Equities Remain Relatively Cheap

With all asset prices having been inflated substantially since 2002, nothing looks exceptionally cheap on an absolute basis. However, equities appear to be inexpensive compared with other asset classes.

If one takes a model of U.S. equities as representative of broader global markets (not strictly true but the data is relatively transparent) we can compare the S&P 500 versus a basket of competing assets such as bonds, gold, commodities and real estate. Currently, the message from the model is unambiguous: equities are at their cheapest relative level in years, despite the bull market (in absolute terms) since 2002. BCA’s indicators show a similar picture for equity markets in most other regions, which is consistent with earnings yields remaining well above bond yields across the globe. Bottom line: While nervous share investors cling to a Wall of Worry, they can be comforted that global equities still offer better value than other assets.

Encouraging UK GDP growth figures

February's UK CIPS Report on services suggests that growth in the services sector has picked up. The main business activity index rose from 57.0 to 58.9, its highest in 2 years. While business expectations slipped, this reversed just part of January's sharp rise. On the face of it, the business activity index points to quarterly rises in the official measure of services GDP of some 1.1% or so.

Remember, however, that the survey does not cover the retail sector. With the drop in retail sales in January pointing to renewed weakness in sales growth in Q1, the survey could once again be overstating the strength of the sector relative to the official data. Bottom line: At face value, the rises seen in all 3 of the services, manufacturing (see below) and construction PMIs this week points to GDP growth remaining relatively strong in Q1.

U.K. manufacturing slows, but..

While The U.K. manufacturing sector grew, it was at a slower rate than expected with both domestic and foreign orders falling back sharply. However, importantly the PMI figures remain above the critical 50 boom/bust level. These numbers do not materially increase the likelihood of a Bank of England  rate cut on 9th March.

The MPC has some room to manoeuvre but its main concern is whether the housing market again will become dangerously speculative and bubble like after a year long reprieve. At the moment the persistence of strong housing demand is putting a floor under house price inflation and we can expect the consumer to respond albeit with a bit of a lag. Moreover, stronger continental European data also limits the downside risks for the U.K. economy. The MPC has never changed interest rates in March and does not look likely to break that habit. However, despite recent encouraging data, there is still a question mark over the strength of the recovery in the consumer sector and inflation is back below its target. Bottom line: Expect a modest loosening of UK monetary policy later in the year.

By contrast with the ECB there are upside risks for rates

Yesterday’s European Central Bank’s rate hike to 2.5% was fully anticipated and had little impact on European capital markets. The focus now shifts to economic data to time the next rate hike.

This could be sooner rather than later because economic surprises will remain positive, based on the message from most leading economic indicators. The ECB's upward-revised growth forecasts for 2006 (1.7%- 2.5%) are less optimistic than many projections. Core inflation remains low at 1.3% but the ECB is focused on headline inflation, property prices and money growth, all of which are strong. The ECB is also concerned about the impact of second-round effects, with the risk that high oil prices will boost wage demands. Bottom line: The ECB will raise rates by more than currently expected. Expect a 3.25% refi rate by year-end against a backdrop of real economic growth near 3% 

BT bought by Private Equity……not such a crazy idea! 

The story in the white Times this morning that private equity firms are looking at BT has led the market to wake up to the fact that BT is a prime candidate for one of the mega-deals that private equity firms are now looking to do. This may turn out to be just a bit of market tittle-tattle, but neither BT's size nor its pension fund deficit would necessarily be a barrier to a private equity takeover. And remember, that unlike most of Europe's other incumbent telcos, BT has no State involvement, not even a golden share.  

How do the numbers stack up? A standalone valuation of BT's cashflows is perhaps 233p (current price 217p up 9p this morning). Private equity could pay significantly above that because they would have a clean slate with which to restructure BT and improve its value above our standalone scenario: 

What you do to BT if you are a private equity fund? Williams de Broe suggest:

1. Separate BT Global Services. This great business could be: a) sold to France Telecom, Deutsche Telekom or Telefonica (b) IPO'd.

2. The UK business could then be fully split into wholesale and retail. The Retail business could be IPO'd at some point in the future, but in the meantime could have its costs cut much faster than BT's incumbent management feels able to do.

3. The rump UK wholesale business could have costs cut savagely. The 21CN network rebuild would be completed, but slowed down. The free cash flow yield on this for the private equity buyer would be massive. 

Stay tuned! 

And finally……………… 

The UK’s first case of bird flu

HAVE A GREAT WEEKEND!

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.