Quality will outshine dull forecast

Weaker external demand, tighter lending and a hike in the household savings ratio dampen the prospects for economic growth in 2008 – but the market will continue to reward quality.

The outlook for British economic growth in 2008 is challenging, with forecasts for higher inflation coupled with pressure for lower interest rates. Three negative factors are contributing to this view.

First, external demand is likely to prove weaker in 2008 because of a sharp slowdown in America and weaker growth in Europe. American economic data on housing and employment and leading indicators such as the yield curve and data on new orders are behaving in a pattern consistent with previous recessions.

Second, overleveraged banks are tightening their lending criteria to both the household and corporate sectors. The lower availability of credit, particularly in the wake of the Northern Rock debacle, has contributed to a marked weakening in British house prices.

Finally, the household savings ratio in Britain is likely to rise from extremely low levels. The savings ratio in 2007 hit lows last seen in 1960 and is half the average level of the past 20 years. A change in consumer behaviour that saw the ratio return to the average level could tip Britain into a recession.

The economic downturn in Britain is likely to be deeper and more widespread than in recent mini-cycles, such as that of 2005, which followed a similar degree of monetary policy tightening as now.

Analysis suggests that consumers and small businesses may be facing interest payment shocks on a similar scale to that preceding the 1990 recession. Policy rates have already been cut more quickly in America and Britain than occurred in the early 1990s cycle, and we expect further material cuts throughout 2008.

The greatest uncertainty is the extent to which policy rate cuts will transmit through a damaged financial system and stimulate the spending of an already indebted consumer.

The next Bank of England Monetary Policy Committee’s (MPC) decision on interest rates is eagerly awaited. The MPC is in a quandary. It is under pressure to follow the lead of the Federal Reserve to cut rates to stimulate growth and consumer spending while fending off the prospect of a recession, at least for the time being.

However, it also has to balance the pressure for sweeping cuts with its primary objective of managing the government’s inflation target of 2%. This creates a dilemma when it considers such cuts, given that inflationary pressures are mounting as petrol, energy and food prices continue to rise.

So what does this all add up to for the equity markets? The consensus of broker forecasts is for about 8% growth in British earnings per share. This would represent an acceleration from the 4% growth that is expected to have been delivered in 2007 and we feel is far too optimistic. With a worsening economic outlook we expect flat earnings to be a reasonable result for the market as a whole.

This is not a bearish assumption. If we look at previous downturns, profits relative to GDP have fallen by as much as 20%. Earnings growth is likely to be strongest in those large companies with international earnings that are exposed to strong Asian economic growth and benefit from a weaker level of sterling.

Oil stocks and banks each make up about one fifth of British earnings, which makes aggregate market growth particularly sensitive to the price of crude oil and the timing of loan write-downs.

Equity markets are in the middle of a two-way pull, with poor earnings momentum on one side and falling interest rates on the other. This is likely to lead to a volatile year for equity returns.

Earnings downgrades may well have the upper hand in the early part of the year, until the market grows in the confidence that it can see the bottom of the downturn, or that interest rate cuts are gaining traction.

Thereafter, the market may make progress. Valuations have enough room to expand – the 2008 price/earnings ratio is 11.6 – accommodating forecast cuts and allowing the market to finish 2008 marginally up.

Last year was only the second year in eight that the FTSE 100 outperformed the FTSE 250. With pressure on domestic earnings and a weak sterling this may continue into 2008 with particular performance from megacaps. Britain is particularly concentrated, with the 12 largest companies representing about 44% of the market capitalisation.

In 2007 there was also a widening of the dispersion of valuations across stocks, which had become tight.

Until the relative winners and losers in the slowdown become apparent this trend is likely to continue, with the market “paying up” for quality, growth and predictability. The big call to be made at some point in 2008 will be timing a recovery in value stocks.