Investor: An insider's guide to the marketFinancial markets were caught on the hop last week when the Bank of England announced a surprise quarter point hike in the base rate to bring it to 5.25 per cent. Markets had been expecting a rise in February or March so the surprise was more in the timing of the move rather than the actual rate increase.
Furthermore, the bank had moved earlier than expected with its two previous moves so that the timing of the latest quarter point rise was not out of character. In contrast, the Federal Reserve and the ECB have generally succeeded in signalling interest rate changes well in advance through carefully worded official statements.
Analysts quickly focused on inflation as the likely explanatory culprit. Annual inflation in the UK rose to 2.7 per cent in November, its highest rate since comparable records began in 1997. By last week economists were expecting the inflation rate to nudge up to 2.8 per cent in December. Post the rate hike analysts assumed that the bank moved due to a preview of the December inflation data.
On Tuesday the official release reported that inflation had indeed accelerated to 3 per cent in December, which goes a long way in explaining the Bank of England's decision. The bank targets consumer price inflation at 2 per cent and is required to write an explanatory letter to the government should the rate deviate by more than one percentage point from this level. Therefore, the bank's governor, Mervyn King, does not now have to write an open letter to the government explaining why inflation was so far off target and what action was being taken to tackle it.
However, a further rise in the base rate to 5.5 per cent now seems certain, particularly given that retail price inflation is running at an annual rate of 4.4 per cent, which is the highest rate since December 1991. Trade union wage bargainers focus on this measure of inflation and therefore the bank will be closely monitoring wage settlements in coming months.
The higher inflation rate has given a further boost to sterling this week on top of the injection that it received last week from the surprise interest rate rise. The pound has strengthened significantly against all currencies so far in 2007 and Investor expects it to remain firm for the foreseeable future. The sterling/dollar exchange rate is now around $1.96 and the psychologically important $2 to the pound cannot now be far away. Sterling has also firmed against the euro, as the interest rate differential in its favour seems set to be maintained in 2007.
For Irish investors developments in the UK now present some interesting investment options. Official sterling interest rates of 1.75 percentage points above euro rates means that sterling deposits look very attractive. Of course there is currency risk but on a three- to six-month view a fall in sterling versus the euro is unlikely. Of more interest to long-term investors are the opportunities offered by the UK equity market.
In particular those investors who wish to diversify their equity portfolio should closely examine the London stock market. Firstly, in terms of currency risk, the UK scores more highly than the US market as the dollar remains in a medium-term downtrend. The London stock market is the largest in Europe and offers investors an enormous range of companies to choose from.
For those investors who do not feel equipped to pick individual shares, an exchange traded fund (ETF) based on the FTSE100 is a tax and cost efficient alternative. An ETF can be bought and sold just like any other share. It is an index fund that holds a portfolio of securities that in this case are the constituents of the FTSE100 index. Therefore, investing in a single share gives investors exposure to the overall UK stock market.
Also, just like ordinary shares, ETFs pay a regular dividend. The current dividend yield on a FTSE100 ETF is approximately 2.8 per cent. The price/earnings ratio (p/e) on the FTSE100 is forecast at 12.2 for 2007 compared with a multiple of 15 for the S&P500 and 14 for the ISEQ 20 ETF.
Corporate earnings in the US and Ireland are forecast to grow at a faster rate than in the UK, thus partially justifying their higher p/e ratios. Nevertheless, a dividend yield of just under 3 per cent and a p/e ratio of approximately 12 are not expensive and highlight the investment value available in the UK stock market.
