Although at times it seemed otherwise, 2004 was a pretty good year for UK equities with a total return from the AllShare index of 12.3%. This performance was largely due to the market’s defensive qualities with a broad spread of international companies (including oil, mining and tobacco) finding favour. Economic growth also remained robust, albeit slower than 2003.

Interest rates seem to have peaked. The minutes from the latest meeting of the Bank of England MPC showed unanimity for keeping interest rates unchanged but at the same time expressed a more dovish tone than for a while. If the next interest rate move is down then UK equities with a yield of 3.2% look attractive. From an international perspective the UK is a defensive market and relative performance should receive a boost for this reason.

UK companies are continuing to generate significant amounts of surplus cash and shareholders are asking how this will be spent. There are two options – acquisitions or distribution. Given a lack of opportunities it seems more likely that companies will focus on returning value to shareholders by buying back shares or increasing dividends. This is positive and a key reason why we think that equities will outperform bonds in 2005.

Although generally upbeat we end on a more cautious note. The housing market is showing signs of a correction which is likely to impact on consumption, a key driver of economic activity over the last few years. Most commentators believe there will be a General Election in May. It seems probable that a Labour Government will be re-elected, albeit with a reduced majority, and the main concern is unlikely to be the result itself so much as the consequences. The Chancellor will either have to raise taxes or reduce spending if he is to keep to his ‘golden rule’.

The high dividend yield remains attractive and equities offer a better potential return than bonds. But the uncertainty of the election means that as we move into 2005 we have lowered our UK target weighting to neutral, from 57% to 55%.