Consumers are suffering from rising inflation and constrained wage growth. Inflation is curtailing spending power. The Consumer Price Index is now at a nine-year peak and inflation is now higher than the growth rate of the economy. The pattern of price increases is strongly biased towards energy-related spending such as petrol, travel and utility charges and these are difficult to reduce in the short term. Extra spending on energy is also deflationary and requires savings to be made elsewhere. The impacts of higher tax, local tax and higher interest rates are also still having a negative effect on the consumer.
Wage growth is constrained for several reasons. First, unemployment has risen for seven consecutive months. Second, new entrants to the labour pool are holding down wages through competition, particularly at the lower end of the market. Third, global wages are being limited by competition from China in a growing number of areas. Finally, companies have poor pricing power in June, factory input costs rose by 12%, factory gate costs by 2.4% - meaning that margins are under pressure.
Government spending to slow
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Economic growth estimates and the tax income that would flow from economic growth look increasingly exposed. With the budget deficit already above EU guidance levels and spending continuing to rise, cuts in government expenditure would be desirable.
Expectation of economic revival in Europe have again proved prematurThe situation in Italy has continued to deteriorate and the electoral stalemate in Germany puts at risk the steady progress being made
Prospects for the market
With so many near term issues to focus on, the UK market has yet to reflect the pressures on the economy and corporate earnings in 2006. In 2005 to date, one third of the rise in the UK equity market is attributable to the strength of the oil sector. Major weakness here will make overall progress difficult.
Dividend growth will continue to provide support to the market. Despite the strong rise in the market this year, yields are unchanged because of the strength of payments. On a market capitalisation basis, after the rally of the past quarter, smaller companies look vulnerable relative to large caps.
By John Kelly, Head of Client Investment at Abbe
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