Scott banks on a hard landing but not a full recession

As equity markets continue to reel from the fall-out of the credit crisis, with banks among the worst hit, Ted Scott, manager of the top performing F&C UK Growth & Income Fund warns that the US economy is headed for a hard landing.

"There has been a distinct feeling of panic in the market over the last few days. Investors hate uncertainty," explained Scott.

"The repercussions of the credit crisis will rumble for many more months but the misplaced optimism of October when stocks rallied has now been replaced by extreme pessimism as the market assumes the worst."

Scott's view has long been that the market has been too complacent on the economic outlook for the US and other G7 countries. He believes that a hard landing, but not a recession, is the most likely outcome.

"The risks of a recession have increased but both the UK and the US economies are still growing at a reasonable rate. We're a long way from the two quarters successive negative growth that qualifies as a recession." He added that "the US consumer has so far remained resilient despite the collapse in the housing market and the key to avoiding recession, as it is in the UK, is whether unemployment increases significantly. I believe jobs data will weaken and consumer spending will fall as a result but not sufficiently to cause recession. His conclusion is partly based on his belief that the US Federal Reserve and Bank of England Monetary Policy Committee both have a lot of scope to lower interest rates in response to a softening economy.

In the UK interest rates have yet to be lowered despite the credit crisis and the collapse of Northern Rock.

He points out that a key feature of the market since the credit crisis broke has been the polarisation of performance in the market.

"Decoupling has become a buzz word. Emerging markets and companies with exposure to them have massively outperformed domestic and cyclical stocks."

"While there is clearly some merit in the argument that emerging markets are in the midst of an industrial revolution there is no doubt in my mind that if the US and other G7 countries have a hard landing, or worse, then growth in emerging markets will be affected."

"The inexorable rise of some emerging markets has been driven by liquidity with little heed to fundamentals. For the UK, many stocks with emerging market exposure have reflected this flight of capital and in my view will be vulnerable to sharp sell off."

Partly for this reason Scott's F&C UK Growth & Income Fund has avoided the mining sector and other stocks, such as SAB Miller and Standard Chartered bank, which have been re-rated because of their emerging market exposure. Scott adds that "one of the key decisions for fund managers over the next few months, especially income funds, is what exposure to have to the financial sector. Banks still represent about 15% of the UK market but they have been in freefall for much of the last few months. There is no doubt they are discounting a lot of bad news, perhaps even dividend cuts and rights issues in some cases. I have therefore gradually been adding exposure, reducing a long-standing underweight."

"Our analysis of PE ratios on banks suggests profits will be downgraded by at least 40%. The yield relative to the market for most banks is higher than the levels when the UK last had a full-on recession in the early 1990s. The exceptions are the Asian banks, HSBC and Standard Chartered, which have performed much better reflecting the emerging market exposure.

"As we believe that emerging markets are vulnerable and there is much better value in domestic banks, purchases have been concentrated on them. If the sector turns we believe these banks are the ones that will perform. We are now just under market weighted in the domestic banks," he said.