Investment outlook for 2007

[NikWilson]

Just in case anyone on here is really interested - just thought I would put this up as this has been going out to our clients.


Nik




Inflation rates - the worst is over but volatility remains

In the short term I would expect inflation to rise and move above the target of 2%. In the mid term however, the effect of rising energy prices and rising import prices should subside and I predict that this will bring inflation below the current target. Given oil prices have already risen substantially, from an inflation point of view, I expect the worst to be over. Of course, there is a risk that oil prices could double from here and in turn have a major impact on inflation rates, but that risk at present is low.

Interest rates to rise again?

At the moment, most areas of the economy are strong or are strengthening - so in the short term there is little likelihood that interest rates are going to fall. I am expecting rates to peak at 5.25% in the first quarter of 2007 and, currently, the interest rate markets are pricing-in a fair chance of this rate rise in the first three months of 2007.

UK equities - cost of debt the significant driver

In 2007 the risks to inflation are larger than normal on both the upside and the downside and I suspect that this will lead to volatile interest rate expectations over the course of the year. This in turn, will lead to a volatile equity market.

Currently, a large factor determining equity market performance (for all but the largest companies) is the cost of debt compared to the cost of equity. Quite simply, if the cost of debt remains low and the cost of equity remains high then I would expect to see quoted companies continuing to be approached with a view to being taken over either by overseas companies, by other UK companies or by private equity.

Therefore, to form a view on the equity market for 2007 I must take a view on the cost of debt and compare it to the cash flows being generated by UK companies. Although I expect interest rates to rise slightly and possibly bond spreads to widen slightly, I don't expect the cost of debt to rise sufficiently enough to challenge the strong cash flows being generated by companies. Consequently I expect to see further corporate activity in 2007, which will be supportive to equity markets.

It is worth recalling that in 2005 we had two sharp pull backs in the equity markets - in April and in October, and in 2006 we had one pull back in May. Although all of these were for different reasons, a common factor was the fear of the cost of debt rising significantly. Whilst the equity market continues to be keenly influenced by the cost of debt, I expect to see further pull backs of this nature in the future, and most probably in 2007. Where company fundamentals remain the same, we will use these pull backs as buying opportunities.

Housing market to remain buoyant

Despite likely interest rate rises, I am still expecting house prices to rise - but at a much lower rate, perhaps 2-3%. I perceive that the demand for housing in the UK will remain strong, especially at the lower priced end, whilst the more expensive properties are likely to be sustained by bonuses and overseas money.

For house prices to fall we need a UK specific event which would bring forced sellers on to the market. This could happen in two ways; either sharply rising interest rates that would cause the cost of mortgages to spiral upwards, or a recession causing unemployment to rise sharply. At the moment I do not believe either of those scenarios are likely.

Consumer spending recovering

Consumer spending remains volatile but has recovered from the slowdown in 2005. I would anticipate this recovery continuing and foresee consumer spending growing at its average rate but not as rapidly as that of the late 1990s.

In summary

Overall I expect the UK economy to be robust in 2007 allowing UK corporate profits to remain healthy. I also expect the cost of debt to remain low and therefore expect the equity markets to make further progress in 2007, though with the same volatility that we have seen over the last two years. Furthermore, as the global economy rebalances away from the US and towards the rest of the world, this will benefit the UK because our exports are biased away from the US.

[duncan]

interesting Nik - what is it that you do?

[Stuart]

Thanks very much Nik.

I follow the trends of house prices quite closely and your thoughts echo my own. Gives me a good reason to gently increase my rents

Nik is an independant financial advisor Dunk.