Issue 81 | June 2010

The Newsletter is now available via email.

If you wish to receive it in this format please contact
us at: newsletter@firstequity.ltd.uk

Crisis of confidence
UK Equity Market: FTSE 100 index-last 90 days

Source: Bloomberg
The UK market: Crisis of confidence
The FTSE100 index started May on a weak note as the escalating eurozone debt crisis sent further tremours through global
stock markets. Investors were worried that contagion from Greece could spread to other at-risk peripheral eurozone countries.
Furthermore, the announcement of a major new austerity package for Greece provoked violent protests and pointed to a clear
lack of resolve among Greece’s population to shoulder the fiscal burden being imposed by creditors. To add to investor worries
Australia set out plans for a substantial minerals industry tax and the latest Chinese economic data pointed to slowing economic
growth. These factors, and a precipitous fall, and subsequent recovery, on Wall Street – apparently caused by a large number
of automated sell orders - led to extreme turbulence in the markets. By the end of the first week the FTSE100 index had fallen
by nearly 8%, accompanied by high levels of turnover in shares. The massive emergency funding facility announced by the EU
and IMF at the start of the second week in May calmed markets’ fears and resulted in a short squeeze, which sent markets
sharply higher, while in the UK the announcement of the new coalition government also soothed investor concerns. However,
the positive mood didn’t last long as investors’ enthusiasm for the funding deal faded over worries that the effect of the austerity
measures would seriously undermine global economic growth prospects. Investors were further unnerved by Germany’s
unilateral and totally unexpected ban on naked short selling (albeit of only a limited number of stocks and shares), which raised
questions over a lack of cohesion among Europe’s decision makers and fed investors’ paranoia that governments knew
something that the markets didn’t! With the return of fears over the eurozone banking crisis and heightened tensions on the
Korean peninsular undermining confidence in global equity markets, the FTSE100 index fell below the 5000-level – some 11%
down on the start of May. However, this proved to be a short-lived blip as bargain hunters moved in believing that at these levels
stock prices were discounting most, if not all, of the bad news. By the end of the month the UK index had recovered and moved
firmly above the 5100-level, although that still left it some 6.6% lower on the month.

Sector Performance during May

Top 5 % Bottom 5 %
Personal Goods n/c Industrial Metals & Mining - 20.4
Tobacco - 1.5 Oil & Gas Producers - 10.7
Fixed Line Telecommunications - 1.6 Construction & Materials - 9.7
Pharmaceuticals & Biotechnology - 2.4 General Retailers - 9.4
Nonlife Insurance - 2.5 Automobiles & Parts - 9.3
Source: FTSE International Limited

FTSE 100 Company results due in June

Company Date due Type of result Company Date due Type of result
Johnson Matthey 3 June Final
Source : Companies

Economic Indicators due in June

Announcement Date Announcement Date
UK interest rates 10 June UK retail sales 17 June
ECB interest rates 10 June US CPI 17 June
UK Consumer Price Index (inflation) 15 June Monetary Policy Committee meeting notes 23 June
Eurozone Consumer Price Index (inflation) 16 June US interest rates (FOMC) 23 June
UK employment figures 16 June

Inflation threat
Both private sector economists and the Bank of England continue to be wrong footed by the stickiness and higher-than-
expected levels of inflation in the UK. The level also remains noticeably above the UK’s major trading partners in the EU
and USA, although the weakness of Sterling against the euro and US dollar has been a major factor in its elevated level.
Since early 2005 the Consumer Price Index (CPI) of inflation has only three times been below the 2% target level set by
the government. The first two times, in early 2006 and mid-2007, the CPI rate fell only briefly, and marginally, below the
target level. The last time saw CPI rates fall very sharply from a 5.2% peak level in September 2008 to a low point a year
later of 1.1%, and rates remained below the target level for some six months. A major (but delayed) influence on both
the recent sharp rise and fall in CPI was crude oil prices. While for the vast majority of the past decade CPI inflation has
remained within the 1% to 3% band, it has been on an upward trend since the early 2000s, and, unsurprisingly, has
been considerably more volatile in recent times.

In recent months the combination of stable to rising fuel prices compared to falling crude oil prices a year ago, the end
of the temporary cut in VAT in January this year and the continuing impact of a weak pound on import prices has seen
all measures of inflation steadily increase. Despite these factors the extent of the recent rises, excluding an unexpected
fall in February, has surprised commentators. Thus CPI inflation has risen from 2.9% in December 2009 to 3.7% in April,
compared to analysts’ average forecast of 3.5%. The main factors influencing the rise were clothing and footware, food,
and alcoholic beverages and tobacco (due to increases in excise duty). The Retail Prices Index (RPI), which includes
mortgage interest costs, and is thus often seen as a better guide to the real cost of living, and is widely used as an index
for wages and pensions, has increased from a decline in prices of 1.6% in June 2009 – its recent low point – to plus
5.3% for the 12-months to April this year, a 19-year high. The main factors affecting CPI also affect RPI, which has been
also substantially influenced by the substantial rise in housing costs. Thus last year mortgage interest payments were
falling by 7.7%, following the cut in interest rates from 1% to 0.5%, but this month rose by 0.6%.

