Market view

February was not a bad month for the blue chips but the real fun was to be enjoyed among the small caps and especially on AIM. The FTSE 100 Index ended 2nd March at 4,540.11, a gain on the month of 3.62 per cent.

Cracking results from BAe Systems led defence stocks higher while commodity prices hitting multi-year highs across the board meant that the mining bonanza continued. A poor showing from two FTSE heavyweight sectors, pharmaceuticals and banks, was in both cases down to a somewhat mixed set of full-year results. And that restrained the blue-chip index.

Without any heavy exposure to banking or pharmaceuticals the FTSE 250 Index was rather more interesting, gaining 4.89 per cent on the month to close at 6,353.62. With its heavy weightings bias towards banks, oils and pharmaceuticals the FTSE 100 is in many ways far less representative of the general state of health of UK Plc than the FTSE 250.

The FTSE Small Cap Index gained 3.77 per cent on the month to close at 2,715.62 but once again the star performer was the punter’s paradise – AIM. Not a day seems to go by without AIM enjoying yet another IPO and the FTSE AIM Index ended 2nd March at 935.4, a gain on the month of 5.13 per cent. Among the juniors, mining and – oddly enough – technology stocks as well as the speculative shells and recovery plays continue to lead the charge. The small investor’s appetite for risk seems to be insatiable.

Base rates
In the new-look economics A-level everyone has to pass, so our first question this year will be “Can US base rates stay at 40 year lows forever?” To make it really easy this is multiple choice: ‘A’ equals YES and ‘B’ equals NO. Quite amazingly it appears that a good percentage of investors, especially in America, would still somehow contrive to fail even this test. The answer, by the way, is ‘B’.

It thus came as something of a shock to many that with the American economic recovery gathering strength and even the jobless numbers starting to fall (there had been talk from Democratic Presidential hopeful and superbore John Kerry and others of a ‘jobless recovery’) that base rate increases moved onto the agenda. Even the ultra-cautious Federal Reserve chairman Alan Greenspan hinted that at some stage base rates would have to increase, from 1 per cent.

Why does this matter? For starters it has stopped the dollar sliding. Since the weaker greenback has been one of the main drivers behind US corporate earnings growth – certainly among exporters – this might just curb some of the wilder expectations of analysts when it comes to future earnings growth. And secondly, one of the reasons that the Nasdaq has powered up to trade on a forward price earnings ratio of 34 (higher if one accounts for options in a conservative manner) is that equities appear to be the safest home for your money. If one views equities as fully valued or even over-valued, suddenly moving your assets into the bank starts to look a bit more attractive if the yield on bank deposits starts to pick up.

And finally, increased base rates might both curb the ongoing consumer spendfest and perhaps also deter some corporates from over-borrowing for acquisitions. M&A activity is also back on the agenda at present.

Corporate confidence
In the UK base rates were maintained at 4 per cent in March but few believe that they will stay there for long. One of the checks on the monetary hawks is that sterling has been strong enough to pinch exporters. Whilst the hawks might worry about house price inflation and consumer debt – both of which are clearly running at unsustainable levels – there is no desire to squeeze exporters in a way that might threaten the recovery in corporate confidence. But if US base rates are increased that might well allow UK rates to rise without pushing sterling too much higher.

If UK base rates are 4 per cent one wonders whether on a yield of around 3.5 per cent the FTSE 100 really offers that attractive a home for one’s money? With the ISA season in full swing you are no doubt bombarded, as am I, by fund managers pointing to how equities have soared over the past year (best not mention 2000-2002) and the implication is that there is more of the same to come.

But with the FTSE 100 on a forward PE of around 16 it seems pretty evident that quite a lot of good news is already in the price. The earnings season that has just been completed showed that – as a whole – UK plc was optimistic that 2004 would show another year of recovery. However, base rates are rising, fuel prices are rising (crude now trades at $32 a barrel), wage and associated costs such as National Insurance are rising and commodity prices have soared. And there is no evidence that, across the board, all of these cost prices can be passed on to end-users.

As such it is not implausible to suggest that while UK plc may see decent sales growth this year, as whole there will be significant margin squeezes suffered by some. Whilst others (perhaps the consumer-related stocks) might struggle even to increase sales should interest rate increases really bite. I remain to be convinced that as a whole UK plc will show earnings growth of much more than high single figures during 2004 and on that basis it is hard to argue that equities offer extremely good value. Meanwhile, if Wall Street takes a tumble then the knock on effects will be obvious.

Of course there is selective value. As a stock picker by profession you would not expect me to argue otherwise. Whilst the strong rally among small and mid-caps has left some stocks looking more than fully valued some have been left behind. And so this is not a time when I am preparing to head for the hills with my cans of baked beans. But equally I am in no rush to buy one of the many FTSE Tracker ISAs that I am being offered either.