Only a euro collapse can change our equity views
Plans in Europe to fund banks directly via the European Stability Mechanism were initially taken positively by the market, evidenced by a short, sharp bounce in share prices.
There is obviously a latent desire among investors to buy equities on any hint of an easing of wider problems, although this has lessened during the past three months.
But as last week reminded us, the slightest whiff of a worsening eurozone debt crisis can send markets running for cover. The FTSE 100 index shed more than 2 per cent in a single day on July 23 as Spanish government bond yields surged above the 7.5 per cent mark.
Should investors be ‘risking’ their capital in stocks at this point?
Broadly speaking, growth remains lacklustre in the US and China, and eurozone worries are omnipresent. A lack of confidence in the eurozone has certainly acted as a drag on the UK’s economic growth.
Given these headwinds, investors are faced with the challenge of protecting the real value of their capital. Real interest rates on cash and conventional government bonds have been woefully inadequate to protect against higher inflation over the past three years, compelling investors to ‘risk’ capital in order to preserve its real value. This situation is unlikely to be reversed anytime soon, with real interest rates becoming even more negative if governments look to turn on the liquidity taps once again. Given this scenario, we continue to see equities as one of the most effective ways of protecting against this risk.
There is no disguising the fact that the UK economy continues to struggle and the government’s credibility has suffered due to several volte-faces by the Treasury. The chancellor, George Osborne, remains committed to his programme of spending cuts, but investors are putting increasing pressure on the authorities to implement government policies to promote growth, in addition to monetary measures such as quantitative easing.
Although the FTSE 100 is disinclined to dip below 5,500, last week’s volatility reflected a degree of unshakeable euro uncertainty. The average FTSE 100 stock is currently priced at roughly 10 times its earnings. The average mid-sized FTSE 250 company is trading at approximately 11 times earnings. Earnings are projected to grow at a reasonably robust rate in 2012 of roughly 8 per cent, although this may prove illusory if the economic recovery falters again, and if the up-coming reporting season sees downgrades to earnings numbers. Economically sensitive stocks have also been very volatile as investors worry about global growth slowing.
Even if capital gains on equities fluctuate, however, the stockmarket yields 4.2 per cent, with dividend increases expected to be 6-8 per cent. The UK market therefore does not look expensive if the global economy continues to recover through 2012 – but that does require the US economy to lead the way.