Rates drop can spell share rise

Interest rates in the UK have been on hold for five months, the longest period of rate stability since the MPC came into existence. We think rates have peaked at 6 per cent and could fall by year-end. With rates likely to rise in the US and euroland, the outlook for UK equities is becoming more positive, although globally we remain cautious.

Interest rates in the UK have been on hold for five months, the longest period of rate stability since the MPC came into existence. We think rates have peaked at 6 per cent and could fall by year-end. With rates likely to rise in the US and euroland, the outlook for UK equities is becoming more positive, although globally we remain cautious.

The prospect of lower interest rates and a soft landing should keep domestic growth robust. For investors, areas that outperform in these periods are more secure growth sectors. Pharmaceuticals are amongst the best-performing sectors in four of the six periods of rate peaks we examined, with utilities, life assurance, food retail and tobacco appearing more than once. Almost without exception, underperform- ing sectors have been cyclicals, especially industrials.

Chemicals, autos, textiles, forestry/paper, steel and engineering have all repeatedly lagged as interest rates start to fall. Evidence suggests falling interest rates are not a sufficient condition for moving overweight in cyclicals.

This time sector relative performance has been skewed by the New Economy effect. Telecoms, media and technology (TMT) stocks can be classified as growth, but their dramatic rise and fall over the past year has been more a fad rather than a cyclically-driven phenomenon.

Since the 6 per cent rate peak in February, defensive sectors dominate the best performers, contributing nine out of the top 10 since February, with only forestry/paper, helped by M&A activity, breaking the defensives'monopoly.

The analysis of previous periods when interest rates have peaked shows even when they start to be cut, the defensive sectors outperform, along with the more secure growth sectors. The most attractive stocks over the next few months may be within the transport and restaurants/pubs, sectors which have constituents with strong defensive characteristics as well as more cyclical stocks. Food producers, water, beverages and insurance also have the potential for further gains given their relative lack of outperformance against the ex-TMT index.

Poor performers this year within defensives include S A Breweries, Whitbread, Bass and Allied Domecq which may attract investors looking for safe earnings.

Transport stocks and BG also appear to have lagged behind other defensives, and the water stocks, Boots, Unilever and Sainsbury all have the potential to outperform if investors can have assurance of stability.

The best of the defensives have already performed strongly this year, but some stocks that offer defensive characteristics and growth prospects may continue to outperform. These W Morrison, BAA, ABP, AstraZeneca and Centrica.

The analysis of previous periods when interest rates have peaked and begun to turn down shows growth stocks also perform well. This has included sectors such as support services, software, IT hardware, telecoms and electronics. Today, growth stocks are dominated by TMT, which is still suffering from the fallout. We are cautious on current valuations but we believe the Old Economy growth sectors are more attractive over the next six months. These include health, support services and pharmaceuticals, plus selected stocks within financials, engineering, electronics and distributors. All of these sectors/stocks have the potential for non-cyclical growth not tied to the prospects of TMT.

Experience suggests that despite the prospect of UK rates falling by the end of the year it is too early to move overweight in industrials.

The writer is a UK strategist for HSBC investment bank.