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

Suggested Topics
Start your day with The Independent, sign up for daily news emails
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Ashdown Group: Business Analyst - Financial Services - City, London

£50000 - £55000 per annum: Ashdown Group: Business Analyst - Financial Service...

SThree: Trainee Recruitment Consultant

£18000 - £23000 per annum + OTE £45K: SThree: At SThree, we like to be differe...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + competitive: SThree: Did you know? SThree is the o...

Recruitment Genius: Administrator - IFA Based

£22000 - £24000 per annum: Recruitment Genius: This is an opportunity to join ...

Day In a Page

Major medical journal Lancet under attack for 'extremist hate propaganda' over its coverage of the Israeli-Palestinian conflict

Lancet accused of 'anti-Israel hate propaganda' over coverage of Gaza conflict

Threat to free speech as publishers of renowned medical journal are accused of inciting hatred and violence
General Election 2015: Tories and Lib Dems throw their star names west to grab votes

All noisy on the Lib Dems' western front

The party has deployed its big guns in Cornwall to save its seats there. Simon Usborne heads to the heart of the battle
How Etsy became a crafty little earner: The online market has been floated for £1.2bn, but can craft and capitalism coexist?

How Etsy became a crafty little earner

The online market has been floated for £1.2bn, but can craft and capitalism coexist?
Guy Ritchie is the latest filmmaker to tackle King Arthur - one of our most versatile heroes

King Arthur is inspiring Guy Ritchie

Raluca Radulescu explains why his many permutations - from folk hero to chick-lit hunk - never cease to fascinate
Apple Watch: Will it live up to expectations for the man or woman on the street?

Apple Watch: Will it live up to expectations?

The Apple Watch has apparently sold millions even before its launch tomorrow
Don't fear the artichoke: it's a good cook's staple, with more choice than you'd think

Don't fear the artichoke

Artichokes are scary - they've got spikes and hairy bits, and British cooks tend to give them a wide berth. But they're an essential and delicious part of Italian cuisine
11 best men's socks

11 best men's socks

Make a statement with your accessories, starting from the bottom up
Paul Scholes column: Eden Hazard would be my Player of the Year – but I wonder if he has that appetite for goals of Messi or Ronaldo

Paul Scholes column

Hazard would be my Player of the Year – but I wonder if he has that appetite for goals of Messi or Ronaldo
Frank Warren: Tyson Fury will be closely watching Wladimir Klitschko... when he wins it'll be time to do a deal

Frank Warren's Ringside

Tyson Fury will be closely watching Wladimir Klitschko... when he wins it'll be time to do a deal
London Marathon 2015: Kenya's brothers in arms Wilson Kipsang and Dennis Kimetto ready to take on world

Kenya's brothers in arms take on world

Last year Wilson Kipsang had his marathon record taken off him by training partner and friend Dennis Kimetto. They talk about facing off in the London Marathon
Natalie Bennett interview: I've lost track of the last time I saw my Dad but it's not because I refuse to fly

Natalie Bennett interview: I've lost track of the last time I saw my Dad

Green leader prefers to stay clear of her 'painful' family memories but is more open about 'utterly unreasonable' personal attacks
Syria conflict: Khorasan return with a fresh influx of fighters awaiting the order to start 'shooting the birds'

Khorasan is back in Syria

America said these al-Qaeda militants were bombed out of the country last year - but Kim Sengupta hears a different story
General Election 2015: Is William Cash the man to woo Warwickshire North for Ukip?

On the campaign trail with Ukip

Is William Cash the man to woo Warwickshire North?
Four rival Robin Hood movies get Hollywood go-head - and Friar Tuck will become a superhero

Expect a rush on men's tights

Studios line up four Robin Hoods productions
Peter Kay's Car Share: BBC show is the comedian's first TV sitcom in a decade

In the driving seat: Peter Kay

Car Share is the comedian's first TV sitcom in a decade. The programme's co-creator Paul Coleman reveals the challenges of getting the show on the road