Mergers and acquisitions to lead investment thinking in 2007

Last year was a good one for equities in spite of the May wobble. The forces that supported the equity market remain in place - if weaker - going into 2007.

Many stock market strategists say equity valuations are generally inexpensive and corporate balance sheets remain strong. That may fuel continued merger and acquisition activity by both trade and private equity buyers - a key driver of the stock market in 2006. Here are some of the investment themes to look out for in 2007.

M&A

If M&A is again to be the dominant theme, how best to play it? Citigroup's answer is that mid-cap travel, engineering and support services stocks look particularly susceptible to takeovers. The main risk to this scenario is a significant rise in the cost of borrowing.

Not everyone is optimistic. Philip Isherwood, UK strategist at Dresdner Kleinwort, says the M&A boom will peak in 2007. "This use of cash [in M&A] is a symbol and symptom of a bubble," he says.

Liability-driven

An important theme of 2006, this will continue apace in 2007.

The term describes how UK pension funds are re-working their asset allocation to match the nature of their promises to pay inflation-linked cash sums regularly and over long periods. Because shares are volatile, pension funds have been trying to reduce their exposure to UK equities. They are investing more in alternatives such as fixed income, derivatives, commodities, property, hedge funds, emerging markets, private equity and infrastructure.

Infrastructure

Once regarded as dull, this sector has new-found allure. Investors with large long-term liabilities are drawn by the steady, long-dated, low-risk yield available from utilities and infrastructure assets such as hospitals, toll roads and highways. Such assets sometimes even have government backing.

Investment banks such as Macquarie of Australia are rushing to meet the surge in demand and raise funds - the biggest is Goldman Sachs' new $6.5 billion (€4.9 billion) fund. Yet some investors, such as Investec Asset Management, worry about the hype and point out that these assets are not risk-free. Standard & Poor's recently warned that the sector was a bubble.

De-equitisation

A hideous term used to describe the way equity markets seem to be drying up.

Cheap debt has funded M&A activity and helped private equity expand. It has also encouraged companies - with shareholders' backing - to buy back shares and raise dividends rather than re-invest in expansion.

Overseas interest in buying UK companies is compounding the effect, with more and more companies being taken off the UK stock market. Analysts reckon shrinking equity markets may more than offset declining demand for mainstream equities from big institutional investors and help to boost FTSE share indices next year.

Emerging markets

Asia ranks high among a number of fund management groups' hot tips for 2007.

The notable exception is Legal & General, which is concerned that Asia will suffer the "delayed effects of a second and third quarter US slowdown over the next six months". L&G is also nervous, although "not bearish", about China, which it says "has embarked on a policy of induced slowdown. Import growth has decelerated and construction activity . . . has come off the boil."

Hedge funds

The hedge fund world will increasingly polarise. On the one hand there will be secretive managers who want to run money for a select group of individuals without interference from international regulators; on the other, those who will forgo some of their freedoms if it gives them access to the money of mainstream company or state retirement funds and insurance institutions. The distinction between this latter group and more conventional asset managers of long-only funds is blurring.

Commodities

Fast growth in emerging markets will push up the price of oil, gold and other metals, as well as soft commodities, some investors believe. Others are more wary. Gold is again being tipped by those who point out it benefits when the dollar weakens. Some say it could rise to new highs of more than $700 (€531) an ounce on the back of strong demand from India, China and the Middle East. One of Threadneedle's picks of the year is Lonmin, the platinum producer.

Environment

This is an increasingly hot topic. Standard Life believes environmental issues will shift from the fringes of socially responsible investment into mainstream asset management and corporate behaviour.

Property

UK commercial real estate delivered total returns of 20.6 per cent in 2006 as values continued to rise amid a recovery in rental markets. Offices outperformed retail and industrial property for the first time since 2002. A debate has raged as to whether "yield compression" is sustainable. Is it wise to buy London offices at a yield of 4 per cent, when 6 per cent was normal three years ago? So far, fortune has favoured the brave buyer. But not everyone is comfortable.

Paul Kennedy, head of research at Invesco Real Estate, predicts yields will remain at about their current level. If so, investors should experience reasonable returns, particularly if rents keep rising. But movements in long-term interest rates will be key during 2007.