Beware of false profits in UK equities

The equity market has been weak, despite some good economic news. The latest retail and industrial production figures have been stronger than expected while unemployment continues to fall.

The recovery in the UK is in place and contrasts favourably with continued weakness in Europe and a faltering upturn in the US. Not only is the real economy performing well, inflationary pressures remain subdued.

But, despite being an optimist on the equity outlook over the longer term, I believe that investors are correct to be cautious in the short term.

The reason is profits. The market has already discounted economic recovery and a strong rebound in corporate profits.

When the price/earnings ratio (p/e) of the market is high, investors are seen to be paying a high price for corporate earnings. Currently the ratio is almost 20 times. When this has happened in the past, as in 1987, the market has crashed. However, the ratio can also approach more reasonable levels if corporate earnings recover strongly, as I believe they will. Analysts at NatWest Securities are looking for 30 per cent profits growth in 1993.

Unfortunately, there are considerable uncertainties attached to this forecast. The reason why the profits rebound is so strong at a time of modest growth and low inflation is that several large companies have made substantial provisions that depressed profits in 1992. For example, British Aerospace announced provisions of pounds 1bn. Analysts expect no more write-offs, but the US experience has shown this to be a heroic assumption.

The rebound in profits as write-offs unwind has masked the steady downgrading of underlying profits growth. For example, of 17 significant forecast changes made by our analysts over the past month, 15 have been downward revisions.

Some downgrades are the result of the weakness of the European and US economies, but there is another important factor. Much of the low inflation is being achieved at the expense of profit margins.

For example, retail sales volumes are being improved by discounting. Food retail share prices are tumbling because inflation has been lower than expected. In the US, Philip Morris and Procter & Gamble have adopted strategies to increase market share by keeping prices competitive. This will directly affect UK companies such as BAT and Unilever, and British companies such as Bass are already adopting similar strategies.

The difficulties in pushing through price increases are emerging just when the labour market is turning. Until now companies contained costs by productivity growth and low wage settlements. The unexpected fall in unemployment in recent months suggests that labour costs are more likely to rise from here.

Many parallels can be drawn between the US and UK equity markets. One notable feature early this year was the interplay between fiscal policy and consumer confidence. President Bill Clinton's proposals to reduce the US budget deficit involved plans to raise taxes. At the threat of tax increases US consumers took fright and confidence fell.

A similar pattern is likely to emerge in the UK. Now that recovery is under way and inflation is muted, the Government's first priority is to reduce the public sector borrowing requirement. This will dominate newspaper headlines in the run- up to the Budget on 30 November.

The press will be full of scare stories about which taxes may have to rise. With the Budget so close to Christmas, UK consumers are likely to become more cautious and spend less.

There are many reasons why the upside on the equity market should be held in check. The Government is in disarray, dividend growth is poor, and there are considerable calls on investors' finances.

Rights issues, privatisation and gilt issuance have all placed a burden on investors. But over the next few months the factor that will matter most is the trend in corporate earnings. If profits disappoint, then at its current expensive rating, the UK equity market is vulnerable.

The author is head of economics and strategy at NatWest Markets.