Despite the prospect of a consumer-led US slowdown and the tightening of global monetary conditions,...
Despite the prospect of a consumer-led US slowdown and the tightening of global monetary conditions, the FTSE 100 endured a volatile few months before reaching its recent five-year high.
Heavy exposure in the London market to energy and mining stocks led to a good deal of volatility. These sectors have struggled on the back of slowing global growth causing less demand for commodities.
However, UK growth in the second quarter was above its long-term trend (+0.8% on the previous quarter and +2.6% on the previous year). This was driven chiefly by the service sector as retailers and the leisure industry were given a boost on the back of the World Cup.
As a result of such robust growth, the Bank of England raised rates in August by 25bps to 4.75%, taking the market somewhat by surprise. It is likely that the Bank of England will raise rates to 5% in November and then perhaps beyond that in the New Year, the main reasoning behind the bank rises being to stop headline inflation feeding through into consumer prices and wages.
The Monetary Policy Committee (MPC) has regarded the energy price falls as potentially stimulating core inflation, leading to a relative increase in spending power on the part of the consumer as well as producers' margin rebuilding.
Recent evidence suggests manufacturers are increasingly looking to pass on increased input costs via the price of finished products. Such inflationary pressures, combined with the MPC's bullishness on global growth suggest the Bank will remain alert to inflationary pressures and continue to withdraw monetary stimulus going into 2007.
An environment of increasing interest rates will continue to put pressure on consumer-related sectors as household income growth is curbed by high utility prices and rising interest payments. These are set to reach nearly 10% of income by the year end. In this context, the recent strength of consumer spending looks unsustainable.
A further consequence of increasing interest rates has been to give continued support to sterling, which is at its highest level against the dollar since 1990. Currency strength has acted as a brake on British exports, which have struggled to hold their own against competition from low-cost producers such as China. Although manufacturing order books remain strong, demand growth has been primarily domestic (capital and consumer goods).
However, sterling increasingly looks overvalued, and with interest-rate tightening expected to peak early next year it is likely there will be a fall in the price of sterling. In the event that the European consumer recovery is able to weather a US slowdown, a fall in sterling against the euro will offer a healthy boost to British manufacturers, for which the EU is the primary export market.
Meanwhile, Britain's public finances remain a concern, with the Government in danger of breaking Gordon Brown's self-imposed rule of maintaining net public debt below 40% of GDP. Should Brown take the Labour helm, the new Government will either need to rein in public spending or raise taxes, something Brown would be loathed to do.
At this stage, the ongoing uncertainty around the Labour Party leadership is a concern to the market, especially if challengers declare their intent to run against Brown. Both of the two potential alternatives, John Reid and Alan Johnson, are Blairite modernisers and would be favoured by the market.key points
Service sector boosts UK economic growth, helped by the World Cup
Market surprised by Bank of England rate rise
Labour leadership battle will be bad for economy
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23% fall since Q1
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