The UK stock market is getting riskier by the day
Investment Director – The Fleet Street Letter
David Stevenson Oct 08, 2010
Yesterday brought a fair splattering of UK financial headlines. And there was very little good news to speak of.
The Halifax told us that British house prices are tumbling. The Bank of England did nothing on the interest rate front, despite all the talk of further quantitative easing. And Marks & Sparks warned about trading conditions. The only glimmer of cheer came from UK industry, but even there the current positive mood may not last much longer. Small wonder the pound dipped further against the euro.
Yet UK shares are still within spitting distance of their highest level since June 2008. Despite yesterday's small decline, the stock market appears to see few risks right now.
So what's going on?
Yesterday was a bad day for property bulls
The Halifax housing market index was a shocker. Prices fell by 3.6% in September from August - the worst monthly reading on record. That took the year-on-year rate of house price inflation to -0.7%. It's the first time this has been negative since October 2009.
Also, the IMF warned that UK house prices could "correct" further. I'll not say too much else about this here, as this week's issue of MoneyWeek magazine includes our latest property roundtable. Our experts give their latest views and five-year forecasts, and we've put in some new charts too. So don't miss it - subscribers can read the story here: What next for property prices? (If you're not already a subscriber, get your first three copies free here.)
All things considered, yesterday was a bad day for property bulls. As Merryn Somerset Webb says in her latest blog, Even ultra-low rates can't prop up house prices for ever.
And if property values tumble again - well, we learnt from last time what can happen next. Many loans made by the banks could go sour. In turn, that could mean more write-offs and less lending. In short, another vicious circle could start - which would hurt bank shares for starters.
It wouldn't be great for consumption either. Falling house prices make consumers feel poorer and more cautious about splashing out. So yesterday's warning from Marks & Spencer that trading conditions are likely to get tougher should come as no surprise.
Consumers are right to be cautious - everyone knows that government cutbacks are coming even if the coalition hasn't given us chapter and verse yet. But lower state spending - and the inevitable job losses - are hardly ideal for rising UK share prices.
So the outlook is poor for banking and retail - but what about manufacturing? After all, British industry provided one of the few good news stories yesterday. A 0.3% rise in manufacturing output lifted its annual growth rate to 6%. Not a bad recovery from recession, you'd think. The problem is that these good tidings are unlikely to last too long.
"Demand in key export markets like the eurozone remains weak and exporters' order books have been deteriorating", points out Jonathan Loynes at Capital Economics. "The coming UK fiscal squeeze is likely to hit domestic demand for manufacturers' products. Forward looking industrial indicators have already weakened markedly over the last few months, pointing to a fairly sharp production growth slowdown ahead".
In other words, we can't expect much more growth from many of our manufacturers - or their share prices - in the near future.
Special FREE report from MoneyWeek magazine: Don't be fooled - house prices will fall again!
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What's holding the market up?
So what exactly is holding this market up? Because investors certainly don't seem to be fazed by all the pain in the 'real' economy. Apart from a brief dip yesterday, the FTSE 100 index has marched upward since early July. It's now within a smidgeon of its recent April peak, which was the highest point since June 2008.
In a nutshell, with the UK's economic outlook heading for the doldrums, it looks like almost all the bulls' hopes are resting on the Bank of England and how much new money it will print via quantitative easing (QE).
Sure, the Bank sat on its hands yesterday. The bank rate remained at a 0.5% record low, and it decided not to add any more QE to the £200bn already churned out. But bullish investors clearly believe that it's only a matter of time.
This group - heavily populated by City share salesmen - reckons if the Bank creates enough cash, eventually this must force up prices somewhere. Much of the last batch of cash ended up in the financial markets - pushing up share and bond prices - so these cheerleaders for more money printing want to see history repeat itself.
But here's the rub: this might not do the trick in the way its cheerleaders hope.
Beware market bulls
Yes, bond prices would probably get a short-term fillip if the Bank of England buys gilts. That would drive down yields. But equities could be a different matter. QE has so far failed to make much impact on real business activity as bankers have run scared from lending. And if property prices start plunging again, giving lending departments even more jitters, that could seriously hurt our economy, regardless of QE.
"We think there's a point at which investors' faith will start to waver if a second round of QE fails to make any difference to the economy", says John Higgins at Capital Economics. "At that point, domestic equity prices could be vulnerable to a significant pullback". In other words, any more QE could actually do a lot of damage to confidence, and thus to the stock market.
Some say that because gilt yields are now so low (ten-year gilts currently yield around 3%), investors must switch to shares to get better returns. If they're talking high-yield defensive stocks, which we like, we'd agree.
But other than that - well, just take a look at this chart. It shows what happened the last time that ten-year gilts yielded about 3% around end-2008. The FTSE 100 tanked - because investors panicked that company profits were about to be crushed by the recession.
What's the chance of history repeating itself here? The risks for the UK stock market are rising the higher it goes. It's time to be very wary of market bulls.
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