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Financial Times: London investors buy into decoupling theory

By Neil Hume in London
Published: October 13 2007 03:00 | Last updated: October 13 2007 03:00

UK house prices are falling at their fastest pace in two years. The chancellor of the Exchequer, Alistair Darling, has lowered his growth forecasts for the economy. The Treasury has had to guarantee new deposits at troubled mortgage lender Northern Rock, and the big clearing banks are still reluctant to lend to one another.

This is not usually a backdrop associated with rising share prices. Yet the FTSE 100 came within eight points of a seven-year high this week and is now close to the levels it was trading at before the credit squeeze started in July.

From its summer low – the FTSE 100 hit 5,858.9 on August 16 – it has risen 15 per cent, or 872 points.

How can share prices be rising when the economic outlook appears so gloomy both in the UK and US?

Is it possible to be bearish about the UK economy but bullish on the UK market? The simple answer appears to be, yes.

Equity strategists and City traders believe one main factor lies behind the market’s sharp rebound: it is decoupling. This is the idea that the economies of the developed and developing economies are no longer closely correlated.

Therefore, a slowdown in the US or Europe, for example, can be offset by strong growth in the Bric countries – Brazil, Russia, India and China. “As opposed to equity markets taking a lead from the US, the baton has been passed to Asia and China, at least temporarily,” says Graham Secker, equity strategist at Morgan Stanley.

“Investors are really buying into the decoupling argument.”

Morgan Stanley forecasts that the global economy will grow at 5 per cent this year and 4.5 per cent in 2008.

Global growth is good for the UK market, according to Darren Winder, head of macro and strategy research at Cazenove.

“The largest 10 stocks account for 50 per cent of the UK market. Yet the percentage of profits these companies make from the UK is very modest,” Mr Winder says.

Vodafone, for example, makes only 6 per cent of its profits from the UK. The same is true of oil companies BP and Shell, while in the mining sector it is even more extreme.

“The mining sector accounts for 12 per cent of the FTSE 100’s profits. And their earnings are entirely from overseas,” Mr Winder says. It is therefore unsurprising that the mining sector has spearheaded the FTSE 100’s recovery from its August lows.

Those strong performances have offset big losses in other sectors such as housebuilding, banking and property.

Of course, global growth has not just helped the UK market. The reason why the Dow Jones Industrial Average and the S&P 500 have recently hit record highs is because of the strong performance of multinational corporations whose businesses are global. Asian markets have also been hitting records.

The outlook for interest rates has also helped London’s recent strong run.

The US Federal Reserve has already cut rates by 50 basis points to 4.75 per cent in an effort to stop the credit squeeze affecting the wider economy, and most analysts expect it to repeat the trick if necessary.

In the UK rates look to have peaked at 5.75 per cent, and could even be reduced by the end of the year.

The key question now is whether the FTSE 100 can push on and reach the record high of 6,930.2 set at the height of the dotcom boom in 1999.

Most equity strategists believe it can.

“Despite the recent rally, European equities still trade on less than 13 times prospective earnings. Valuations do not look stretched unless profits collapse, which is unlikely,” says Jonathan Stubbs, head of European equity strategy at Citigroup.

Mr Winder agrees: “Equity valuations, in our view, continue to discount a harsher operating environment than we believe is likely to materialise over the next 12 to 18 months.”

But not everyone is as positive. Gareth Evans, UK equity analyst at UBS, says: “We are concerned that the new-found enthusiasm could peter out. Implied volatility is higher and bond yields are still falling. In the past this has given rise to a weak equity market.”

Copyright The Financial Times Limited 2007

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