FTSE Rides Out Tough Times

published 8 June 2006

The UK's FTSE index is a resilient thing. So far this year, it has risen nearly 8% to its highest level for nearly three years and seems to be holding its ground despite the worsening economic and bad corporate news filling the press. Profit warnings from UK-listed firms are on the rise, says Allister Heath in The Business. The number of firms forced to issue profit warnings in the second quarter of this year was up 52% on the same period last year and was the worst quarter for profit warnings since the fourth quarter of 2002. The most warnings came, predictably, from retailers, the media and entertainment sector (which has been hit by a cut in advertising budgets) and the support-services sector.

One reason for the FTSE's surprising resilience is the splendid performance of BP and Shell, says Robert Cole in The Times. The two dominate the oil and gas sector, which in turn accounts for 15% of the FTSE's movements. Other sectors have played their part (electricity shares are up 21% this year, for example), but "oil is where the action is". But there's another more general reason for the FTSE's strength interest rates. The more bad news traders hear, the more convinced they become that interest rates will soon be cut. This is good news for them, as markets look to the future, not the past. The lower a yield it expects from gilts in the future (ie, the lower they expect the Bank of England to set interest rates in the future), the higher a valuation they'll put on the potential returns from equities. So when interest rates are expected to fall, equities often do pretty well. This market is rising not because there's anything good to say about the UK economy, but because there are so many negative things to say about it.

But as we often point out, a series of interest-rate cuts is far from a given. As the UK economy is running out of puff, so is our currency and that means imported inflation. The Consumer Price Index is currently running at a seven-year high. A rate cut (which will mean a weaker pound) could force it higher. And if it goes much above the Bank of England's target of 2%, it's going to be very hard to keep cutting rates. Traders may be able to bank on one cut, but not much more than that. As the pound falls, rates may move back up and the FTSE back down