Factors are working for and against market's prospects

The recovery may have stalled, says Jenne Mannion, but it's hard to tell if this is short-term or a big warning sign

The UK stock market has stalled, after an otherwise strong recovery that kicked in from the Iraq war in March 2003. Industry experts are divided in their opinions about whether this is a short-term blip or a hint of bleaker days ahead.

The UK stock market has stalled, after an otherwise strong recovery that kicked in from the Iraq war in March 2003. Industry experts are divided in their opinions about whether this is a short-term blip or a hint of bleaker days ahead.

The UK stock market can be classed as tightly range-bound, dancing closely around 4400 rather than making any significant upward progress. During July, the FTSE 100 index fell by around 2.5 per cent and is down by around 5 per cent since it reached a high of almost 4600 in late April this year. The falls come on the back of a strong recovery since March 2003, where the top 100 UK companies have posted a approximately a 20 per cent gain.

There are factors acting both for and against the prospects for the UK market. Favourable to equities is the powerful combination of strong growth and low inflation in the UK economy, a situation often referred to as the "goldilocks" market, for being not too hot and not too cold, as in the story of the three bears. Meanwhile, UK unemployment is at a 30-year low.

Richard Turnill, head of asset allocation and economics at Merrill Lynch Investment Management, says business confidence is also good, especially within the manufacturing sector. He says: "Furthermore UK companies, which are often global leaders in their fields, are attractively valued compared to their US competitors. Based on their 2004 earnings there is a 30 per cent valuation gap."

But at Henderson Global Investors, Tony Dolphin, director of economics and strategy, argues this has been the case through the past decade and the current valuation gap is not a reason alone to get excited about UK equities.

"Among the reasons for believing this valuation gap might be maintained include poor historical UK earnings growth, and persistent selling of equities by UK pension funds," Mr Dolphin says.

Another headwind for the UK market is the highly indebted consumer. If consumers are forced to tighten their belts, less money will be spent on goods and services from UK companies, therefore dampening their earnings capability.

Certainly, a key reason for the resilience of the consumer to date is the wealth effect associated with rising residential property values. But house prices are showing signs of cooling and stories of an imminent crash have gathered pace in recent months.

But Graham Ashby, a UK fund manager at DWS Investments, argues that this does not spell doomsday: "The analysis that property is overvalued fails to take into account the increase in the size of the UK population or the fact that most mortgages are no longer dependent on a single income. That said, our expectation is that house price growth will slow over the next year in reaction to rising interest rates."

Rising interest rates in both the UK and US are also sending jitters throughout equity markets. UK interest rates are now at 4.5 per cent following two increases in May and June, and are widely expected to reach 5 per cent or more.

Philip Barleggs, head of asset allocation at Insight Investment, said: "For equities, higher interest rates mean higher borrowing costs for future corporate investment and higher costs for servicing current debts. However, interest rate rises generally occur when the economy is expanding. This expansion is usually reflected in corporate earnings, which underpin stock prices. Corporate profitability and economic outlook are just as important for stock markets as the prevailing level of interest rates."

Of course, the UK is not insulated from the rest of the world, and uncertainty about the health of the global economy and the US election have also contributed to current stock market jitters.

Another concern is the oil price, which on Wednesday hit a 21-year record high of $43.05, before slipping back, up from $28 last September. Dearer oil presents a serious risk to inflation, as the cost of running a business increases and that is passed on to prices.

It is how this combination of positive and negative factors tip that scales that will largely determine the direction of the market. An equal balance between the two could well mean investors face little more than sideways action for some time to come. But individual companies could drive the market higher by delivering better-than-expected earnings results and surprising on the upside.

Most banks are reporting their interim results in coming weeks and as this sector represents around a fifth of the value of the FTSE 100 index, it is a crucial time for the market.

Results so far have been mixed. On Wednesday HBOS, the UK's biggest mortgage lender, reported interim pre-tax profit was up 21 per cent. The positive news pushed the shares up 4 per cent. But in the previous week, Northern Rock reported that its first-half-profit growth had slowed to 7.6 per cent, substantially down from the 24 per cent growth in the first half of 2003. The mortgage bank's share price failed to make progress on the day of the announcement.

