After the party comes the hangover

UK equity markets may be set to end 2006 on a high point but according to Ted Scott, manager of the top performing F&C UK Growth & Income Fund, a significant mid-cycle correction may be on its way.

"Following the correction in May, markets have surprised on the upside supported by profit and earnings growth, with Q4 results in the US being especially robust," said Scott.

"There has also been an increased level of takeover activity, particularly in the second half of the year driven by the low cost of debt. Indeed much of the Mergers & Acquisitions activity in 2006 has been debt financed with potential returns generated on shares in quoted companies far exceeding the cost of debt. I feel the market has re-rated as a result, rising to a higher valuation."

Scott said that today's low inflation, low interest rate and low bond yield environment was conducive to this activity continuing into 2007 but warned the US was a wildcard with many of the much debated market indicators, not least the slowdown in the housing market, pointing to a weakening in the strength of the economy.

"UK investors are counting on a soft landing in the US. Although the afore mentioned factors, namely positive profit and earnings numbers and the low cost of debt, should shoulder the market through the first quarter of 2007 - potentially buoying it up a further 10% - I am convinced that a mid-cycle correction is almost inevitable, presenting a major downside risk to equity markets.

"The US dollar has weakened and if the consensus view that the interest rate cycle in the US has peaked is correct, any fall in interest rates could see the dollar weaken further. This could also destabilise equity markets if it proved to be a sharp sell off, as it would reflect a lack of confidence in the US economy and also less attractive returns in widely held dollar denominated assets, especially in the Far East."

Apart from the unforeseen risks from terrorism or natural disasters, Scott points to the bubble in takeover activity as another potential risk to equity investors.

"If UK interest rates rise or bond yields increase, or if one of the larger credit deals goes into default, it could see equity markets falter particularly in the mid cap arena, which has already been on the receiving end of a lot of speculation. But for the foreseeable future, the outlook looks quite sanguine. A lot of the money raised by private equity funds has yet to be invested, which should propel the market along for some months yet."

Nevertheless, Scott said he had increasingly moved his weighting into companies which could remain robust in the event of a downturn, including some utilities such as National Grid and United Utilities as well as supermarket giant Tesco, Vodafone and Glaxo Smith Kline.

"2006 has been a great year for equity investors," said Scott, whose three funds - F&C UK Growth & Income, Stewardship Growth and Stewardship Income – have all enjoyed a year of barnstorming out performance, "but its worth noting that the bigger the party, the worse the hangover."