Market View

May was not a good month for equities. In the Middle East the political situation deteriorated once more. And this was at least partially responsible for pushing oil up to a 21-year high – Brent crude topping $39 a barrel. Corporate news was mixed with a bid for M&S but profits warnings as well – Emap and Rentokil being prominent sinners in that regard. And the Bank of England appeared to be taking an increasingly hawkish view on interest rates.

The FTSE 100 closed the month down by 2.56 per cent at 4,430.7. With BP, Shell and BG group accounting for more than a fifth of the Footsie by weighting and enjoying a decent month (thanks to crude prices) the headline figure actually looks rather better than the underlying picture. The FTSE 250 index (with no big oil component) ended down by 2.81 per cent at 6,053.6.

Thanks to bid action at M&S and bid speculation at MFI and Matalan, General Retailers were the best stocks to be in, gaining 5.3 per cent on the month. Decent results from British Land and Land Securities helped Real Estate gain 1.9 per cent, but weak numbers from Vodafone and a flight to safety and away from growth saw TMT stocks on the back foot.
That flight to safety also saw small-cap stocks take something of a beating: the FTSE AIM index lost 3.3 per cent on the month (it would have been worse but for AIM’s heavy exposure to mining stocks – a sector that rallied in May), while the FTSE Small Cap index (with much less mining exposure) fell by 4.5 per cent.

Inflationary pressures
Is a high crude price inflationary? In the US the consensus is that it is not; in the UK the consensus is that it is. Thus the sharp spike in oil prices was seen as a sign that the Federal Reserve might take a more dovish view on base rates than had previously been thought: the dollar weakened and US equities trod water in May.

Back in the UK it is obvious that large sections of the chattering classes were terribly scarred by the 1970s. Not by having to wear flares and having to listen to Brotherhood of Man and Leo Sayer but by inflation. In the US the bogeyman is always deflation (the trauma of the Great Depression still haunts policymakers). Here any sign of strength in house prices or an increase in petrol prices is seen as a sign that the MPC must hike rates.

I am sure that the chattering classes have – as ever – got it wrong. In the 70s there was already inflation before oil prices started to rise, thanks to the economic incompetence of the sterling devaluers and deficit budgeters Wilson and Heath. Thus, faced with higher fuel costs, companies were able to pass those costs on to customers. Meanwhile, organised labour was so strong that in order to ‘protect the brothers’ wage inflation became an issue.

Times have changed. Bob Crow and his bone-idle comrades on the railways are now more or less the only trade union with any power, so the workers are in no position to demand higher wages to offset soaring petrol prices. And after years of low inflation (thanks to the relatively prudent fiscal stance adopted by Britain from 1979) the British public has simply become resistant to companies passing on price increases. Higher oil prices in 2004 act in the same way as a tax increase – to reduce the level of personal disposable income – and thus, whilst higher petrol prices might cause a brief inflationary blip, the basic effect of crude heading north is to be deflationary.

Thus, assuming that crude stays trading in a $33–38 range for most of this year – and given the constraints on OPEC production, not to mention the potential for wildcard events in the Middle East, that does not seem unreasonable – that should reduce the need for base rate rises across the Occidental world. That is not to say that higher crude prices are a good thing for equities or a good thing per se. For some companies (airlines and chemical manufacturers are prime examples) oil and oil products form a very high percentage of total costs and so, given their limited pricing power, the earnings outlook must be bleak. As I write, EasyJet has served up yet another warning that says as much.

So where does this leave UK equities? The profits warning from Rentokil was a shock. It was also atypical in its magnitude. Most of the companies issuing warnings – including Emap – still expect to increase their earnings over the next 12 months but just not by as much as had been expected. And the vast majority of companies issuing trading statements or results still appear to be on track to, at least, meet expectations. Forecast upgrades still outnumber forecast downgrades quite significantly.

However, with the FTSE 100 still on a prospective price-earnings ratio of around 17, one might argue that such a preponderance of upgrades is very much needed in order to justify even current levels. It is not as if equities look especially expensive when compared to other asset classes (notably housing and bonds). In fact if anything equities look marginally better value by historic standards. It is just that, as a universe, it is hard to argue that equities offer compelling value.

As a bear, one can make a plausible case that any huge external shock (the House of Saud falling and oil spiking up to $60?) could leave equities very vulnerable indeed.

The best a bull can argue is that the second year of a bull market often sees a period of consolidation but that as companies start to deliver on the earnings growth projected for the next 12 months, investors will start to look ahead to another year of earnings growth and that it is at that stage that value will appear. Neither case is especially compelling: there is no great rush to buy, but equally the case for “selling in May and going away” looks pretty weak as well.

Tom Winnifrith runs the free-to- register share tip and market report service www.UK-Analyst.com