Markets flashing red over profits

Rising interest rates could bring a remarkable period of corporate profits to an end
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The Independent Online

The United States economy has certainly delivered a loud wake-up call to the world's stock markets: the era of cheap money is coming to an end.

The United States economy has certainly delivered a loud wake-up call to the world's stock markets: the era of cheap money is coming to an end.

With the dollar climbing rapidly, US interest rates set to rise from 46-year lows, and the UK already half way through a period of tightening, life is about to get tougher for businesses. There is growing concern that the markets are sending a signal over future levels of corporate profits as central bankers decide the world had been given sufficient breathing space after the global downturn of the past three years.

Certainly UK plc had enjoyed a profitable ride recently. The rates of return enjoyed by British businesses are close to a four-year high, according to the latest official figures. In the second half last year profitability spiked up sharply, ending a three-year downturn and returning to levels last seen at the peak of the boom in 1999 - with both services and manufacturing joining the party.

In fact, the rebound ended a pretty miserable spell since 1997 that saw profitability decline since Labour won power. So was it a short-term spike or the start of a long-term revival?

Experts believe the upturn was a sign that companies were finally reaping the benefits of the massive restructuring they had gone through.

It also coincided with the start of the revival in economic growth, both at home and abroad, and the decision of the Bank of England to cut rates to their lowest levels for almost half a century.

"Growing levels of optimism, sustained consumer spending and a period of low interest rates are all factors that can help explain the improved results," said Simon Longfield, a partner at Grant Thornton, the accountants. "The question is whether it can be sustained."

Given that stock markets tend to price in a profits recovery some six months before it arrives, it is not surprising that the FTSE 100 index troughed in March last year. Doubtless the panic over the impending Iraqi war had a lot to do with that, but it is also true that the market hardly looked back from that point, enjoying strong rises month after month until interest rate worries kicked in this spring.

On top of that, of course, is the surge in the oil prices, which saps cash from consumers' pockets and adds to businesses' raw materials bills.

So are the markets looking forward to tougher times? Certainly most of the main forecasters believe 2004 could be the peak. The OECD became the latest body yesterday to point to a slowdown from next year. Jeremy Batstone, the head of research at the Fishe Group investment house in London, said stock markets were at a "watershed".

"Markets are forward looking and they have a slowdown in economic activity in 2005 and they are looking at the prospects of higher inflation and that is a very, very aggressive headwind for equities to sail into," he said.

Analysing corporate profits was vital to gauging true stock valuations. "It is my suspicion that costs are rising for business because of rising energy costs and because labour costs are rising," he said.

The latest official figures show average earnings growth hit 4.9 per cent in March, well above the Bank's "comfort level" of 4.5 per cent. Even stripping out massive City bonuses the figure is 3.8 per cent and rising. Fresh figures today are likely to show a further increase.

"That means businesses' margins are naturally going to come under pressure and investors may need to be wary of that," Mr Batstone said.

Grant Thornton's Mr Longfield said some businesses would soon have to restructure their debt as high-yield bond finance taken out some two years ago fell due within a climate of climbing bond yields.

While it was telecoms, energy and hotels that were hit by their debt burdens after the crash, he said this time it would be manufacturers, IT and media companies facing the need for refinancing.

However other analysts are more upbeat. According to BDO Stoy Hayward, the business advisers, companies are increasingly optimistic about their prospects going forward.

Its "poll of polls" survey showed output at its highest since 1994, suggesting annualised economic growth could reach 4.2 per cent in the autumn.

Looking forward, the optimism index - which relates closely to GDP growth two quarters ahead - has reached its highest level since 1997.

Peter Hemington, a partner at BDO, said: "Businesses don't believe that things will get tougher - in fact they think that things will be very rosy indeed."

He said interest rates would probably peak at 4.5 per cent - meaning just one rate hike - while the Government would do nothing to shock the economy in the run-up to a likely summer 2005 general election.

In any event there is some doubt as to how accurate a predictor of corporate health the stock market is. While corporate profits were broadly flat until their recent pick up, the stock market had gone through a surge, a crash and a mini-boom.

The obvious conclusion is that the stock market is driven by a whole host of factors outside pure corporate profits levels - such as speculative investment, political influence, taxation, red tape and the global environment.

The Centre for Policy Studies, a right-leaning think tank, recently analysed the performance of the stock market since Labour won power on 1 May 1997. It found that the FTSE 100 was virtually unchanged, gaining just 10 points over that period - the worst track record of any of the main markets in North America and Europe.

Unsurprisingly the CPS laid the blame at the door of the Government, highlighting the removal of tax credits for pension funds, an £18bn annual burden from tax and red tape, and a massive increase in public spending that has "crowded out" private investment.

Certainly the annual Equity Gilt Study by Barclays Capital shows that the growth rates in dividends slowed from 1997 and actually went negative in the early years of this decade.

The analysis, however, does not examine the impact of global recession on the UK, which has one of the greatest levels of international exposure among major indices. It is estimated that half of the FTSE 100's earnings come from overseas.

Analysis by HSBC shows that while earnings for listed companies have declined, the profitability of the wider business sector has risen strongly - indicating UK plc is doing better than the FTSE 100.

The CBI, the employers' organisation, is a long-standing critic of the Government's record on tax and red tape but declined to endorse the CPS hypothesis.

Ian McCafferty, its chief economist, said the stock market recently had been driven by concerns over higher interest rates and oil prices rather than any "UK-centric" issues.

But, like Mr Batstone, he sees the labour market as a pressure point into next year. "It is very seasonal which means wage rates for this year have largely been set but I have anecdotal evidence from businesses saying, 'We had a good wage round this year but I think we're going under pressure in 2005'."