The age of austerity should not hurt stocks

Kathleen Brooks
A WEEK has passed since the emergency Budget set the UK on a path of fairly aggressive fiscal consolidation. Public spending will be cut in real terms, Vat is scheduled to rise and new rules are in place to ensure that the debt-to-GDP ratio will fall back to more sustainable levels in the coming years.

So in an age of austerity where should investors park their cash? Analysts at UBS have reiterated their positive view on UK equities, and now expect the FTSE 100 to rise to 6,250 by the end of this year, a 20 per cent increase from current levels. The main gist of their argument is that although the measures to repair the UK’s fiscal woes are steep, they will not push the UK’s economy back into recession.

In fact, the spending cuts and tax increases announced by George Osborne last week could even boost stocks. Firstly, the Budget reduces the chances of an interest rate hike later this year, which is good news for businesses as it keeps debt financing costs low. This should also keep a lid on sterling appreciation, which is welcome news for Britain’s exporters.

Secondly, other measures included in the Budget, like the cut in corporation tax from 28 per cent to 24 per cent, received a warm welcome from the business community. Beverage companies like Diageo, the makers of Guiness and Baileys, and C&C, the Irish cider maker, can breath a sigh of relief that alcohol duty was not increased. And even retailers have been given six months to prepare for the 2.5 per cent increase in VAT, which will not be implemented until 4 January next year.

And it’s not just a supportive macro environment that will boost stocks – valuations are also looking attractive. UBS’s current price-to-earnings ratio for the FTSE 100 is 10.3 for 2010 and 8.5 for 2011. This compares with a long-run average of 13 times earnings, which suggests that the FTSE 100 looks cheap relative to history.

It’s all very good to look cheap, but is there real value? By far the most compelling argument for FTSE appreciation this year is the geographic dispersion of the index’s earnings. Nearly three quarters of earnings, excluding financials, come from overseas: 26 percent coming from Europe, 22 per cent from North America and, crucially, 26 per cent coming from the rest of the world, led by fast-growing emerging markets nations.

But what about BP? The oil giant is one of the largest companies on the FTSE 100, even after losing half its value since the Gulf of Mexico oil spill. Although costs relating to the clean-up continue to spiral, there are signs that some of the pressure on the company has started to ease after President Obama told David Cameron that BP should remain a strong and stable company. Whether that is enough to save the firm remains to be seen.

So while bond yields and cash rates remain meagre, there is a strong argument for contract for difference traders to invest in equities, especially in an environment where overall returns could be hard to come by in the coming years.