Potential two year recession ahead

As we near the end of a bumpy Q2 that saw a strong rally in equity markets only to falter with sharp losses among UK house-builders, financials and retailers, Ted Scott, manager of the F&C UK Growth & Income Fund, says the second half of the year is likely to be equally volatile.

With the slowdown gathering pace and rising inflation limiting options for further rates cuts, Scott believes it could take up to two years for the UK economy to really recover. "Usually recessions last around 18 months and we haven't entered into recessionary territory yet."

Scott explained that the combination of economic slowdown and higher inflation - or stagflation - is "deadly" for equity markets.

"The reason why equity markets did quite well in the 1980s and 1990s was that the economy was pretty stable, showing steady growth and low inflation. Bond markets are now effectively saying that they expect inflation to go up to 3.5 or 4% and that's bad news for equities because it affects ratings."

He added: "The rally in equities that followed the rescue of Bear Stearns is typical of a bear market. People saw the bailout of the US bank as a turning point in the credit crisis and markets went up around 14%, but there was no substance to it. The credit crunch is spreading out into the wider economy and the outlook for equities will remain challenging."

Under the current environment, Scott has been increasing exposure to more defensive large cap stocks - mainly utilities, telecoms and pharmaceuticals - which now represent 35% of the portfolio. Utilities, for instance, account for 14% of the F&C UK Growth & Income Fund, nearly four times more than the sector's All Share Index weight.