`Wall of cash' will preserve UK equities

The falls in equity markets on both sides of the Atlantic over the past couple of days have done little to narrow the widening gap between New York and London shares. Indeed, it has only heightened speculation as to how or whether the gap will be closed; will the UK now catch up with US equity prices, or will New York fall, possibly dragging London down in its wake?

Given the length of the economic recovery in the US and the recent strength of Wall Street, shares there were due for a correction. The UK is at a different stage in the cycle and other pointers are giving grounds for some optimism about the outlook for the UK market.

Sentiment has clearly changed dramatically in the past couple of months. Since early March, the Footsie has climbed around 10 per cent, clawing back some of last year's bond market-induced losses. The proximate cause is the turnaround in prospects for institutional liquidity as the market has savoured the likelihood that further mega-deals will follow the pounds 9bn takeover of Wellcome by Glaxo, of which around two-thirds was cash. Already, the Richemont bid for Rothmans and the SBC takeover of SG Warburg could push a further pounds 2.3bn back to institutions.

Barclays de Zoete Wedd forecasts that cash raised from corporate activity this year will hit pounds 14bn - pounds 2bn more than the pounds 12bn likely to be earmarked for rights and privatisation issues. Societe Generale Strauss Turnbull is even more bullish, suggesting that mergers and acquisitions could generate pounds 20bn this year.

This "wall of cash" comes at a time when fundamental valuations remain reasonably good for UK equities. One of the oldest, the relationship between equity yields and the coupon on long gilts, is determinedly pointing to good value in shares, as our chart illustrates. Although it has levelled off recently, falling gilt yields and fast-rising dividend returns have pulled the ratio down to around 2.1 since the start of the year. As BZW points out, the last time Footsie was at these levels, the ratio was a more worrying 2.4.

The current yield on the FT-SE All Share index at just under 4 per cent also remains a long way from the danger level of 3 per cent hit in 1972 and 1987 ahead of severe bear markets. Looking out to the end of this year, a prospective return of around 4.5 per cent compares favourably with base rates currently at 6.75 per cent.

Earnings valuations are less clear cut.The price-earnings ratio on the All Share at 16 times is well above the 10-year average of 14.9. But, falls in the general market and forecast upgrades mean the prospective multiple falls below the long-run average to about 13, on current earnings estimates.

Analysts are also looking for a lengthening of the traditional business cycle this time, with only a slight deceleration of earnings growth over the next two years. SGST forecasts a slowdown from last year's 20 per cent to only 18 per cent in 1995, dropping to 12 per cent in 1996.

Certainly, the economy seems - either by accident or design - to have been better managed than in recent cycles. There are few signs of boom conditions on the high street and the consensus is that growth is likely to slow from 4 per cent to a more sustainable 3.2 per cent this year, dropping to 2.9 per cent in 1996.

The googlies are, as ever, interest rates and politics, two unknowns which are becoming increasingly intertwined. The recent decision by the Chancellor, Kenneth Clarke, not to raise rates has thrown out calculations that the UK was near the top of the interest rate cycle.

As evidence continues to flood in that consumers remain reluctant to spend - the latest being yesterday's news that mortgage lending fell in April and a profits warning from WH Smith - the peak may be delayed. NatWest Securities forecasts that rates could go up another half per cent in the autumn, but BZW is looking to next year before rates peak at around 8 per cent. It is not yet clear that the market has fully taken on board the possible threat this represents.

The most important concern remains politics. John Major's difficulties in holding on to his majority appear to grow by the week, making it less likely that he will be able to hold out for the full life of the current parliament in 1997. Although a Labour government would not necessarily be bad for many industries, the stock market remains a long way from understanding what the impact of a change of administration would be.

So while the outlook for liquidity and fundamental valuations remains good for UK shares, investors should be prepared for shocks as the political risk starts to be built into valuations.