Inflation

Source: ONS Source: Bank of England

The Bank of England’s latest quarterly Inflation Report, published in early May, strikes a largely dovish, but highly
cautious tone. The overview was that the UK economy continues to emerge from recession as global demand
picked up, although the pattern of recovery was uneven and the level of activity generally remains well below pre-
crisis levels. Added to this heightened concerns about the fiscal position in some countries has led to renewed
fragility in financial markets. CPI inflation remained well above the 2% target, influenced by the restoration of the
standard rate of VAT to17.5% (estimated to potentially add up to 0.5% to inflation over 2010), higher oil and other
commodity prices and the past depreciation of Sterling, which has resulted in higher import prices. The Bank’s view
is that as these temporary effects on the level of inflation wane, downward pressure from a persistent margin of
spare capacity is likely to cause CPI inflation to fall below the target level (2%) for much of the two-year forecast
period. This view is backed up by surveys which suggest a significant margin of spare capacity within companies.
Furthermore, factors such as earnings growth remaining low, combined with the fact that employees have been
willing to accept lower wages or part time working, have contrbuted to the resilience of employment levels relative
to the falls in output. In addition, the new coallition government’s intention to make substantial savings not least in
employment levels in the civil and public services, could lead to further significant rises in unemployment levels. The
Bank’s forecast is, therefore, that the near-term outlook for CPI inflation is somewhat higher than in their last Inflation
Report in February and suggests that inflation will remain above target for the remainder of this year, although it
should return to target level by late 2010. Thereafter, as the temporary effects raising inflation wane, downward
pressure from the persistent margin of spare capacity is likely to drag inflation below the target level (but remain in
the 1% to 2% range) for the remainder of the target period. Further out the downward pressure will fade as the
recovery takes hold resulting in the level of CPI trending back towards the target level. However, the extent to which
inflation will decline is highly uncertain, and will depend largely on the degree of spare capacity, and that will depend
on the strength of the global and UK economic recovery. In addition, inflation may remain higher than forecast if the
current period of above-target inflation causes expectations of medium-term inflation to rise. Nevertheless, on
balance, the MPC committee members judge that inflation is somewhat more likely to be below target for much of
the forecast period.
 Some economists now believe that the
Bank of England’s attitude to the level of
inflation is too relaxed, and claims by the
Bank that inflation will fall sharply are starting
to stretch credulity. Certainly there is clear
evidence that the Bank has consistently
underestimated the level of CPI (see chart
left), as shown by the fact that the Governor
has had to write seven letters to the
Chancellor of the Exchequer explaining why
inflation was more than 1% above target
level and none as to why it was more than
1% below target in the past two years. For
example, a year ago the Bank forecast that
CPI inflation in the second quarter of 2010
would be 0.7%, it now appears likely that the level will be some 3% higher. One of the main reasons for the disparity in
levels of inflation has been the Banks judgment that the dis-inflationary effects of the recession, and a large output gap,
would completely overwhelm any inflationary effects of a weak pound. This has been proved wrong so far. The Bank of
England continues to maintain that the current wave of inflation is due to temporary and unexpected events (including
an 80% rise in the price of crude oil since the start of 2009, a weaker pound resulting in an increase of 15% in import
prices since start of 2008, and the recent rise in VAT). Nevertheless, core inflation – CPI excluding food, energy and VAT
– has been edging higher since mid-2006 to currently stand at 2.5%. Commentators argue that the likely effects of weak
sterling on imports and changes to VAT levels have been clear for some considerable time without significantly
influencing the Bank’s forecasts. Interestingly there are now signs that the Bank is becoming more sensitive to the threat
posed by persistent high inflation, as in his letter to the Chancellor the Governor singled out the risk that inflation
expectations might edge higher, which could lead to more persistent and higher levels of forecast inflation over the next
two years. The fear is that persistent high inflation will demand higher interest rates (as the Organisation for Economic
Cooperation and Development suggested recently, although this is largely at odds with economists views) with obvious
negative implications on the fragile economic recovery now under way.

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

The information in the newsletter is taken from publicly available sources and the newsletter is distributed for information purposes
only. Whilst reasonable steps have been taken to ensure the fairness of any views expressed, First Equity Limited does not offer any
guarantee as to the accuracy or completeness of the information. The newsletter is not intended as a solicitation to buy or sell any
securities or investments which may be mentioned. First Equity Limited is regulated and authorised by the Financial Services Authority
and is a member of the London Stock Exchange and the PLUS Market.