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Over the last year, consumer spending in the UK has slowed considerably. This, combined with a wider malaise in credit markets, has contributed to a slowdown in economic growth. The backdrop is not looking rosy for the UK stock market. However, this does not mean there are no opportunities out there. Investors need to take action to protect themselves in such circumstances, but a closer look at the UK reveals there are also many opportunities.

There is no doubt the global economy has generated some depressing news. There can be few observers who disagree that there is, and will be, a continued worldwide slowdown in 2008. Some fear this slowdown will even result in a recession. Given the openness of the UK economy, it cannot help but be affected by global events.

The news elsewhere is far from buoyant. The latest edition of the International Monetary Fund’s World Economic Outlook says the global expansion is losing speed in the face of a major financial crisis and the slowdown has been greatest in the advanced economies, particularly the US, where the housing market correction continues to exacerbate financial stress. Growth in western Europe has also decelerated, although activity in Japan has been more resilient.

The IMF predicts the US economy will tip into a mild recession in 2008 due to the combination of the housing and financial downturns. However, it predicts a modest recovery in 2009 as balance sheet problems in financial institutions are resolved. Western Europe will also slow below potential owing to trade spill-over, financial strains and negative housing cycles in some countries.

However, there is some positive economic news – the IMF predicts positive growth for the world economy in 2008, even if it should slow to 3.7 per cent, or 1.25 percentage points lower than the growth recorded in 2007. The key observation here though is much of this growth will come from emerging and developing economies, which will see growth slow, yet still remain robust both in 2008 and 2009.

The emerging and developing economies have so far been less affected by financial market developments and have continued to grow at a rapid pace led by China and India. Commodity markets have also continued to boom, despite slowing global activity, with strong demand coming from emerging economies. Biofuel-related demand has also boosted prices of major food crops. Some of this rise in commodity prices can also be attributed to the extra attention given to it as a result of commodities having become considered a separate asset class.

Given the global backdrop, it is hardly surprising that, like most stock markets around the world, the UK has had a weak first quarter. As a broad measure of stock market returns, the FTSE All-Share index fell 9.9 per cent in the three months to the end of March.

Over the first quarter, the best-performing sector in the UK was basic materials which remained flat, while many commodity prices surged higher over the first two months of the year, before giving up some of their gains in March. Industrials performed relatively well but still fell by 5.2 per cent. It was unsurprising to see these more defensive sectors performing relatively well. On the flip-side, the consumer goods sector declined by 7.3 per cent. Interestingly, the financials sector rebounded from recent weakness, but still ended the quarter down 7.2 per cent.

The weakest sectors were telecommunications, consumer services and technology, which fell 19.7 per cent, 16.3 per cent and 14 per cent respectively. The performance of technology stocks suffered as mobile handset manufacturers and suppliers reported weak market conditions as economic growth slowed. Company announcements from AT&T and Deutsche Telekom caused investors to worry that new telecom services such as mobile and broadband may not be as defensive as traditional services.

The corporate sector is under pressure as the shortage of credit bites. The non-financial liquidity ratio – corporate funds available – has now fallen to a 10-year low. This will slow domestic investment. Add to this a growing current account deficit – the 5.7 per cent of GDP reported for Q3 2007 was worse than the US – and the outlook overall remains poor. Higher energy bills and food prices, falling house prices and reduced availability of credit will all contribute to continued economic difficulties and have a knock-on impact on consumer demand in 2008.

Despite this negative picture, investors would do well to remember over half of UK earnings are derived from overseas. Well-run UK companies with diversified earnings streams, both geographically and by type, will continue to thrive. For example, demand from both emerging and developed markets will buoy demand for oil, while problems with refining capacity will keep prices high for some years. Stock picking is still essential in the oil sector – while several companies will do well over the next two or three years, it is those companies with access to fields with the best reserves, such as BP and Royal Dutch Shell, that will outperform over the longer term.

For the longer-term investor, UK equities in aggregate continue to offer good value. However, divergent sector performance during the past 12 months has revealed some stark differences in valuation. For example, the basic materials sector is now looking expensive from a historical perspective. Conversely, the healthcare and financial sectors are trading at very attractive levels. Furthermore, at current levels, only the financials and telecoms sectors offer yield in excess of the FTSE All-Share index.

The banking sector has been one of the weakest performers over the first quarter of this year. However, UK banking exposure to sub-prime lending has been less severe than first expected. RBS, Lloyds TSB and HBOS all announced exposure at the lower end of the scale. Factoring in a slowdown in loan growth over the medium term would not be unwise, but our outlook for the banking sector remains positive.

UK banks now look cheap after a tumultuous year. Price to book values are just 1.5 times versus 2.5 times for the whole market. UK banks may see further price falls over the next one or two years, but they are now at all-time lows in terms of valuations, with yields for the industry around 6-7 per cent. HBOS, Royal Bank of Scotland and Lloyds TSB are all looking good. They are well positioned to pick up business from Northern Rock, do not have significant sub-prime exposure and are well diversified.

The defensive characteristics of portfolios positioned to take advantage of a slowdown in economic activity will bear fruit throughout 2008. Longer term, UK equities in general continue to offer relatively good value. There is particularly good value in the blue chips. While the mid caps are more exposed to a downturn in the UK, large caps such as oil, pharmaceuticals and banks have a high proportion of overseas earnings, which are set to be boosted by a recovery in the undervalued dollar.

To be positioned for anything other than slowing economic activity and stock market volatility in the UK this year would be foolish when all the indicators point to such conditions. Despite the uncertain outlook, stock valuations are around some of the lowest they have been for 10 years, creating ideal conditions for the UK equity income sector.

The defensive characteristics of a long-term valuation strategy, to which equity income lends itself, is ideal in current market conditions. As well as being defensive, it would help take advantage of a slowdown in economic activity and pick off the opportunities afforded by market volatility. This approach will bear fruit in 2008 and at a time when UK equities generally offer good value for the long term.

Stuart Tyler is senior investment analyst of Lincoln Financial Group

Main points:

- It is clear we are in the midst of a slowdown and this will continue for the remainder of 2008

- The IMF predicts the US will fall into a mild recession. The UK could suffer as a result of this because of its exposure to global markets.

- Basic materials was the best-performing sector over the first quarter of 2008, while telecommunications, consumer services and technology fell 19.7 per cent, 16.3 per cent and 14 per cent respectively

- A defensive strategy of looking at long-term valuations is the best way of riding through these troubled times.