Investor - An insider's guide to the market: The UK general election has come and gone without causing even a minor ripple in the British financial markets.
Admittedly, there were no real surprises but the lack of impact reflects one of the success stories of this UK government.
The Chancellor's decision to make the Bank of England an independent institution is arguably the most important factor underpinning the solid performance of the UK economy during the term of the Labour government. With Gordon Brown confirmed to remain as Chancellor prior to the election, there was little left for the markets to worry about.
Earlier this week, the Bank of England decided to keep UK base rates at 4.75 per cent. The bank has been very successful in curbing incipient inflationary pressures by moving early to raise interest rates. House price inflation has now slowed sharply and booming consumer spending has also been tamed.
Over the past few years, it has been buoyant consumer spending that boosted the UK economy, while the industrial sector struggled to remain competitive. Now that interest rates are higher and sterling is strong, the risks of recession in manufacturing output have heightened.
According to the Office for National Statistics, the level of industrial output in March fell to its lowest level since autumn 1996, after manufacturing output fell 1.6 per cent between February and March.
Most forecasters now believe that the UK government's 3 to 3.5 per cent growth forecast for 2005 will not be met. A looming problem for the Bank of England is that this slowdown is being accompanied by an uptick in inflationary pressures. The annual rate of inflation for factory gate prices rose to 3.2 per cent in April, compared with 2.8 per cent in March. If this trend persists, it will not be long before it feeds through to higher consumer prices. This may present the Bank of England with a dilemma since it would be difficult to reduce interest rates to help the slowing economy if inflation became problem.
For investors, the slowing UK economy clearly has implications for the UK equity market. A striking feature of the UK stock market in recent years is that small and mid-cap stocks have dramatically outperformed their larger brethren. This is reflected in the large outperformance of the FTSE 250 index (which covers the next layer of companies below the top 100), versus the FTSE 100 index over the past several years.
On average, FTSE 250 constituents are more exposed to the UK economy than the constituents of the FTSE 100 and they have benefited disproportionately from the relative strength of the UK economy. Therefore, it is highly likely that the FTSE 250 index would underperform the FTSE 100 if the UK economy does indeed slow down.
Although Investor believes the UK economy will hold up reasonably well in coming years, the current evidence of a significant slowdown points towards underperformance from UK companies heavily exposed to the UK economy. This suggests that the long period of outperformance from the FTSE 250 index has come to an end.
Investor says...
On average investors will do better to concentrate on FTSE 100 companies rather than on FTSE250 companies for at least the remainder of this year.
