Threadneedle: impact of sustained market volatility

Rebecca Chesworth, Threadneedle UK Equity Investment Specialist comments: "The last three months have seen the worst quarterly return for UK Equities for almost six years. Since the start of the year, the FT All-Share has fallen by 11% (10% including dividends), in a background of continued unwinding of leverage.

Intra-day lows were reached on 21st January, when the significant nervousness in financial markets prompted an emergency cut in rates by the Fed. Much of the quarter was spooked by credit markets, which priced in default rates double those of peaks in previous recessions. Towards the end of the quarter, the market swung wildly on the near collapse of Bear Sterns, and the ensuing rescue offer. The Fed's action since then has signalled its intention to prevent failure of a major institution and helped steady the credit markets.

The FTSE 250 index has continued the out-performance seen since mid-January. In sector terms, the biggest falls have been in consumer services (retail and leisure) and telecommunications. Mining, oil services and industrials and real estate have held up relatively well.

Earnings forecasts have been surprisingly resilient, and company management are still upbeat (albeit admitting that visibility is short). Results announced in Q1 showed some deterioration, but there were still more companies beating than missing forecasts. Despite the large earnings downgrades to banks, estimates have not fallen in aggregate because of the strong demand for commodities which continues to boost mining profits.

The weakness of sterling against the Euro, and some reversal of the trend against the dollar, has been another feature. This should support exporters but will negatively impact the translation of overseas earnings. Sterling's weakness added to the pressures on inflation, with world food prices taking over from utility bills as the primary cause of concern for consumers.

Are we over the worst?

The nervousness over the last few weeks shows that the sub-prime saga is far from over. We can expect rumours on the health of investment banks and hedge funds to continue, and corporate defaults to rise. The market's focus will continue to be on leverage in all its guises, with banks, companies and consumers all facing much higher financing costs and tighter credit despite the cuts in central bank rates.

We have not identified the turning point yet, but are certainly looking for it. Meanwhile, we remain positive over the longer term, seeing support from attractive valuations, particularly dividend yields, and the financial health of UK plc. We expect the return of M&A and more activity from the Sovereign Wealth Funds. And we believe in the sustainability of growth in Asia and emerging markets which offers a growing source of revenue for some UK companies.

How have funds been positioned?

Whilst risk appetite remains low and the markets volatile, we are comfortable with Threadneedle funds defensive stance. Nevertheless, whilst we have not seen the end of the global credit crunch, things may not continue to get much worse, and we don't wish to ignore a likely recovery in the market later this year. For this reason we are selectively looking for value opportunities, particularly where the stocks are early cycle or interest-rate sensitive.

The main sector overweights, food retail, tobacco, utilities and defence show our preference for visible, sustainable growth. The large underweight positions; beverages and food producers, are in expensive, defensive sectors which are suffering challenges to their profitability, or areas reliant on the UK consumer, such as general retail and banks.

Within mining, we are happy that forecast momentum is strong on the back of rising base metal prices and low stock levels; however we are uncertain of the impact of US slowdown on demand. Some funds have been taking profits.

UK funds remain underweight in banks, concerned by the deteriorating revenue outlook and the continuing write downs of financial assets. However we are also mindful of the sector's extreme volatility and its impact on short term performance and do not wish to be too underweight. The team favours the banks with secure balance sheets and long-term growth prospects, such as Standard Chartered and HSBC, and is staying clear of those that could have funding problems of need equity issuance, such as HBOS and RBS.