Market Report: Inflationary times

The UK has basked in a whole summer's worth of hot days this year. Glorious as this has been, global warming is no fun for farmers, not just here, but across the globe, and is one important factor behind rising inflation.

For arable crop farmers in the UK, sustained high temperatures and lower soil moisture results in earlier spring ripening, reduced yields,

poorer germination, an increase in pest activity, and greater wastage in all-important potato crops. After last year's sweltering summer, for example, biscuit and snack makers were forced to pay an additional 20% for flour.

So, having got used to the astronomic rise in precious metals this decade, we're now going to have to get used to paying more for agricultural commodities. An acute example is corn. The front-month contract for a bushel of corn on the Chicago Board of Trade has jumped from $1.86 at the end of 2005 to over $4 today, as rising demand, not least for ethanol, has sent supplies to their lowest levels in 34 years.

Consumers will feel the impact of higher corn prices in a very extensive range of products, not just corn-based products themselves but beef and poultry which depend on corn for feed. Even Coca Cola has been hit because along with other soft drink makers, it uses corn syrup as a sweetener.

The emerging middle classes of Asia and Eastern Europe are also spending more on food and developing a taste for all things western, straining the equation even more.

Inflation

The 3.1% figure for the March consumer price index (CPI) is the highest jump in inflation for nearly 16 years, and more than one percentage point above the Bank of England's 2% objective. If you use traditional retail price data, which includes mortgage interest payments and council tax, inflation comes out even higher at 4.8%.

One factor is last year's increases in electricity and gas prices, which will soon drop out of the year-on-year comparisons. But the trend is still set upwards, and a particularly worrying feature is that many companies are no longer content to take the squeeze on their margins and are beginning to hike their prices.
 
Several influential voices have warned that this bout of rising inflation will end the way of all cycles in a blow out. While the money markets are pricing in perhaps 6% by year-end, which would be the highest rate since 2001, former London Business School professor Tim Congdon thinks rates could go as high as 7.5% over the next two years.

Stubborn customer

Inflation is a stubborn customer to deal with, and getting harder. What Bank of England Governor Mervyn King did not explain in his letter to Gordon Brown on why inflation is off-target, is that the Bank's instruments are weakening in the face of increasing globalisation and cross-border capital flows.

International private equity companies, property magnates, hedge funds, and other asset managers who make deals in the UK send demand for sterling up, and the value of the pound on the foreign exchanges follows, irrespective of interest rates, because any borrowing they do is on the international markets. The link between UK interest rates and monetary conditions is consequently diminishing.

Market still cheap?

Stockmarkets have essentially risen for four years in succession with just the occasional, short-lived correction, such as the blips last May and in March this year. This itself is provoking anxiety that the bubble could be about to burst.

There are still some good arguments that the market remains quite cheap. Its current PE of 13 compares with over 26 at the height of the dotcom boom and is roughly the same as it was in March 2003, but earnings have risen by 125% since then.

But the weird characteristic of recent months is how much the market seems to lurch forwards every time there is evidence of more corporate activity involving private equity bids. That suggests fragility and depends absolutely on ability to use the leverage supplied by low interest rates.

Certain stocks are now looking dangerous places to be - banks have done well on the back of the credit expansion and a strong appetite for risk, but while they must benefit from long-term Asian growth, mid-term they could flounder.

Property stocks and retailers could also be hit. According to the Building Societies Association, gross mortgage lending in March rose 23% to £5.46 billion, the strongest March in 20 years. That means three rate hikes since last August have done nothing to put borrowers off. It is as though they've put blind faith in the Bank's independent rate-setting system, whose establishment back in 1998 was Gordon Brown's finest hour. Next week, the Committee will surely get tougher.

For large British corporates, the decline of the dollar is also more serious than it may look. The US probably accounts for nearly half the revenues of the pharmaceutical and aerospace industries, and perhaps one third for media companies.

The impact on smaller companies is much less severe. UBS (USB) has calculated that only 30% of FTSE 100 companies, excluding financials, are in Britain, whereas 66% of the FTSE 250's sales are in Britain, and only 13% of their revenues stem from the US.

All else being equal, however, now is probably a time to overweight blue chips for their defensive qualities. Two UK sectors with little exposure to the US or to discretionary consumer spending are the electricity and tobacco industries.