So this looks like being a telling time for the FTSE 100. Over the next few weeks, the flow of company trading news and its impact on share prices will be an important factor in establishing the direction of the market, while the broader macro-economic factors cannot be ignored.

SHARES FOR A CHALLENGING MARKET

NATIONAL GRID

Share price: 432p

One-year change: +9.9%

Three-year change: -8.9%

Ed Burke, UK fund manager at Invesco Perpetual, says: "This utilities company has a major disposal programme for its regional networks coming up, and is likely to return a major chunk of that cash to shareholders."This company is cheaply valued, and is delivering a good dividend yield."

MICHAEL PAGE

Share price: 168p

One-year change: +18.8%

Three-year change: -9.7%

Stuart Fowler, a UK fund manager at Axa, is optimistic about this recruitment consultant. He points to the impressive recovery in the group's business, with the job count up by 50 per cent over the past year. "The business is very operationally geared to this improvement and this should lead to strong growth in profits," he says.

PARKDEAN

Share price: 207p

One-year change: +37.9%

Three-year change: N/A

Marina Bond, a UK small cap fund manager at Rathbone Unit Trust Management, has held Parkdean in her portfolio for some time. The company owns holiday caravan parks throughout the UK. "This is a quality company with a strong balance sheet, cash generation and decent earnings growth and the price has come back to an attractive level," she says.

LEGAL & GENERAL

Share price: 99p

One-year change: -2.1%

Three-year change: -38.5%

Mr Burke says: "The life assurance sector has been beaten up in recent years but is coming through that now. Legal & General is a superb, trusted name in UK financial services, so I expect it will continue to benefit from strong demand. It is delivering a strong dividend, and is attractively valued."

BPB

Share price: 395p

One-year change: +25.6%

Three-year change: +49.8%

Tineke Frikke, a UK fund manager at Newton, says BPB, the former British Plaster Board, is benefiting from a favourable supply and demand dynamic across its markets in the US, UK and Europe. Despite low growth, this mid-cap stock has been able to increase its prices, leading to 46 per cent earnings growth in the last year. The shares yield 3.7 per cent.

BULL OR BEAR? WHAT THE EXPERTS ARE PREDICTING

MARINA BOND, Fund Manager at Rathbone Unit Trusts

Marina Bond, a fund manager for UK smaller companies, says the economic backdrop is sound for a rise in equities, as UK growth is above trend and there is record low unemployment.

She expects the UK market can deliver double-digit earnings growth this year and next, while company valuations are undemanding. The trigger to an improvement will be better-than-expected earnings outcomes in coming months. She expects the best value will be found among small and mid-sized companies.

"We see a lot of value there," she says. "This part of the market offers an excellent hunting ground. We can find companies in this segment growing their earnings at an impressive 15-20 per cent a year, valued at less than 10 times annual earnings."

VERDICT: BULL

JON THORNTON, UK Fund Manager at Gartmore

THE outlook for UK equities is positive, according to Jon Thornton. He says consolidation remains a key theme in industries as diverse as oils, banks, building, food retailing, pharmaceuticals, tobacco and general retail.

"Following a period of cost-cutting and efficiency improvements among UK companies, the market now offers attractive cash-flow on inexpensive ratings. As such, there is an attractive hunting ground for cash-rich and acquisition-hungry venture capitalists who are becoming increasingly prominent buyers."

Although US interest rates are rising, the anomaly of above-trend economic growth in the US and 1 per cent interest rates could not last for ever. "Even with rises in rates, expansionary monetary policy may not be negative for equity markets."

VERDICT: BULL

ED BURKE, Fund Manager at Invesco Perpetual

Ed Burke expects little progress before the end of 2004, though he expects that over three to five years there are strong gains to be made.

Mr Burke says there are big technical issues impeding imminent progress, including the sale of shares in favour of bonds by pension funds and life insurers. Meanwhile, the consumer is very vulnerable to rising interest rates and he expects the extent of this to become evident in the months up to Christmas.

Nevertheless, he is bullish long-term about UK equities. Mr Burke says many UK companies are cheap -- and there is an abundance of stocks that are attractive in their valuation and dividend yield. The UK stock market is trading on an average price of around 15 times annual earnings, which is in line with the 20-year average. The dividend yield, at around 3.5 per cent, is slightly higher than the 20-year average.

