The Year Ahead: Prepare for a slowdown, but it's not Armageddon

As today draws the curtain on a topsy-turvy year, market experts believe that the recent slowdown in the UK will intensify in the coming months, with several sectors exposed to potentially damaging falls in their earnings outlook.

Growth in the UK's economy hit 3.1 per cent in 2007, driven by a strong first half, but few can see it going anywhere but down in 2008. The consensus is somewhere close to 2 per cent.

Howard Archer, chief UK and European economist at Global Insight, said: "We believe the economy will slow in the face of a number of persistent major headwinds, which will hit consumer spending, business investment and exports. Meanwhile government spending and investment is starting to become less supportive to growth."

While companies and investors piled in during the first half, the euphoria was brought to an abrupt halt in the summer. The seeds were sown across the Atlantic as the sub-prime crisis had a knock-on effect to sentiment surrounding the UK housing markets.

This was followed by a rise in interest rates, declining consumer confidence and the credit crunch, brought into sharp relief by the crisis at Northern Rock.

Michael Saunders, head of western Europe and UK coverage at Citi, said the domestic economy is at a turning point, with growth slowing in response to these issues. The slowing economy led Citi to cut its growth forecast from 2.7 to 1.9 per cent.

Most market participants expect the Bank of England's Monetary Policy Committee to cut interest rates by a further 50 basis points next year to ease the slowdown, after the quarter-point cut in early December. Global Insight's Archer believes the Government will make even more of a statement, cutting the rates by 75 basis points.

The general air of unease facing corporates in the last quarter of this year is set to continue, as well as expectations of tighter profit margins across the market, but experts are not crying Armageddon quite yet.

Ian McCafferty, chief economic of the Confederation of British Industry, said: "Whilst the 2008 slowdown may appear dramatic, set against this year's strong growth, the fundamentals of our economy remain sound and talk of a full-blown recession is overstated. Uncertainty surrounds the extent to which credit conditions will affect both business and consumer confidence and how far the property markets will suffer. Borrowing conditions are already tighter for some households and business."

Martin Weale, a director at the National Institute of Economic Research, said: "There is an argument that profit margins are extremely high, and you wouldn't expect a huge amount of growth going forward. At current valuations, the market could accommodate a slowdown, without upsetting the apple cart."

Companies' earning prospects are looking weaker, but some sectors will suffer more than others. Mr Weale said: "We are expecting slower growth in consumption, which is likely to hit the retail sector."

That spells further bad news for a sector that has had a pretty ghastly second half of the year. The retailers were first hit by the summer washout, followed by the credit crunch and a weaker than expected run-up to Christmas. As the sales got underway last week, many were sacrificing profit margins in a bid to clear stock, slashing prices by up to 70 per cent. Some are predicting worse news as consumers continue to tighten their belts.

The big unknown is the financial stocks. Excepting Standard Chartered, the top UK financials slumped 25 per cent in the past six months as the credit crunch and the Northern Rock factor bit. Mr Weale said: "In trying to predict next year's performance, the finance sector is the great unknown. After clearing up this mess, the focus will be on which new ways of making money they can find. If some decide to go along the recapitalisation route, however, share prices could well suffer."

Of those well placed to continue growing, only the oil sector stands out in 2008, he added, cautioning even the miners, the year's stand-out performers, should not expect to match 2007.

Citi believes there is more to come from the global markets in 2008. It said the bull market that started four years ago "is maturing, but not finished. A slowing global economy will prove a drag on corporate earnings, but lower interest rates should provide support".

Robert Buckland, an analyst at the US group, said last month: "We do not expect to see a significant reversal in corporate earnings in 2008. We still think it is too early to call the peak in this profit cycle."

He added a significant fall in profit margins could turn "a manageable economic slowdown into a corporate earnings rout". The trailing price-to-earnings ratio for the past three years was between the 16 and 18-times range. This is still way off the peak of the tech boom, where companies' p/e reached 35 times.

Angus Campbell, head of sales at spread-betting firm Capital Spreads, said the credit markets would remain tight next year, which could become a huge concern if companies default on debt. Mergers and acquisitions activity would continue, he said, as the weak markets will allow those with stronger balance sheets to take out their struggling rivals.