Issue 74 | October 2009

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Markets running out of steam?

UK Equity Market : FTSE 100 Index – third quarter

Source: Bloomberg
The UK market: Running out of steam?
The FTSE100 index moved sharply lower at the start of September influenced by mixed economic news (positive in the
US and China, but broadly disappointing in the eurozone and UK) and while there are further signs that the global
economy is pulling out of recession there remains uncertainty over the strength of that recovery. Furthermore, there was
a growing feeling amongst investors that the very strong equity markets rally, from their low point last March, could now
be running out of steam. However, a positive reaction to the G20 meeting, where delegates repeated their commitment
to aid a sustained economic recovery, helped by a surprise £10bn approach for Cadbury from the American food group
Kraft, resulted in fresh upward momentum for global equity markets. With positive signs from consumers, and a surge
in buying from from institutional and private investors, fuelled by a flood of government liquity, as confidence grew over
the economic outlook, and poor investment opportunities elsewhere, combined to keep pushing equity markets higher.
This left the FTSE100 index just under the 5200-level, a 12-month high. However, at this point investors became more
cautious, with the combination of greater risk awareness and some profit taking, leading the UK market lower. However,
by the end of the month, and while the trend was gently downwards, investors took comfort from the appearance of
further take-over activity in the US, the FTSE100 index had recorded its best quarterly performance (up 21%) in its 25-
year history leaving it around 47% above last March’s low. Nevertheless, substantial uncertainty remains over the
strength and durability of the global economic recovery, which is likely to see volatile markets conditions over the fourth
quarter, particularly if central bankers commence a programme of withdrawal of the extraordinary stimulus measures
taken to prop up the financial system.

Sector Performance during September 2009

Top 5 % Bottom 5 %
Food Producers + 12.6 Industrial Metals - 8.3
Software & Computer Services + 10.6 Fixed Line Telecommunications - 4.4
Life Insurance/Assurance + 10.3 Leisure Goods - 1.6
Electronic & Electrical Equipment + 9.9 Real Estate - 0.9
Health Care Equipment & Services + 9.0 Construction & Materials - 0.7
Source: FTSE International Limited

FTSE 100 Company results due in October

Company Date due Type of result
Tesco 6 October Interim
Home Retail 21 October Interim
Source : Companies

Economic Indicators due in October

Announcement Date
ECB interest rates 8 October
UK interest rates 8 October
UK Consumer Price Index (inflation) 13 October
UK employment figures 14 October
Eurozone Consumer Price Index (inflation) 15 October
US CPI 15 October
Monetary Policy Committee meeting notes 21 October
UK retail sales 22 October
US interest rates (FOMC) None scheduled
Source : Companies
Sticky inflation
The last two years have seen the annual rate of the UK’s Consumer Price Index (CPI) of inflation rise steadily to a peak
of 5.2% in September 2008, from a level of around 2% in August 2007, and then fall back, initially quite sharply in
autumn 2008, but then at a slower pace over the past few months. CPI finally declined to a rate below the Bank of
England’s target level of 2% in June this year. However, having fallen below the target level in June to 1.8% over the rate
a year earlier, the level of CPI inflation proved far more resistant to further declines than expected with an unchanged
level in July, well above City economists’ consensus forecast of around 1.5% year-on-year. The latest inflation number,
released in mid-September showed a small decline of 0.2% over the month, leaving the year-on-year rise in CPI at 1.6%
in August. The main influences on the most recent fall were lower food prices, and gas and electricity costs – although
the latter two items were unchanged over the month, they were lower compared to prices a year ago as suppliers
sharply raised tariffs. Against this higher oil prices contributed to increased transport costs.

The more inclusive Retail Prices Index (RPI), which is widely used as an index for wages and pensions, has fallen more
sharply, and considerably further, than CPI, since they both peaked at around 5% last autumn. RPI had declined to zero
growth by February this year and was falling by 1.6% over the year to June (down from a fall of 1.1% in May). This was
to prove to be the low point (so far) in the cycle as the rate of annual decline in RPI inflation was reduced in July to minus
1.4%, and, in August, to minus 1.3%. The main reason for the huge gap between CPI and RPI is that the RPI index
includes such items as mortgage interest and house price depreciation expenses, in addition to the usual items in CPI.

The main cause of the sharp rise in CPI inflation during 2008 was the extraordinarily large increase in crude oil prices –
which influenced the price of fuel and energy costs. Similarly the sharp decline in CPI mirrored, although somewhat
delayed, the fall in crude oil prices over the latter part of 2008 and into early 2009. However, the continued weakness
of Sterling, down by around 15% on a trade weighted basis since the summer of 2007, has diluted some of the benefits
of the oil price collapse, and increased the cost of imported goods. The recent ‘stickiness’ of the CPI inflation rate
probably has much to do with the weakness of Sterling, although it did strengthen slightly in the early summer, and more
particularly the rise in the price of crude oil (from around $40/barrel in the first quarter of 2009 to around $70/barrel in
recent weeks). In addition, economists put forward the argument that the economy was stronger than official figures
showed in the run up to the recession.

