UK recession looks likelier than not

Sep 3 2008 by Iain Laing, The Journal

TWO global trends have dominated financial markets in recent months: global growth has continued to weaken, while inflationary pressure has eased.

The main cloud now on the investment horizon is the renewed upward spike in US mortgage spreads. These prevent the average American house-buyer from benefiting from looser monetary policy and declining government bond yields. More positively, energy prices have continued to fall. This should provide more room for central banks to help the economy and reduce the uncertainty associated with high inflation.

Taken together, our view is that the balance of risk and return expectations has not changed that much for markets. We still see substantial upside for risky assets on a 12-month horizon. But we also see substantial short-term risk. Therefore, we maintain our cautiously optimistic view and have a small equity overweight on a 12-month investment horizon. Looking at regional equity allocation, UK and European equities are trading at an increased discount to US multiples. Of course, this raises the question of whether we should move some of our overweight from the US to the UK, where we have been neutral. We think not; the reasons why are mainly cyclical. For a start, the current economic troubles began in the US, so the US is further ahead in both its economic correction and its policy response. Moreover, it has a higher probability of further fiscal policy action. Also, US earnings are likely to be less volatile than the UK, which has a high weighting towards commodities and an increasingly weak domestic economy. The implication is that the earnings correction could be more serious in the UK, especially if our expectation of a rebound next year does not materialise. Therefore, we have moved our tactical asset allocation to a 1% underweight in the UK.

The other region that has seen most structural changes recently is emerging markets, where we have our other major tactical equity overweight. Emerging markets are however still highly cyclical in terms of both earnings and market dependence.

We believe that emerging markets’ tactical performance (relative to developed markets) is still driven by the same factors as have been evident since the break-up of the Soviet Union and the reunification of Germany – ie real interest rates, global liquidity, risk and fear. These are combined in our emerging markets indicator, which currently suggests substantial outperformance in emerging markets relative to the MSCI World over the coming 12 months (in US dollar terms). The favourable prognosis for emerging markets contrasts with the UK – where, realistically, a recession looks more likely than not next year. So, for investors with a global portfolio, we would advocate a small underweight stance in UK equities for now.

Andrew Miller, regional head, Barclays Wealth