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The bull fight

Finance and other directors who have been wondering whether all their efforts will ever be reflected in a higher share price can take heart from the recent improvement in stock market sentiment. Investors who have soldiered on through the last three bearish years are being advised to hang on to their shares a bit longer. The question is, will it last?

After taking a three-year hammering in global markets, investors are willing to risk investing in stocks, according to analyst Paul Mortimer-Lee at BNP Paribas, who is looking for a 10%-15% rise in stock market indices next year. Signs of optimism are being fuelled in part by solid earnings growth for US companies. “For four quarters now, profits have risen in the US, mainly due to the impact of cost-cutting,” explains Mortimer-Lee. “US earnings momentum is improving significantly.”

With corporate America on a timid upswing, it would be logical to look for a knock-on effect in Europe. However, European restructuring (with the exception of Britain) has been less aggressive than in the US, and Euroland is suffering from the strengthening of the single currency.

There is a danger, according to Mortimer-Lee, that the US stimulus measures may prove ineffective, in which case markets could be looking at another setback similar to the summers of 2001 and 2002, when indices fell by more than 20% without any exogenous shocks. “We can only hope the stimulus policies pursued since 2001 will be effective,” he says. “Otherwise, we have still not reached the bottom of the bear market.”

All eyes are focused on the US economy – the powerhouse of global economic growth. So far, the US recovery is being led by consumer spending, according to David Barker, Ernst & Young partner in charge of corporate finance for the financial services industry. However, as Barker points out, this implies a potential danger from several factors, notably a sharp rise in interest rates or unemployment. He says there is no reason to expect a dramatic move on either of these two fronts. “The tone of business services feels better across the range of services we provide, but we have to be mindful of economic indicators,” he says.

“There has been a significant increase in M&A activity in the mid-size corporate sector, partly because of people restructuring their businesses, demerging non-core activities and so on. But the market is finely balanced around a situation in which positive sentiment is running ahead of economics.”

Growth in the UK market has been driven this year primarily by the expansion of the services industry. This, according to analyst Robyn Barnett at UBS, has helped to offset weakness in the manufacturing sector, which accounts for a fifth of the British economy. “While the UK economy has remained relatively resilient to the recent slowdown in world activity, the underperformance of the manufacturing sector serves to highlight that it is not immune to the effects of a downturn in world trade,” says Barnett.

But the latest data provide further evidence that the downturn in manufacturing activity appears to have bottomed out.

Further good news for UK equity markets was provided by Sweden’s solid rejection of EMU membership in September’s referendum. The outcome of the Swedish vote has all but eliminated the chances of a UK referendum on the euro taking place before the next election. Even then, with public sentiment running against adopting the euro, most analysts are discounting British membership under any government. The removal of this doubt provides a strong measure of market stability and helps clear the decks for future growth on a sterling-based economy.

“UK entry to EMU could have a negative portfolio flow impact on the UK equity market,” says Citigroup equity strategist Robert Buckland. “As UK institutions rebalance their funds to a pan-European mandate, we suspect that UK selling would swamp continental European investors’ buying of UK equities. This effect would be felt most in small and mid-cap stocks. For now, however, with opinion firmly opposed to EMU, investors probably need not concern themselves with this issue.”

Michael Hartnett, director of European equity strategy at Merrill Lynch, favours what he calls the ‘Goldilocks’ scenario that European equity investors need to consider for the first-half of 2004. This is, in essence, the middle way between the ‘Triple-Dip’ and ‘Take-Off’. In this scenario, US growth moderates to 3.5% and slow-burning European recoveries prevent ‘freak shows’ in fixed income and foreign exchange markets. In this sequence of events, yield curves remain steep and investors remain in equities.

But equity leadership rotates from low-quality beta back toward moderately priced, genuine earnings stories.

However, with global markets having achieved a 30% rebound since mid-March, it would be logical to expect at least a brief pause for breath.

As far as Britain is concerned, Citigroup’s Buckland modestly reduces the size of his underweight recommendation on the safe haven of UK stocks.

“We stay negative on the basis of the market’s defensive characteristics and also the prospect for a rising interest rate cycle that could come much sooner than the market anticipates, driven by robust economic growth,” he says. Pro-cyclical sectors that will benefit most from near-term recovery – energy, construction, media, telecoms and technology – are in fashion.

Economic strengthening in the OECD and a gradual rebound in stock market indices are likely to coax some fixed-income investors into equities over the coming months. This optimistic view, however, comes with a number of caveats. The underfunding of pensions in Europe sits under the corporate world like a huge time bomb, fuelling demand for fixed-income products. The situation in Britain, where nearly 70% of pooled pension funds are invested in equities, points to a long-term trend out of equities into fixed income.

How do the people who run the companies whose shares have been performing so dismally over the past three years see the future? By best estimates, directors’ sales versus purchases of their own companies’ shares is running at a ratio of about six-to-seven times. “This reflects the sentiment of those who are closest to the corporate market,” says one analyst. “It highlights a cautious, if not a still slightly bearish, view coming from market-savvy people.”

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