Inflation replaces credit crunch as great threat

In the year since he assumed management of the Santander UK Growth Fund on 16 July 2007, Richard Moore has delivered top quartile performance and the fund is ranked 59 out of 326 in the UK All Companies sector.

Richard uses a hybrid investment process based on the economic cycle. In bearish or uncertain markets, he adopts a top down sector approach, since all stocks in affected sectors such as consumer cyclicals can be subject to contagion. When markets recover, the fund takes a bottom up approach based on fundamental analysis to identify strong companies whose stocks have been undervalued.

Richard gives his views of the markets and the changes he has made to his portfolio.

"When I took over management of the fund in July 2007, I rebalanced the portfolio into more defensive positions and adopted a top down investment process based on the macroeconomic and sector outlook. I therefore reduced exposure to banks and consumer cylicals and moved into tobacco, telecommunications and pharmaceuticals.

"As a result, the fund was well positioned for the credit crunch on 12 August 2007 and the fund has remained defensive since. I started 2008 with a relatively cautious view due to the continued risk of recession in the US. Although a state of recession has not been confirmed, it is now not so much a question of whether the US market will experience a downturn but how long this downturn will last and how deep it will be.

"The UK economy appears to be more resilient, but the credit crunch and deteriorating outlook for consumer expenditure will continue to undermine the market. Inflation has now replaced the credit crunch as the key factor in determining market prospects, and this remains driven by the oil price.

"A high oil price will mean reduced consumer consumption, lower corporate profit margins and more hawkish central bank policy. Whilst the slowdown may be discounted in equity prices there is unlikely to be a sustainable recovery whilst inflationary risks remain.

"Equities are now trading at comparable levels to the trough of the 1990-1992 recession. The FTSE 100 is trading at P/Es or 10.5, against a trough of 10.4 in 1991, while bank stocks are trading at P/Es of 5.4 against a long term sector average of 12.

"This has lead to a short term rally in heavily oversold stock but we believe that the oil price will remain high, and this will remain critical to any future stock market rally.

"We are therefore remaining defensive and underweight in cylical sectors, and in smaller companies, highly leveraged companies or those showing balance sheet weakness. First half profit reports - due to be announced later this summer - will give a clearer indication of the impact of inflation on corporate earnings. In the meantime, we expect markets to trade sideways to downwards."