ECONOMIC ANALYSIS - Trading statements show that there is still no

The key investment theme of 1999 has been the improving domestic and international economic outlook. Having toyed with the prospect of a 1930s-style depression in the Q3 1998 market melt-down, markets are now suggesting that the UK (and world) economic downturn is not even as severe as that experienced in the early 1990s. Indeed, expectations of a traditional hard landing for the UK economy have now been replaced by expectations of a soft landing. For companies and investors alike it is important to gauge the scale of this economic recovery and also to translate the impact of this recovery to company performance. To do this we look at the latest trading statements from UK plc. Trading statements are often given at company AGMs and therefore give the first update on 1999 conditions since the 1998 final results. The overall message is still one of caution. While the corporate sector has never reported the apocalyptic trading conditions that share prices were starting to reflect back in October 1998, neither does it report a sudden recent upturn. A common complaint is that trading conditions remain difficult. Few companies are brave enough to say that they can see a marked improvement in the overall outlook. Probably most optimistic from recent trading statements are the housebuilders Bryant and Wimpey, which confirm a rebound in the UK housing market. Elsewhere, the recent statement from New Look, a UK clothing retailer, is typical: “current trading satisfactory in a highly competitive market”. There are no indications that inflation is about to make a comeback. Pricing power remains elusive for all companies, with the emphasis upon margin expansion and cost-cutting dominating any brash expectations of top-line growth. Restructuring is another common theme, particularly for those companies where the top line is under most pressure (M&S, Storehouse, Booker, First Leisure, British Airways). This will be a key driver behind further merger activity in the UK. For the optimists, probably the most encouraging sign is that trading conditions have at least stopped getting worse. For instance, M&S suggested that that there were some “more encouraging conditions in the recent past”, which produced a sigh of relief from investors who had been bracing themselves for yet more dreadful news. Many of the recent trading statements come from UK consumer stocks. Although it has stopped deteriorating, their trading environment remains tough, and one should be wary of the recent widespread rebound in consumer cyclical share prices. Any economic upturn will not be strong enough to bail out the weakest companies. It is not enough for companies to sit back and expect an improvement in the economic background to solve their problems. Some restructuring will be needed to restore profitability (M&S, Storehouse, Sainsbury). The overall picture remains one of considerable excess capacity. Competitive pressures mean that “trading conditions continue to be difficult” (Devro). Consumer cyclical bulls suggest that current trading statements are lagging indicators and that the upturn in consumer spending will drive more positive statements next year. This argument is tempting, but should be treated with scepticism. We expect an upturn in consumer spending to real 3.2% growth in 2000. However, the excess capacity and consequent lack of pricing power reported by consumer companies means inflation will stay low. We expect nominal consumer demand growth of 5% to 6% in 1999-2000, still well below the levels seen in 1997-98. This suggests that, while the top-down data may improve over the next 12 to 18 months, only a few companies will be able to report any benefits. Trading updates from industrial stocks emphasise the dependence upon continued strength in the US economy. RMC, Caradon, GKN and TI Group all highlighted the strength of North America. In some cases (for example RMC) this was enough to counterbalance weakness elsewhere (Europe, emerging economies). This suggests that those industrial companies with significant exposure to the US may continue to be the main source of positive profit surprises in the short term. However, an eventual US slowdown in 2000 offers some medium-term challenges. Another point emphasised by recent trading statements is that companies should be wary of making ambitious promises to the market, particularly while nominal GDP growth (the key driver behind corporate sales growth) remains around the 4% to 7% level. Rentokil’s share price has suffered as a result of admitting that its traditional 20% earnings growth target will be unattainable, and Glaxo Wellcome’s ambitious targets have also come under pressure. It has been frequently emphasised that the financial industry represents a long-term growth market in an otherwise mature economy. To this end, it is interesting to see that Sun Life is one of the few companies able to report a strong start to 1999. These industry growth characteristics will remain attractive while they remain so elusive elsewhere. The overall message from UK companies is that investors should be wary of wholesale rallies in economically-sensitive stocks. It is undoubtedly positive for these companies that the phase of multiple profit warnings and wholesale downgrades appears to have stalled, but it also seems unlikely that the demand upturn will be strong enough to drive the comprehensive upgrades that a more sustained rally would demand. Jonathan Stubbs is UK strategist at Salomon Smith Barney, London.