New Star Fund Managers give their outlooks for 2007

UK equity 2007 outlook by Stephen Whittaker, joint CIO and manager of the New Star UK Growth Fund

“At the beginning of the year I said that 2006 would generate double digit returns for UK equity investors and this looks to have held true. I would be surprised if 2007 does not offer similar returns although there could be increased volatility given the latter half of 2006 has produced several months of relative calm.

“Nevertheless, there are strong reasons to remain bullish on UK equities given a benign UK economic backdrop. The housing market remains strong and employment levels are higher than they were a year ago. Inflation is being kept low as technology and a pool of labour from developing markets drive down the price of goods and restrain wage bargaining.

“Asset prices have adjusted to a flatter interest rate cycle but I believe equities are still not fully reflecting this, nor the improvement in profits, and deserve a re-rating. In particular, the UK equity market should continue to benefit from the process of de-equitisation as foreign company takeovers, share buy backs and private equity de-listings cause the volume of listed shares to shrink. This should provide structural support for equities in 2007 at a time when demand for equities is growing as investors return to the stock market and cash-rich companies remain hungry for acquisitions.

“My favoured sector for 2007 is financials. I believe UK banks are cheap because their share prices are discounting a recession, which I believe is not going to occur. Life insurers also look attractive as their business models are returning to growth and the sector appears set for a round of consolidation.”

Europe 2007 outlook by Richard Pease, manager of the top-performing New Star European Growth Fund

“In 2006, takeover activity was particularly strong in Continental Europe. The financial sector was the most active and the fund benefited from its exposure to Italian banks involved in consolidation such as Unicredito and Banca Intesa. The array of cash-generative companies in the fund led to gains from bid activity in holdings as diverse as Portugal Telecom and Elior, the French catering group.

“Even with rising interest rates within the eurozone, credit is still relatively cheap and corporate activity is likely to remain a defining feature of the European equity markets in 2007. Shareholder activism is also becoming increasingly apparent, with companies and private equity groups such as Macquarie forcing a more Anglo-Saxon model onto European companies. This should encourage management in Europe to become more competitive and unlock value for shareholders.

“The eurozone economy managed to outpace the US in the third quarter of 2006. It is still too early to tell whether the recent pick up is a blip or a sign of the long-sleeping European picking up the baton from the weary American consumer. Either way, corporate profitability appears robust and the New Star European Growth Fund, through its focus on well-managed, cash-generative companies should be in a position to benefit from opportunities within the equity markets.”

Fixed interest 2007 outlook by Theodora Zemek, head of fixed interest at New Star and manager of the New Star Fixed Interest Unit Trust and Managed Distribution Fund.

“Yields are generally higher at the end of 2006 than a year earlier. This offers bond investors better value, although the higher yields are a reflection of increased inflation risks. While the oil price has declined, there are other price pressures in the system that are likely to keep core inflation relatively high. Our current models give a greater than even chance of there being a quarter point rise in interest rates in the UK in the first quarter of 2007.

“Real yields are still at historically low levels and inverted yield curves – where it is cheaper to borrow longer into the future than over the short term – mean better value appears to exist among shorter-dated bonds. We would be cautious of buying longer dated government bonds as this end of the market is likely to be the most volatile in 2007. In the UK, long-dated gilts have been supported by foreign buying and any removal of this prop could have negative repercussions.

“Our favoured area of the market remains corporate bonds because profitability remains high and cash flows are strong. We expect the US economy to slow down but not to go recessionary and for global growth to be better than the market consensus, which should prove a good background for high yield corporate bonds. At a sector level we continue to believe bonds issued by chemicals and cable companies will perform well and the semiconductor sector is looking increasingly attractive.

“The corporate environment has become more shareholder friendly. As such, protective covenants that protect bondholders in the event of a takeover and downgrade to below investment grade are likely to become more commonplace.

“2006 has been even better than 2005 in terms of the low level of defaults and we anticipate 2007 to be another year of low defaults. That said, some of the recent deals have been priced very aggressively and it is often the better companies that are the worst culprits and may be storing up trouble for the future. It will therefore be increasingly important that bond investors look for new issues with sensible capital structures.”

Property 2007 outlook by Roger Dossett, manager of the New Star Property Unit Trust

“UK commercial property has had a strong run, with annual returns above 18% in the last couple of years. It is difficult to see this level of performance being maintained in 2007 although the fundamentals of the sector remain attractive, with long-term rises in rental income underpinning potential capital growth. 2007 is likely to be about tempering investor expectations towards annualised total returns in the high single digits.

“Given the buoyancy in business and financial services there was a notable improvement in the fundamentals for offices in 2006 and this should strengthen into 2007, particularly in the London market where falling vacancy rates are leading to higher rents in the City and West End. We believe double-digit rental growth in prime office locations in 2007 will not be uncommon. We have spent the last couple of years biasing the New Star Property Unit Trust’s portfolio to take advantage of this trend.

