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Another turbulent year for shares

Modest valuations and strong liquidity flows should provide good support
ONE OF the most troubling aspects when assessing the outlook for the equity market in 1999 is the sense that the lessons of 1998 are still not clear, even at this stage.

While the decisive global policy response in the final months of the year has clearly restored calm to world markets, it is impossible to say whether the underlying tensions have been resolved. If there is one lesson that we should have learnt in 1998 it is modesty, as the limits to our understanding of the global financial system became painfully clear.

Nevertheless, highlighting these uncertainties does not free us from the seasonal task of previewing the year ahead for the equity market.

An appraisal of the broad economic outlook looks like a good place to start. The story here seems straight forward. Inflationary pressures will probably continue to ease worldwide, but there should be no recession, either in the UK or in the global economy.

While at face value this seems a reassuring economic scenario, the underlying reality may be less comforting. Low real growth is one thing, low inflation another, but having both at once is unfamiliar territory for the UK economy.

Nominal GDP growth in the UK looks set to be around 3 per cent in 1999, the slowest growth in 50 years. This, of course, is not just a UK theme, but part of a much wider global phenomenon which should see lower growth across Europe in 1999 and in the US as well.

As companies are discovering, this is a world in which sales growth is hard to generate, requiring cutbacks in costs and investment to preserve profitability. The recent trend in analysts' earnings forecasts illustrates how these pressures are mounting.

Analysts began 1998 expecting earnings growth of 10 per cent for the year. But, as the graph displays, it has been downhill ever since. The latest estimate shows that analysts now expect earnings to fall by more than 1 per cent in 1998. The final outcome will probably be closer to -5 per cent.

This process has by no means run its course. Forecasts for earnings growth in 1999 show analysts once again starting the year expecting earnings to expand at a double-digit rate. So much for low nominal growth. The out-turn looks likely to be closer to zero than the current 12 per cent consensus forecast.

If that seems a recipe for a bad year ahead for the equity market, it is worth noting that the trend in the overall equity market has typically been only weakly correlated with forecast revisions. Furthermore, growth is not the only factor driving equity markets, and it is of some comfort that other key influences are sending more positive signals.

Economic policy is the first of these. While a world of low economic growth is one in which profits will expand more slowly than in the past, it is also a world of greater economic stability. With inflation and output volatility having fallen to historical lows and the economy exhibiting few signs of major financial imbalances, policy can continue to ease in 1999.

Base rates look set to fall from today's 6.25 per cent towards 5 per cent, with most of the cuts taking place in the first half of the year. Further rate cuts look likely in the US and across Europe.

For equities, the prospect of further interest rate cuts provides encouragement to look through earnings downgrades and to focus on the prospect of growth recovering from late 1999. This is a global theme, to be reinforced in the UK by favourable fiscal measures. Both the cuts in corporation tax and the abolition of Advance Corporation Tax (ACT) in April will boost corporate profitability.

The second area of comfort for the equity market is valuation. Although equity analysts may be slow to adjust their forecasts in the face of slowing growth, markets move swiftly. Current bond/equity valuations show that equities have already priced in a considerable degree of bad news. Indeed, the stock market is cheaper relative to bonds than it has been during recent recessions. While the easing of economic policy in 1999 should promote a re-rating of equities against bonds, at the very least it should strengthen the valuation floor.

In a valuation context, the prospect of structurally low inflation should reinforce this more positive cyclical story in 1999. While earnings may grow more slowly in a low inflation era, these earnings are likely to be of higher quality and more durable than in the past, and therefore warrant a higher rating. There is strong empirical evidence of this inverse relationship between equity valuations and inflation. If inflation is historically low, then P/E multiples can stay historically high. Our own inflation valuation models would suggest that fair value on the UK market is pretty close to the current rating.

The third positive theme for the equity market in 1999 is liquidity. While liquidity fundamentals look healthy enough at the start of the year, the combination of falling interest rates and changes to both corporate tax and personal tax look set to strengthen these influences throughout the year, most notably in the first half.

For the second year running, 1999 may well see the corporate sector emerging as the biggest buyer of UK equities. M&A activity is booming, new insurance is scarce and share buybacks should remain widespread, boosted by the abolition of ACT in April.

Taking all these flows together, companies look set to be net buyers of UK shares to the tune of some pounds 20bn in 1999, in the process adding more cash to already bulging institutional coffers.

The retail investor also looks set to be a big buyer in 1999. The prospect of PEPs disappearing is likely to encourage one final fling by private investors to use up allowances in March and April while it is still possible.

Lower interest rates should reinforce this trend, a theme that may also influence institutional asset allocation in 1999.

While every rate cut improves equity market fundamentals, it also diminishes the appeal of cash as a rival asset. It is notable that the year begins with pension funds holding almost 7 per cent of their assets in cash, a weighting last seen in the early 1990s when interest rates were well into double digits.

In summary, while the prospect of frequent and sizeable earnings downgrades in the early months of the year will weigh heavily on the equity market in 1999, modest valuations and strong liquidity flows should provide good support.

As the year progresses, the beneficial impact of the easier policy environment should become more apparent, sustaining the market's advance towards our estimate of around 6,200 on the FTSE 100 by the year end.

While global influences should also become more supportive as the year progresses, we believe they remain capable of producing meaningful bouts of turbulence along the way. Expect surprises.

Paul O'Connor is an equity strategist at Credit Suisse First Boston