Interest rate hike could hit returns

The prospect of further interest rate hikes in early 2007 is dampening analysts’ enthusiasm for British equity markets, with some doubtful of whether the UK stockmarket can deliver gains.

All eyes are on British interest rates. They stood at 5% in November, but the prospect of further hikes has led analysts to think hard about whether the stockmarket can deliver a fifth year of gains in 2007.

The case for higher rates rests on inflation and the strength of economic activity. The Consumer Price Index stood at 2.4% at the time of writing, above the Bank of England’s 2% target.

Gross domestic product growth, meanwhile, amounted to 0.7% in the third quarter, equivalent to an annual rate of 2.7%. The British potential growth rate – the level at which the economy can grow without triggering rising inflation – is thought to be about 2.5%.

Mike Lenhoff, a strategist at Brewin Dolphin Securities, argues interest rates “are the only thing that could really hurt the equity markets”, given that neither valuations nor the outlook for earnings growth appear to pose major threats.

“There could be one more 25 basis point rise in UK rates,” he says. “The key risk is probably the interest rate outlook if there is some sort of upward pressure on inflation.”

Lenhoff says he can see why some people “feel a bit cautious”. “We have had four years on the trot of really good equity markets,” he says. “And it is fair to ask if there is a high probability of getting a fifth really good year.”

The FTSE 100 index of large-cap stocks rose 12% over the year to November 23 – up 85% from March 2003’s low. The FTSE Mid 250 index is up 27% over the year, while small-caps are up about 15%. This compares with an 18% return from the MSCI World index over the same period.

Credit Suisse, an investment bank, puts the British stockmarket’s price/earnings multiple at 13.1, compared with a global P/E of 15.5. It puts the market’s dividend yield at 3.19%, well above the global figure of 2.11%.

The bank says in a research note released in early November that the British equity market is not as cheap as these figures appear to suggest. It bases its conclusion on an analysis using corporate cashflow data, deploying a measure known as Cash Flow Return on Investment.

Credit Suisse says 17 of 23 UK sectors have a higher CFROI than their global peers, excluding Japan. This implies the British market “looks expensive”, the bank says.

It recommends going 10% underweight in Britain relative to the MSCI World index. This represents a 9.3% portfolio weighting compared with 10.3% in the index.

Credit Suisse fears the Bank of England will raise interest rates more than the market expects, perhaps to as high as 5.5%. “The worry we have is that such a degree of rate hikes leads to an increased chance of a policy mistake,” it says.

“This may be more of a problem for domestic UK given that the debt/service ratio is close to being back where it was in the recession days of the early 1990s and that the household-liabilities-to-income ratio is 20 percentage points above that in the US.”

The bank also argues that Britain is no longer a “defensive” market. Traditionally, the UK is thought likely to outperform other markets when leading economic indicators signal a slowdown. However, Credit Suisse says resources now account for 24% of Britain’s market capitalisation, so it is cyclical rather than defensive.

Mark Hall, manager of the Rensburg UK Select Growth fund, is also eyeing the possibility of higher interest rates over the next few months.

“The outlook for the equity market is as difficult to read as ever,” he says. “The data is very mixed at the moment but on balance it seems that short-term interest rates in the UK will have to go up again in the new year to ensure inflation falls back to within the target range.”

Lombard Street Research, an economics consultancy, argues British money supply data also indicates interest rates could be heading higher. The M4 measure of money supply – also known as broad money – rose by 14% in September, while M4 lending rose by 13.3%.

“An annual rate of 14% represents a highly expansionary monetary environment,” says Jamie Dannhauser,

an economist at the firm. “This rate of money growth will continue to drive up asset prices, in particular house prices.

“Current house price inflation is close to double-digit figures. Based on leading indicators of the housing market, we estimate that it will be 10-15% in 2007 and this should ensure that household balance sheets remain healthy. Ultimately, this will filter through into higher consumer spending and mean that consumption continues to act as a major boost to UK growth next year.”

Dannhauser says an interest rate hike will be necessary next year, given the growth in Britain’s money supply, to get inflation back on trend.

However, there is by no means a consensus that interest rates will go up in 2007. Some analysts expect British economic growth to slow and borrowing costs to fall. BNP Paribas, for example, sees rates falling in the middle of next year.

Another intriguing possibility is that the backdrop for British economic decision-making – an assumed potential growth rate of 2.5% and an inflation target of 2% – needs to be revisited.

This line of argument suggests that immigration, including the arrival of Eastern European workers, has boosted Britain’s population over the past decade, and therefore raised the UK economy’s potential growth rate.

Rising British unemployment over the past few months, despite robust growth, is said to provide evidence that there is some slack in the economy. Hence it can operate at a higher clip than previously thought and interest rate hikes could be stayed – or so the argument runs.

The Bank of England will have to evaluate such arguments in the months ahead, which could comprise a particularly delicate period for the country’s economic policymakers.