Rising rates threaten to derail growth

Even before Israel and Lebanon started lobbing rocket grenades at each other, the stock market was not short of reasons to be nervous: earnings, inflation, interest rates, leverage, oil prices - the list went on and on. Now that Middle East tension has been added to the mix, the next few months are likely to be difficult for investors.

Take the outlook for company earnings, one of the most important determinants of the market's direction. According to Robert Parkes, a strategist at HSBC, last year was the best on record for UK corporate profits since records began 40 years ago. Our own economy may not look too bad - although it is worth remaining wary of companies that are heavily dependent on consumer spending until our debt mountain has been further eroded - but elsewhere the outlook is less certain.

In the United States, interest rates have risen 17 times to their highest level in five years, with the specific aim of slowing growth and choking off inflationary pressure. The risk is that the rises will go too far, too fast: Simon Ward, global strategist at New Star, puts the risk of a US recession at about 20 per cent - but he says that risk will rise sharply if Federal Reserve chief Ben Bernanke listens to those who warn that more rises are needed to cure the inflationary pressure building up in the economy. 'It is important that he stops [increasing rates] soon,' said Ward.

Japan, too, has just raised interest rates to 0.25 per cent, ending six years of zero rates, and while there are clear signs that its economy has finally turned the corner, there are risks that the latest rate rise - particularly if it is quickly followed by others - will derail the recovery.

British companies are international - about half the profits on the UK stock market are generated overseas, so their earnings are likely to be affected by a slowdown in the rest of the world - and if the US does tip into recession, it would be bad news for investors everywhere. It is, therefore, no surprise that many economic commentators expect earnings growth to slow. Tony Dolphin, director of economics and strategy at Henderson Global Investors, for example, thinks predictions of an 11 per cent rise in global earnings next year are too optimistic and that they could end up being little more than half that; Bob Doll of Merrill Lynch thinks even this year's estimates are too high.

Of course investors look forward, rather than back, so some slowdown in earnings has already been factored in, particularly after the recent falls. But if the oil price stays high - or, worse, rises still further because of the conflict in the Middle East - inflationary pressure, which has so far been mitigated by rising unemployment and therefore low wage inflation, could start to bite. High oil prices would also add yet more pressure to the gas-guzzling US economy.

Edward Bonham Carter, joint chief executive of Jupiter Asset Management, expects the 'grumpy behaviour' of the stock market to persist, pointing out that such a correction was inevitable after three strong years. He does not believe this is the start of a long-term bear market, but cautions that investors should be seeking out those companies which can offer 'genuine' growth now that the economy looks likely to be slowing.

New Star's research on three previous bull markets bears out the prediction that this is a correction rather than anything more fundamental. But, while the historic charts would suggest that the market should quickly race back to its previous peak of 6,900, Ward is more cautious, reckoning that a rally to about 6,000 is the best that can be expected in the near term.

Given the market uncertainty, there should be no rush to invest. Private investors would do better to wait until the autumn, when the City returns from holiday and the trend in the market should be clearer.

Who let the investment 'dogs' out?

Over the last three years, the FTSE 100 index has risen by almost two thirds and, unusually for shares, virtually every sector and size of company has done spectacularly well. It takes a very special kind of manager to do badly in such benign investment conditions.

However, there is no shortage of such specialists around. Bestinvest's annual Dog survey, which picks out the funds that have lagged behind their benchmarks for each of the last three years, found that 52 funds did just that, up from 38 in the previous survey, accounting for £8.6bn of funds under management.

Worse, some of the survey's stalwarts seem to be unable - or is that unwilling? - to do anything to improve their performance. Take M&G: almost 15 per cent of its funds are classified as 'dogs', including its 'flagship' £2.2bn Prudential UK Growth fund, which has turned £100 into £149 over three years, £17 worse than simply investing in the index. An indexed fund would have been far cheaper: Best's Justin Modray calculates that its 1.5 per cent annual management charge means investors are paying £33m a year for the fund, three times what an indexed fund would charge.

M&G is by no means the worst culprit: Canada Life has a staggering 42 per cent of its funds in the Dog survey, while 37 per cent of First State's and 24 per cent of Henderson's qualify. That illustrates that management changes are not necessarily a cure: Canada Life actually caused the problem by appointing Mark Bon and Paul Jay to its Growth fund in 2003. Best's Manager Record Analysis index indicates that there would be only a one in 1,000 chance that they could achieve this feat through simple bad luck.

Sometimes, previously good managers become 'dogs' because of a wrong call, as happened to First State's Angus Tulloch. His Global Emerging Markets fund qualifies as a 'dog' because he was cautious on the asset class as it enjoyed a spectacular bull run. Best's Dogs report underlines that it is rarely sensible to buy a poor performer in the hope it will get better. It also pays to review your portfolio to evict the 'dogs' - or buy a multi-manager fund to do the work for you.