Market view

Trading volumes were not massive in August but they never are. But they were more than respectable given the time of year, and the mood in the City was upbeat. The FTSE 100 Index advanced by 2.43 per cent between 1st August and 28th August to hit 4,197.97. The move should have been greater but a couple of sectors with disproportionately high FTSE 100 weightings (banks and telecoms) barely budged. The former’s reporting season was unexciting. The latter is yet to convince anyone that 3G won’t be a bit of a disaster.

The best performing sectors were steel (that one horse town called Corus is pulling further and further away from meltdown), IT Hardware (thanks to very sparky corporate numbers in the US) and the cyclicals (such as autos and mining), which surged on a growing feeling that the US economy is starting to rev up.

The FTSE 250 Index has much lower exposure to banks and almost no exposure to the telecoms sector and so its advance was more impressive than that of the blue-chip Index. It added 4.2 per cent on the month to end 8 August at 5,569.64.

However the real story was, once again, small caps. For the most illiquid stocks all that really matters is confidence and confidence has re-entered the building, holding hands with greed. And that means that small caps are continuing to set the pace. The FTSE Small Cap Index advanced by 5.53 per cent to hit 2,398.5 on 28th August while the AIM Index closed the same day at 728.74 – a 7.2 per cent gain on the month.

Deflation hoax
It is the job of economic experts to make big calls. And just occasionally we all make a call that proves wrong. Six months ago more or less every expert was predicting that the big threat to the global economy was deflation – i.e. the sort of perpetually falling prices suffered by Japan. And, almost to a man, the experts urged Central bankers and Governments to take concerted action to prevent the Western economies from all going Japanese.

Today deflation is yesterday’s scare story. Indeed our old friend inflation has been recast as the bogeyman with a sharp rise in the price of gold evidence that at least some investors take this threat quite seriously.

The economic data published in recent weeks has – as ever – not sent an entirely clear signal. The massive monetary and fiscal pump priming of the Western economies does seem to be paying off in the US. Most economic data in North America points to increasing business confidence and, at least, stable consumer confidence. Moreover, on balance, the recent Q2 corporate earnings season showed most companies not only hitting (or in a good number of cases surpassing) their earnings targets but also a very good number of accompanying upbeat trading statements. And the good vibes came across all sectors.

Meanwhile there are signs that after 14 years of gloom the Japanese economy is starting to show the first green shoots of recovery - although at this stage they are very much bonsai shoots.

The debt burden
In the UK there is evidence of an uptick in corporate confidence and our own results season has been pretty upbeat. Having said that there are concerns in the UK both about high – and unsustainable - levels of consumer debt and also about Government spending which is clearly completely out of control and the huge tax rises which this has already resulted in and will result in over the next few years.

In that sense the UK is moving closer to Euroland where years of implementing the sort of crazy economic and social policies advocated by the Guardian newspaper have left Germany and much of the rest of the Eurozone in a severe recession with dole queues of near Weimar proportions.

However if the great engine of global growth that is the US economy (coincidentally a country whose economic policies have been consistently attacked by the Guardian newspaper) really gets moving that will drag Europe along on its coat tails. It is unlikely that the UK (and to an even greater extent Euroland) can match the sort of economic growth that the US can deliver but we should at least see some growth.

The big question is whether the stock market rally seen since March of this year (which is now almost 25 per cent in the UK) discounts an economic recovery – and hence increased corporate earnings – in 2004 and 2005. At its current level the FTSE 100 already trades on an historic price earnings ratio of 17 which – unless earnings growth is going to be dramatic – can hardly be described as a bargain basement level.

Ultimately the level of earnings growth does bear a correlation to overall GDP growth and in the UK there are good reasons why this growth will not be that exciting. The high levels of debt, both corporate and personal, must act as a drag on growth since if companies (or individuals) do experience any increase in earnings the prudent policy must be to use that extra cash to repair balance sheets rather than invest in new plant (or make consumer purchases) or pay extra dividends. Whilst there is no evidence that consumers will be anything other than reckless, UK plc is likely to show some prudence.

Moreover the state of the Government’s finances is poor. At some stage during the next 36 months the Government will have to either cut its spending (unlikely) or increase taxes – yet again - quite sharply (very likely). That is not going to encourage greater consumer or corporate spending nor will it help corporate earnings (i.e. post-tax profits) growth.

Investment analysts – like economic experts –don’t always get it right. When it comes to corporate earnings their tendency in recent years has been to be over-optimistic. And with this caveat it is worth noting that most analysts do not expect UK corporate earnings growth in 2004 and 2005 to get anywhere above low double-digits. Indeed many are more cautious than that. And on that basis whilst the current rating of the market is not outrageously high, it is not the sort of rating that screams out “we are at base camp preparing for the next bull market.”

FTSE 100