VERDICT: SIDEWAYS

NEIL CUMMING, Fund Manager at Hichens Investment Management

There are big issues to be addressed, says Neil Cumming. He argues that big problems face banks, pharmaceuticals and telecoms -- and the market will make little progress in the short term.

In pharmaceuticals, there is concern over the R&D pipeline. The telecoms sector is feeling the pinch over fixed-line businesses, and there are profitability concerns over mobile telephony.

"A significant issue for the banking sector is the big consumer debt pile," he says. "Even a bid for Abbey National last week met a lacklustre response. Against these issues, interest rates are rising. A soft landing in the UK housing market is vital to settle nerves in banking, while a Republican win in the US will be the most favourable election result for pharmaceuticals."

VERDICT: NEUTRAL

HAYDN DAVIES, Chief Economist at Barclays Global Investors

The outlook for the UK market is bleak, despite the combination of strong growth and low inflation, according to Haydn Davies. "Unfortunately for investors, the consumer-led expansion of the last 10 years has not resulted in strong profit growth for UK-listed companies," he says. "Although profits have recovered sharply from their nadir in 2002, earnings in the FTSE 100 are still no higher than they were in 1998. By contrast, the S&P 500 earnings in the US are 25 per cent higher. Meanwhile, the strong pound will continue to weigh on the earnings of the UK's big multinationals."

He says the UK market is highly defensive, with mature industries such as oils, pharmaceuticals and mortgage banks. "There are few opportunities for growth. Many international markets look more attractive."

VERDICT: BEAR

JIM WOOD-SMITH Chief Analyst at Gerrard

Jim Wood-Smith says there is good reason to expect that the FTSE 100 index can return to the top of its trading range of 4575 by the end of the year.

But, a very important influence will be the reception given to the half-yearly reports from the banking sector which started this week with Northern Rock. "The banking sector can move the index sharply in either direction," he says. "Investors are nervous that the banks will sound alarm bells that profits are under pressure from rising interest rates."

Mr Wood-Smith, however, is optimistic these fears will not be borne out. Instead, he expects strong rebounds in share prices: "Rising oil and commodity prices suggest China is back on the growth track, and a slowing US economy would mean a more benign interest rate cycle."

VERDICT: BULL

JUSTIN BROOKE - Stockbroker at The Share Centre

A cautious approach by investors is likely to see the FTSE fall to around 4150 in coming months, according to Justin Brooke.

"At the moment I can see nothing that will kick-start the market," he says. "There are only problems holding us back, namely continued problems in the Middle East and uncertainly over the US elections. Closer to home, we have concerns about rising interest rates. I can't see these issues going away in the near future.

"There is a lot of apathy. Few people are interested in investing at the moment, not helped by the fact it is the summer and much of the City is going on holiday. There are more sellers than buyers and this will lead to further falls."

While he expects the FTSE to decline a little, Mr Brooke does not think it will retreat below the psychologically important 4000.

VERDICT: BEAR

TINEKE FRIKKE, UK Fund Manager at Newton

The UK market will move broadly sideways with a slight upward tilt both over the short and long term, says Tineke Frikke.

"But there will be a lot of volatility. Expect very good days and very red days. Overall, I expect total returns of around 6-8 per cent yearly over coming years, but around half will come from dividends, with only small capital returns.

"Consumer spending is certain to slow, and this will dampen company profits. Rising interest rates will exacerbate pressure.

"A telling time will be after the US election. Irrespective of who wins, the massive budget deficit will have to be addressed.

"The market is cheaply valued, which supports current levels in the FTSE. However it is difficult to see what the driver to push more growth will be."

VERDICT: SIDEWAYS/BULL

JONATHAN ASANTE, Chief Economist at Framlington

Mr Asante forecasts potential gains of around 10 per cent over the remainder of the year. However, he thinks the market is likely to move sideways for some weeks.

This uplift is likely to be fuelled by profits growth. He says growth in the first half of 2004 has been strong. "The best numbers should come through from biotech, healthcare, media, technology, oil and resources stocks."

Mr Asante expects a further boost from corporate activity. London Bridge and Karen Millen have recently been taken over and there is an interesting battle for Londis, the chain of grocery stores. "These have positive profits outlooks and attractive valuations, which should give confidence that shares can make further headway."

VERDICT: BULL