WHAT will the UK economy look like at the end of the recession? Where are the growth sectors in the next cycle? Answers to these questions will be important for a variety of people: investors looking for the best home for their capital, central bankers debating when to alter monetary policy, not to mention politicians in view of an election due within a year.
The downturn has been painful, with the UK economy shrinking at the fastest rate for 51 years, according to the Office for National Statistics, which last week showed activity had contracted 4.9 per cent compared with a year earlier.
However, i
n a few months you will probably see newspaper headlines that the recession is formally over. Business activity should turn positive again, as consumer spending, exports growth and bank lending respond to the various stimulus packages.
Sadly, for many people the after-effects will linger on. History shows that companies continue to fail, and unemployment increases, for at least a year after the recession ends. We also warn that the recovery, both in economic activity and in company profits, is likely to be weak by historical standards. Companies and households are still struggling, with a sizeable mountain of debt to repay. On top of this, whatever the result of the next election, most independent analysis suggests that the tax burden will rise, and certain areas of public spending will be cut, to bring record levels of government borrowing under control.
All this should ensure inflation remains weak well into 2010; companies will find it difficult to regain pricing power when there is so much spare capacity around.
We are not looking for personal spending or the housing sector to be the primary drivers of the recovery when it appears. After all, in the past decade consumer spending has been well supported by the expansion of household debt, both for property-linked and unsecured credit.
The housing market is starting to stabilise, but the overhang of negative equity and the difficulties facing first-time buyers are considerable. After the last major housing crash in the 1990s, it took about seven years before house prices reached their earlier peak. Several parts of the economy are starting to restructure, notably financial but also housing-related services. The further this process goes, the closer the UK unemployment rate will get to three million – about one in ten of the workforce.
Stock markets do not blindly follow economic trends, of course; instead they are looking ahead to sustainable profits growth. While overall consumer expenditure looks to be weak, investors can research opportunities in some of the more defensive areas, such as food retailing, even if luxury and discretionary spending remain under pressure.
Although a recession is very painful, it does sow the seeds for new opportunities. Exports would be a prime example. One important way in which the economy has already adjusted is the slide in sterling. Against a basket of the UK's major trading partners it has fallen about 27 per cent. In contrast, the fall when sterling left the Exchange Rate Mechanism in 1992-93 was only 17 per cent.
The UK remains a major trading economy and a producer of high value added goods and services. Contrary to popular misconception, it is still the fifth largest manufacturing economy, behind the US, China, Japan and Germany but ahead of France and Italy. One area for investors to examine, therefore, is some of the industrial stocks, often priced for distress but potentially seeing better profits growth as the inventory and orders cycles turn around.
It would be wrong to think solely of manufactured goods; exports of high-value business services such as insurance, accountancy, legal, even fund management, are all major areas where the UK is traditionally strong. Hence, within the stock market our analysis suggests that companies in the aerospace, electronics, life services, pharmaceutical and transport sectors could be prime beneficiaries. Some of these would particularly benefit from the fiscal stimulus, such as the large infrastructure plans which a number of overseas governments have introduced.
Sterling matters for another area too: tourism. This sector is already starting to see the benefit as UK residents prefer to holiday at home, while the exchange rate is making the UK a popular destination for visitors from continental Europe.
What kind of portfolios might prosper in this environment? The answer very much depends on each person's willingness to accept risk and their timescale for investing. Looking over, say, the next 12 to 18 months, sustainable yield is a style to consider. Central banks look set to keep cash rates low well into 2010, as inflation remains weak, so a combination of funds investing in good-quality corporate bonds, higher-yielding, dividend-paying companies and commercial property with solid rental cover can provide the income which many investors need.
The economic recovery may have begun but its nature remains rather uncertain. Investors would be advised to remain flexible.
Andrew Milligan is head of global strategy at Standard Life InvestmentsThe full article contains 843 words and appears in Scotland On Sunday newspaper.