“In contrast, the retail sector is likely to experience another challenging year. High street rents are not expected to reach the level of growth seen in earlier years and may even decline slightly in areas where competition remains fierce and footfall continues to migrate to the internet. For this reason retail warehousing is likely to perform best within the sub-sector although bulk-end warehousing may feel the pinch if households delay purchasing big ticket items.

“Industrials are probably set for another year of reasonable performance, although location will remain important. There is a tendency for industrial space to be in the midlands and the north where planning is less constrained and there are plenty of industrial parks. South east locations will continue to command a premium.

“There has been a lot of publicity surrounding the arrival of real estate investment trusts (REITS) in early 2007 but we doubt that the legislation will provoke a sudden rush of property investment and newly created trusts; rather it will be more a case of already existing listed property companies converting into REITS to take advantage of the tax breaks. As they tailor their portfolios in advance of conversion, we will continue to use this as an opportunity to scout for attractive stock.”

Global financials 2007 outlook by Guy de Blonay, manager of the New Star Global Financials Fund – the UK’s best performing financials fund

“The New Star Global Financials Fund had a strong year in 2006, benefiting from European banking sector consolidation. Protectionism is in retreat and cross-border and domestic corporate activity may encourage further re-ratings. The fund has already profited from this trend and many of its portfolio constituents may be involved in further mergers and acquisitions.

“Emerging Europe offers particularly healthy growth prospects although these are best played indirectly. The fund gains exposure by investing in banks with cross-border interests, such as Unicredito Italiano. Western banks are targeting the fast-growing Russian market. Société Générale, another fund constituent, recently doubled its stake in Rosbank and could become the first foreign institution to gain control of a Russian bank, participating in a retail market in which loans and deposits are growing at more than 30% annually.

“Even after 2006’s gains, equities appear attractive by historical standards and even more attractive when gauged against real bond yields. The US housing market has shown signs of stabilising, suggesting that the deceleration in global economic growth will be modest. European financial companies, however, offer more attractive growth potential than their US counterparts and the fund is positioned to benefit as the region’s positive trends continue in 2007.”

US 2007 outlook by Greg Kerr, manager of the New Star North American and Global Equity Funds

“It is clear that the US economy is likely to perform much more weakly in 2007 than 2006 and this will have an impact on the pace of corporate earnings growth. The equity markets, however, seem to be operating on the premise that monetary tightening has peaked and that the US Federal Reserve will begin to lower interest rates in 2007.

“Such optimism may be misplaced given the weaker dollar. While this may reflect a shrinking interest rate differential with other regions it ignores the fact that a weaker dollar would lead to imported inflation and this may limit the Fed’s room for manoeuvre. I am also wary of the political dimension now that the Democrats control both houses: they tend to support higher tax agenda than the Republicans.

“I am therefore cautious in the short term on US equities. They have had a strong run in recent months and the fact that there has been no sector leadership suggests the market has run up on enthusiasm rather than a particular theme. Valuation dispersions are also at a low leaving few anomalies to exploit. In an environment where earnings growth becomes more scarce I am therefore tilting the portfolio towards sectors with organic growth such as technology and away from cyclical industrials while favouring larger companies over smaller, riskier stocks. Even soft landings tend to be accompanied by a few bumps and I believe that a defensive approach in the first half of 2007 will be rewarded.”

Asia Pacific ex Japan 2007 outlook by Lucy Bernays, investment manager for the New Star Pacific Growth Unit Trust

“In the past year, Asian returns have been muted relative to emerging markets in other regions but this is likely to change in the near future. In South East Asia, domestic demand is strengthening, debt levels are relatively low and companies are less reliant on foreign capital. With global liquidity trends likely to deteriorate, this offers the region’s economies some protection in 2007.

“The New Star Pacific Growth Unit Trust was positioned for the US economic growth slowdown and benefited from being underweight in North East Asia. The fortunes of these markets are more closely linked to global economic growth trends and, while performing well earlier in 2006, may be more subdued in early 2007.

“In contrast, South East Asian markets, which are more interest rate sensitive, have benefited from the pause in US monetary tightening and remain attractive. Chinese economic growth remains high and the fund’s infrastructure holdings stand to benefit further, with increased government spending planned for 2007. Domestic demand is healthy, benefiting companies such as China Mobile, whose subscriber numbers are growing strongly.

“The property sector is buoyant across much of South East Asia, with property cheap relative to wages. This is a product of urbanisation and offers attractive growth opportunities, notably in China, Hong Kong and Singapore. A strengthening housing market will not only help Asian property stocks but should also benefit financial stocks in general.

“Vietnam continues to offer exciting opportunities even after excellent gains recently. The economy has grown rapidly and is one of the few genuine competitors to China, offering cheaper labour and competitiveness on other costs. Long-term prospects are positive, with foreign investment likely to increase further in 2007.”