The chart shows the FTSE 100 (dotted line) and the FTSE 100 excluding the Oil & Gas and Mining sectors (solid line). Until recently, the divergence between the two has varied but at most it has been no more than 200 points over the course of the past few years.
That was up until the early part of April. From that point onwards the rise in the FTSE 100 to the mid-May peak became increasingly due, and then exclusively due, to Oil & Gas and Mining. As the chart shows, the gap between the two has opened up by some 600 to 700 points in recent months. For the year to date, the FTSE 100 is down 10 percent while the FTSE 100 excluding Oil & Gas and Mining is down by some 16 percent. From the highs reached last year, the indices are down by 14 and 23 percent respectively, thus confirming the widely held view that the performance of the UK equity market has been flattered by the resource sector.
Given the importance of the banks to the FTSE ex Oil & Gas and Mining - the financials represent about a third of this index - much depends on whether the market has tired of selling bank shares and thinks it is time to buy them. On the other hand, if the fundamentals change for the oil market, say because the developing economies slow down from their sizzling pace of growth and the speculative tide turns, one can see this index outperforming the FTSE 100.
Then again, if interest rates rise in the UK, which is what the gilt market anticipates, this will spell game over for all those domestic earners, which have been creamed already.
Maybe interest rates won’t rise. The MPC is conscious of the ‘undesirable degree of volatility in output’ that would be induced by any attempt to bring inflation down in too short a space of time. The last set of MPC minutes made a point of this and it was repeated in the Governor’s open letter to the Chancellor explaining why inflation has risen above target and what the MPC proposes to do about it. As the letter states, ‘a slowdown is already in train’. Moreover, further restraint will come from the ‘squeeze on real incomes’ and the ‘reduced availability of credit’. Where is the need for an increase in interest rates?
The sell-off from May’s peak level has left the UK equity market in an oversold condition but positive news is needed if any rebound is to be sustained. Keeping interest rates where they are would be good for a start.
Lower oil prices would provide a welcome stimulus for the developed economies. It would take the pressure off headline inflation and hence ease concerns about any immediate need for higher interest rates elsewhere. Bond markets might relax a bit and this would help equity markets. In the UK the big international earners in the FTSE 100 - ex Oil & Gas and Mining are likely beneficiaries of a stimulus provided by lower oil prices, especially if sterling continues to weaken. The downside is that, while a drop in oil prices will help headline inflation, the stimulus this provides might give rise to upward pressure on core inflation and limit the scope for lower interest rates.
In fact, there still is a surprising degree of resilience about the global economy, in spite of higher oil prices. We commented on this recently (On the profit-taking in bond and equity markets 30 May 2008) and since commenting there has been more positive news flow, particularly in the US, where May’s Non-farm payrolls as well as May’s retail sales came in ahead of expectations. Also, in contrast to what has been happening to date, the latest from Consensus Economics Inc shows an upward revision in the consensus forecasts for GDP growth this year in the US and the eurozone, not to mention China (the second in a row).
Nevertheless, there is still a slowdown under way in the major economies and GDP forecasts for next year are being revised down. Yield curves in the gilt market and in the eurozone bond markets are now inverted. This is not the case in the US Treasury market but if it was, it would be signalling a recession.
Maybe a recession is an interest rate hike away in the UK and the eurozone.
The message from equity markets is that the forces underlying economic activity are verging on the contractionary and the FTSE 100, with its large exposure to the international economy, is probably as good a gauge as any of the global outlook for earnings. However, the FTSE 100 excluding the Oil & Gas and
Mining sectors may be the better gauge at this point in time.
Although the proportion of sales derived overseas is lower - though by our reckoning this is still in excess of 50 percent - it remains a sensitive gauge of the state of demand ex commodities in the global economy. Right now, it is discounting a lot of bad news and, as the chart below shows, looks inexpensive compared to the FTSE 100.
