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Until the recent technology hiccoughs in the markets, overall prices on the London Stock Exchange were barely changed from a year ago.
Players are watching the Bank of England intently, with some hoping that interest rates have already peaked – a scenario which could give the market enough of a surprise still to kick start it into positive territory.
“There are one or two signs that the rate of growth in the economy is tailing off... so we see the peak in interest rates being not much higher that where we are now,” says Nigel Lanning, director of Dresdner RCM UK. “Base rates of 6.25 to 6.5% could be the peak,” he says and predicts that the market would push higher quite strongly as that fact became discounted.
By the end of this year, the FTSE 100 should be at 7,000 to 7,250, he forecasts. “I wouldn’t underestimate the importance of the interest rate cycle argument – historically interest rates are more important (for markets) than earning expectations,” he says.
Merrill Lynch UK equity strategist Khuram Chawdhry also sees the UK economy weakening: “Economic data and surveys seems to imply that the economy should slow in the second half. But interest rates are nevertheless likely to go up.
“We are starting to see a pick-up in inflationary pressure at the production end. This does not bode well for the market,” he says adding that he sees the FTSE 100 ending the year at around 6,400 – only marginally higher than now.
Max Ward, head of UK equities at Baillie Gifford, agrees that the most worrying factor for the equities market is the prospect of a continuing rise in interest rates. But on the positive side, corporate profits are showing good growth and apart from the technology sector, stocks are trading at a reasonable level of valuation, he says.
He sees the Bank of England pushing base rates up by 50 to 100 basis points this year: “And I don’t think that’s priced into the market.”
But Paul Mortimer-Lee, chief capital markets economist at Paribas, takes a different view. With so many signs of weakness in the economy, he says, there is very little upside for interest rates: “We may see one (rate hike), but forecasts of rates going up to 7% are wide of the mark, because sterling is just too strong to withstand that.”
With the UK ahead of the rest of Europe in the economic cycle, better levels of growth have been coming out of continental companies. Coupled with the fact that Europe has a more plentiful supply of growth stocks than the UK, investors are bound to chose Europe over the UK putting prices under more pressure, says Chawdhry.
The $65,000 question, says Lanning, is which sort of shares are going to lead the way in a rising market: “A large number of shares and sectors have been in a bear market – the shakeout in tech stocks is only a month old.”
But Lanning believes permanent changes are taking place in investor behaviour. Having seen the sharp losses suffered by some stocks in the technology sector, investors will in future be a lot more discerning within that sector. “They will be more concerned about a company’s business model that they have been. The more established and credible technology companies, such as Vodafone, Marconi, ARM Holdings and Baltimore Technology, will win over the weaker ones”, he says.
Investors are likely to look more closely at old economy stocks, either where they are finding ways to adapt to the new economy – Tesco, for example – or where the share is cheap, says Lanning. Shares in brewer Scottish & Newcastle are trading at just eight times earnings, he points out.
Merrill Lynch’s Chawdhry expects cyclical stocks such as mining shares, metal or petrochemicals stocks to see more demand over the next few months. While utilities will be a good defensive haven for investors, gas rather than electricity is the place to be: “Electricity companies are seeing downside pressure because of their (falling) prices, and there are a lot of regulation issues in water.”
Market players are right to keep a close eye on developments in the US markets for clues about the UK. “Markets are very global these days, and if we see downside pressure from the US, then that filters through to the UK,” says Chawdhry, and continuing: “The main danger in the US is that the credit tightening cycle will be greater than expected. US forward money rates already seem to imply higher interest rates are on their way.”
Yields on UK Government bonds will stay relatively low, mainly because of the strong demand for the bonds coupled with the diminishing supply. Paul Mortimer-Lee points out that the minimum funding requirement for pension funds has increased the funds’ desire to hold long-dated gilts, at a time where the government is running a surplus.
The 10-year bond is now yielding less than 5.2% – only 10 basis points more than the Germany equivalent – despite the fact that short-term rates are 2.5% more than in Germany, Mortimer-Lee notes. “And supply is only going to get tighter,” he says. The ongoing auction for the next generation of mobile phone licences is continuing.” This is extra money going into the government’s hands, heightening fears of an even tighter government bond supply.

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