Market view: Robert Tyerman gauges the market reaction to the rising trend in interest rates

What Investment, June, 2007 by Robert Tyerman

Neither the long-awaited confirmation of Tony Blair's imminent departure from No. 10 nor the latest widely expected rise in UK interest rates has removed the sense of uncertainty from a stock market still mesmerised by the prospect of yet more bids and deals.

After life insurance group Friends Provident joined the lengthening list of fancied candidates (with interest from French insurer Axa and private equity group J.C. Flowers) gloomier sages have been recalling that spates of bid frenzy, funded by massive borrowings, have in the past often signalled sharp market retreats before too long.

Most expect Gordon Brown as prime minister to pursue much the same economic policies he did as chancellor, at least to begin with. However, many agree with F&C fund manager Ted Scott that Bank of England governor Mervyn King and the Bank's Monetary Policy Committee should have been bolder in May and increased rates by more than 0.25 percentage points to 5.5 per cent, even though that represents a six-year high.

The feeling that the quarter point rise still leaves open the possibility of another similar increase before too long has helped deflect the Footsie from its upward path to around 6,455--nearly 160 points off its 12-month high but still nearly 1,000 points above its 12-month low. The more volatile FTSE AIM Index, scene of much of the action in resources and overseas shares, has dipped below 1,200-75 points down from May last year but 23 per cent higher than last October.

Scott and others argue that with the Retail Prices Index (RPI) showing a 4.8 per cent annual increase, driven by non-discretionary spending items such as fuel, inflationary expectations have also risen. This could make a gradual "fine-tuning" interest rate policy ineffective.

News from Halifax that house prices rose 1.1 per cent between March and April, the lowest monthly increase so far this year, has provided modest reassurance that overheating could be being dampened. However, a strong rebound in manufacturing output for March must be offset against a widening deficit in traded goods between the UK and its European Union partners.

Wall Street has been sending similarly confusing messages, with disappointing retail sales vying with inflationary concerns and mortgage lending write-offs for attention. The Federal Reserve held rates at 5.25 per cent and is expected to leave them there until US unemployment starts to rise.

Nowadays, China is becoming an ever-greater influence on the UK market, as the shockwaves from Shanghai proved earlier this year, and signs of overheating there could therefore be a cause of concern here too. Combined daily trading volume on all the Chinese exchanges has risen tenfold in six months to 25 billion [pounds sterling] a day, as People's Republic equities have soared.

That is more than all other Asian bourses, including Tokyo, combined and is not seen as sustainable without at least a brusque interruption, despite the People's Republic's undoubted economic strength. Meanwhile, Chinese companies are also queuing up to list in London.

But it is the deal boom closer to home that is fuelling most of the current excitement and, in some cases, anxiety. Philip Yea, CEO of investment group 3i, has added his voice to these concerns.

Saying he would not be surprised if another blue-chip company was taken off the market, Yea comments, 'Clearly, not only is there a lot of equity available, but also a lot of debt. However, there is a risk that individual investments will become over-leveraged.'

The 50 billion [pounds sterling] struggle for ABN Amro between agreed merger partner Barclays and a consortium led by Royal Bank of Scotland has involved many twists and turns, on both sides of the Atlantic, including the surprising resignation of ABN Amro's chief financial officer, Hugh Scott-Barrett, while the prices of both Barclays and RBS have retreated.

Hanson, the world's largest supplier of sand and gravel, has doubled in value to 8 billion [pounds sterling] over the past year, having agreed a bid from HeidelbergCement, which has lined up Royal Bank of Scotland and Deutsche Bank to fund it. Financial information group Reuters, which was 350p last July, reached 628p after accepting an 8.8 billion [pounds sterling] bid from the Canadian Thomson group.

Strong performer in the engineering sector Babcock International pleased fans by pulling off the 350 million [pounds sterling] acquisition of the Devonport naval dockyard. Music group EMI at 244.75p has proved another favoured candidate for private equity attention.

Many of the current bids are international, including the private equity and other bidders lining up for Amsterdam-quoted Endemol, maker of the Big Brother TV series. Defence giant BAE Systems reached agreement to buy the US ArmorGroup for 2.3 billion [pounds sterling], as defence industry concentration gathers pace.

Companies are still seeking to list their shares on the London Stock Exchange and AIM, though new issues are stickier than they were and brokers report that "later-stage" companies are likelier now to receive a sympathetic hearing than "early-stage" ones. And there are signs of at least a potential cooling of the housing market.