Price of oil threatens UK recovery

While Steer says a recovery will be led by the FTSE 100, followed by the FTSE 250 and small-caps, he believes that the greatest potential growth is among the mid and small-cap stocks: “I am sticking to my mid-cap bias. We expect earnings growth for the FTSE 250 stocks to reach 18% in 2004 compared with 13% for the FTSE 100.

“The differential has closed, but we expect mid-caps to continue to grow faster than large-caps. For 2005, we think there will be 8% earnings growth for the FTSE All-Share, but this will be exceeded by the FTSE 250.”

The risk to a recovery, says Steer, is the ongoing cost of the situation in Iraq and the high oil price: “The oil price is obviously crucial to the economy. It will take some time for the higher price to feed through, but it is important for the price to come down.”

Among the themes Steer favours at the moment are defence-related companies, particularly those that are involved in technology and counter-intelligence: “There are few companies in the counter-intelligence market, but the UK leads the way. The P/Es of some defence companies are quite high, but with orders being won we are prepared to accept them.”

Another sector that benefits from government spending is PFI: “We like distributors of building materials. With inflation, distributors have pricing power that can be passed on and their margins maintained.”

Steer believes interest rates are nearing their peak and is therefore optimistic about consumer spending. He favours niche retailers with the potential to expand, such as Topps Tiles and Games Workshop.

With institutions significantly increasing their allocations to commercial property, and the proposed tax-efficient investment vehicles likely to lead to greater inflows, Steer believes there is still upside potential in this sector. Another theme is the ageing population, and the fund includes a stake in Corin, a manufacturer of replacement hips and knees.

In the current environment of low inflation and interest rates, Steer says a crucial test of companies is that they should have plenty of cash: “When things are slow, there is little call on capital.”