MPC’s inflation projections Consumer and retail price indices

Annual % change in CPI (based on interest rates at 0.5% and (annual % change)
£175 billion asset purchases)

The chart show the MPC’s view of the likely path of CPI inflation, with the darkest
central band and each successive identically shaded pair of bands each representing
10% of probable outturns
Source: Bank of England Source: Thomson Reuters Datastream

The current level of UK CPI inflation is significantly higher than the comparable indices’ levels reported by the eurozone
and in America. The 16-country eurozone CPI turned negative (a fall of 0.1% in June over the same month a year before)
for the first time since comparable records began in 1991. The target level is similar to that set by the UK government
at ‘below but close’ to 2%. In July the inflation rate stood at minus 0.7% year-on-year, although the latest figures for
August showed a small increase in the inflation rate over the month, but the year-on-year figure was still negative at
minus 0.2%. In the US CPI inflation was reported to be minus 2.1% in July, although the rate had also eased to minus
1.5% in August compared to a year earlier. While the relative strength of their respective currencies, compared to
sterling, could explain some of the gap in the indices, a significant part is likely to be that monetary policy has helped
consumers more quickly in the UK compared to the eurozone and the US. This is because a high proportion of UK
mortgages are on a floating rate basis, or are reset each two year period, while the eurozone and US tend to have a
high percentage of fixed rate mortgages. Thus low interest rates have rapidly resulted in UK households having larger
disposable incomes.

Interestingly core inflation, which excludes such volatile items as food, fuel, alcohol and tobacco, but nevertheless
accounts for around 80% of CPI inflation, was static in the UK at 1.8% in August. This figure is close to the eurozone
and US levels at 1.3% and 1.4%, respectively.

The Bank of England’s latest quarterly Inflation Report, published in early August, made the point that the combination
of the margin of spare capacity in the economy rising, unemployment continuing to increase and pay growth remaining
weak, will continue to exert downward pressure on underlying prices. The Bank was concerned that the poorer than
forecast gross domestic product figures in the first and second quarters threatened to push inflation further below the
2% target mandated by the government, although by how much weak demand will exert downward pressure on prices
will depend on the timing and strength of the economic recovery. On the other hand there may be upward pressure due
to Sterling’s depreciation as companies adjust to higher import costs of commodities and energy prices. There are,
therefore, significant risks to inflation on both the upside and downside. On the assumption that the Bank Rate is held
at 0.5% and the stock of purchased assets reaches £175bn, then the path of inflation is likely to be volatile, with the
Bank of England forecasting at first falling rates as the impact of the sharp rise in energy prices a year ago drop out of
the 12-month comparison, before rising sharply as last year’s VAT cut is reversed. Thus CPI inflation is forecast to fall
towards 1% in the last quarter of 2009, before rising back to 2% early in 2010. Thereafter through 2010, the inflation
rate should decline back towards 1%, before rising slowly again to 2% by the middle of 2011.

More recently the Governor of the Bank of England doused hopes of a swift economic rebound, again warning
households and businesses of a slow and protracted recovery. While there are signs that economic growth resumed in
the third quarter of 2009, he said that the severity of the fall in output during the recession was so great that inflation
was likely to fall well below the target level. Thus it was unlikely that the Bank would rein in its quantitative easing
programme. He added that ‘It is very important not to lose sight of the fact that growth rates don’t tell the story. It is the
levels that really matter’. Given that the depth of the recession was so great, households and businesses will continue
to feel its effect for some considerable time, particularly as to the levels of output and employment. These comments
led to a reassessment in financial markets of the likelihood and timing of any rise in interest rates, with the view now
being that the extremely low levels of rates will remain for a considerable time. This led to the recent sharp decline in
Sterling, something that the Governor appears to be relaxed about, commenting that the pound’s decline was helpful
in rebalancing the UK’s economy towards a greater emphasis on exports. The Bank takes the view that with weak
growth inflation will not be a threat, and explains why interest rates will stay at very low levels and why it will continue
with its monetary stimulus packages. Nevertheless, some economists continue to be concerned over the stickiness of
UK inflation, and have been speculating that interest rates may need to be increased during 2010. In fact the CBI has
recently commented that in its view the Bank will need to start raising interest rates in the spring and they could rise to
2% by the end of 2010.

Certainly the spectre of long-term deflation is one problem the UK is unlikely to face !

First Equity Limited

Salisbury House, London Wall, London EC2M 5QQ
Tel: 020 7374 2212 Fax: 020 7374 2336
Website: www.firstequity.ltd.uk
Paul Henry
email: paul.henry@firstequity.ltd.uk

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