economic growth. Can the relative strength of the UK economy translate into improved performance from the stock market? The FTSE 100 has been one of the weakest indices this year, rising just 1.11% over the past 12 months. The S&P 500 is up almost 15% over the same period. This, in theory, should be good news for UK investors because it means that valuations of UK shares are not as stretched and therefore have further room to grow.

However, smaller companies – where valuations are higher – tend to have more exposure to the domestic economy, while larger companies – such as those found in the FTSE 100 – are more international. Nevertheless, Ben Willis, head of research at Whitechurch Securities, says that the FTSE 100 looks attractive: “We remain optimistic on the outlook for UK equities as a whole but some pockets of the market appear overvalued, particularly within smaller and mid- cap companies. We are navigating this through a bias towards value investing with additional cyclical and domestic exposure to benefit from a continued expansion of the UK economy whilst avoiding more expensive “structural growth” areas.”

This means backing away from those companies that have been prized for offering ‘all weather’ growth, and looking at those companies whose business fortunes are more likely to vary with the economic climate.

This would suggest sticking with the UK stock market going into 2015, even if it looks a little pricey. It certainly looks better than the other options – UK corporate and government bonds, for example, look extremely expensive, particularly if the Bank of England raises rates, which it looks set to do in the latter half of the year. Investing in the UK stock market requires a bit of discernment to avoid the more expensive areas, but it still has something to offer.