US Recovery and UK Market Outlook

The strength of this year’s stockmarket rally has caught many investors by surprise. Clients are questioning why managers are sitting on cash or hiding in defensive sectors. Suddenly last year’s “quality” stocks are out of favour; betting against recovery is proving painful. The scramble to buy cyclicals, financials and commodities has given little chance to buy on dips. Is it too late to realign portfolios?

The pattern echoes early 2009. In the face of a massive injection of liquidity, investors are willing to overlook underlying problems in the global economy and the banking sector. The ECB’s tidal wave of money is washing into almost every asset class. And, company results have turned round sharply. Cyclical sectors like chemicals, autos and paper are comfortably beating expectations. Companies have boosted sentiment with much more positive language about current trading. Many investors have too little exposure to recovering sectors such as banks. The sharpest gains have been seen in stocks that are under-owned by institutions or have been shorted by hedge funds.

The world is more dependent now on US recovery, but recent data is encouraging. The US housing market in particular, is steadily picking up. Its importance should not be underestimated. Construction represents around one-sixth of the US economy – as much as the entire economy of France. European and UK companies exposed to US construction recovery include Ashtead and Wolseley. At this point in the cycle, recovering businesses can look highly-rated, just before we enter the upturn. Plant hire group, Ashtead, has significant operating leverage. Profitability should rise as demand recovers, with many of its competitors having failed to make sufficient investment during the downturn. The survivors, as US construction picks up, should see a sharp profit recovery.

A stronger US economy should boost oil and metals, also. Global oil demand has been growing over the past year, putting pressure on supply. And, since the Arab Spring, governments in the Middle East and North Africa have increased social spend in preference to developing production. Oil has very little spare production capacity globally. Asian oil demand is growing rapidly and Japan is still forced to import energy until its nuclear capacity is restored. There seems relatively little in the oil price for the risk of further disruption or political turmoil.

Against this background, oil and gas businesses both large and small should prosper. Encouragingly, this year has also seen more M&A activity in the sector, with competitive bids for Cove Energy. This has highlighted the opportunity in East Africa, to which others such as Ophir Energy and Wentworth Resources are also exposed. And, the oil and gas exploration businesses operating in the North Sea, such as Nautical Petroleum, which spent much of 2011 out of favour, now also offer value. Bid activity could be the surprise of 2012; oil majors need to maintain reserves.

Managers were rewarded in 2011 for safety in stock selection, and emphasising dividend yield. Many stocks in areas such as pharmaceuticals, consumer staples and telecoms became over-bought and over-rated. These sectors may be used as a source of funds as investors realign portfolios. This sector rotation could trigger underperformance in portfolios that are too defensive. It may be too early to say whether global recovery is sustainable, but the market could see another few months of improving data. We believe that this improving climate merits remaining fully invested.

This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.