Market pain will continue as 'earnings bubble' is set to burst

The current turmoil in the markets – which today (16 August) saw the FTSE 100 slip below the key 6000 support barrier - is set to continue, according to one of the UK's top fund managers.

Ted Scott, manager of the F&C UK Growth & Income Fund, the number one ranked equity income fund over the last twelve months, is warning that problems in the financial markets will now spill-over into the real economy.

"The All Share Index has fallen around 10% since mid July, a move of a similar magnitude to the correction in May last year. However, in my view the similarities end there," said Scott.

Unlike the short-lived correction of 2006 which was followed by a sharp rebound in stock prices, Scott believes that current turbulence – prompted by problems in the US mortgage market and exacerbated by debt repackaged into financial instruments - is more serious.

"The focus of this drama has been on credit derivatives, hedge funds and excessive leverage which seem remote to the man on the street. However, I believe that some contagion to the real economy is now inevitable," he explained.

"The consumer, pumped up on cheap credit has kept the economy ticking. But given the record levels of indebtedness, consumers will now wish to rebuild their savings, particularly if unemployment starts to rise."

Scott points out that because consumption accounts for around 70% of UK GDP, a reigning in of debt will inevitably impact company profits and earnings.

"This is not yet factored into market expectations which still discount a soft landing 'Goldilocks' scenario," he said.

Acknowledging that although the interest rate cycle may be at the peak, Scott believes that the dramatic drop in inflation revealed this week by the Bank of England, does not mean the dragon of inflation has been thwarted.

"There were some 'one-off' factors in the latest inflation figures, such as the heavy discounting of food prices because of the unusually bad weather. It is too bold a call to assume inflation is not a problem. The dis-inflationary influence of Asia is waning as recent data reveals that inflation in China was well ahead of expectations," he said.

While Scott presses home the point that he does not believe a recession is on the cards, he stated "my view is that GDP and corporate earnings will disappoint in 2008."

Although many fund managers currently argue that the market is modestly valued, Scott responded that "this is different from 2000 in that we have an earnings bubble, not a PE bubble."

He illustrated the point by explaining that circa 40% of UK market cap is represented by banks, oil and mining stocks, which also represent 50% of earnings. These sectors are however on historically low PE ratios, suggesting they are at earnings peaks and could be set for significant downgrades.

"Beware the valuation trap - the market's modest PE is an illusion," warned Scott, "adjusting for cyclical downgrades, my view is that equities have further to fall before they become attractive again."

Scott has moved the F&C UK Growth & Income Fund to a defensive stance over some time, targeting stocks with stable earnings in areas such as tobacco, telecoms and utilities, as well as companies with defensive but growing earnings, including some support services and technology companies.