05/07/2007

An Extended Cycle

Stock markets continue to find support from positive earnings growth. On top of this there is a possibility that equity markets enter a new phase where investors decide to pay up for assets, in other words that there is a noticeable re-rating, driven either by retail, corporate or central bank flows, according to research published today by leading investment house, Standard Life Investments.

In the latest edition of Global Outlook, its quarterly investment view, Standard Life Investments examines the main drivers of financial markets: positive earnings growth, revaluations driven by corporate activity, and shifts in discount rates.

Andrew Milligan, Head of Global Strategy at Standard Life Investments, said:

"In recent months equities have largely been in a 'profits phase', rising or falling in line with reported earnings and changes in expectations for future profits. Looking ahead, margins are likely to come under some pressure, from rising unit labour, raw material and debt servicing costs as the business cycle becomes extended, and also from weaker top line sales growth in some countries such as the US but also Japan. Nevertheless, we still expect productivity improvements mean that positive earnings growth will still be seen in 2008.

"Corporate activity has been a key factor supporting stock market valuations. 2007 looks set to be the largest year for M&A and private equity activity since 2000. The driver for this is clear: an earnings yield that significantly exceeds the cost of debt. Looking ahead, larger private equity deals are expected, while the activities of sovereign wealth funds could be significant.

"The final factor has been changes in discount rates. Bond markets have recently reacted very negatively to a mix of negative concerns about growth prospects, central bank tightening, and international capital flows. We expect the world economy will remain robust over the summer, but this upturn is expected to fade into year end as businesses and consumers respond to the steady policy tightening. In addition, in our view inflation pressures remain under control due to structural factors in the global economy. As long as this is the case then bond markets should be able to stabilise after their recent sell-off.

"There are of course some risks to this positive view for financial markets. The first is that renewed weakness in the US economy turns into a recession in 2008. Factors that could make such a development more likely include the risk that central banks, not just in the US, tighten policy too far or for too long, or alternatively if external shocks occur, such as a surge in oil prices.

"Rising levels of household and corporate debt are a second concern. In the UK and Europe, borrowing has increased as households have lowered their savings in an attempt to retain their standard of living. The impact of higher interest rates has already begun to be seen in terms of weakness in such areas as the Spanish construction sector and the UK and Irish housing markets.

"Inflation remains an important threat to the end of this investment cycle. There is growing evidence that inflation pressures peaked in the major economies in early 2007. Periodic problems could appear, with food prices currently the major swing factor. One aspect for investors to monitor is whether inflation pressures in emerging markets cause more aggressive policy tightening.

"The House View currently favours equities over bonds, bonds over cash, and equities over property. Moderately positive earnings growth should provide firm support for equity markets. There are opportunities for individual stocks to outperform strongly if corporate self help and financial leverage picks up, or there is significant M&A activity. Financial markets are expected to remain volatile, reacting to such worries as policy tightening in China, inflation risks in developed markets, or concerns about excessive leverage. Bond markets in due course should rally, given inflation will remain under control in most economies. The House View remains Light in UK commercial property, reflecting concerns about valuations in several sectors. Global property is generally preferred to UK property, helped by strong commercial and retail sector activity."