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02 July 2007

Investors worry over inflation rates for second consecutive summer

It looks like it may be a case of déjà vu this summer with stock market investors increasingly worried about inflation and the knock-on effect on interest rates.

Last year the UK equity market fell almost 10% on these worries before accelerating strongly to finish at a multi- year high.

It is not only a UK problem, as US economists have recently abandoned their expectations of rate cuts this year.

This monetary tightening theme continues globally, providing a major headwind to equities and bonds.

The bond markets have already reacted very negatively to these concerns with the UK 10-year bond yield rising from 4.5% to close on 5.5%.

Surprisingly, at the time of writing, the equity market seems to have shrugged-off these concerns, remaining close to its four year high.

However the impact can be witnessed at sector level with the interest rate-sensitive and highly rated growth stocks being particularly poor performers.

The equity market is not out of the woods just yet, as inflation expectations remain high.

The core CPI measure of inflation is currently trending down from the high of 3.1% in March due to the impact of falling energy prices.

Although the MPC is expected to raise interest rates again, we feel that inflation could continue to fall as wage and employment growth remain weak and there are signs of past rate increases now slowing economic activity.

This is most evident in retail spending and housing demand.

We anticipate GDP growth 2.5% this year and 2.3% next, suggesting a slower but robust outlook.

This, together with the overall strength of global economic activity should be positive for aggregate earnings growth.

While UK equity market investors tussle with the threat of inflation at home and abroad, the main driver of the market’s direction will be liquidity and M&A activity.

Corporate balance sheets are strong and many boards have responded to shareholders’ demands for improved efficiency and the return of excess cash. At the same time private equity funds still have large cash piles to invest.

These broad liquidity sources should continue to provide significant support to the market.

As long as inflation looks like coming under control, the rest of 2007 should shape up to be as good as last year. Market valuations are not particularly challenging and consensus estimates are more realistic.

However with uncertainties persisting in the short term, particularly from overseas, it could be a long summer.

Bull Points

• Strong Global Economy
• Liquidity and M&A activity

Bear Points

• Inflation an interest rate risk
• Bond markets

Hugh Duff
Senior Investment Manager, UK Equities
The Scottish Investment Trust PLC

Published in Investment Week

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