By Mike Lenhoff 15/11/2006 00:00

As the chart shows, headline inflation in the UK is above target and rising. That is despite sterling’s strength, which ought to be disinflationary and which ought ultimately to limit the scope for higher interest rates.

Core inflation, which has been on a downward trend since the middle of last year, has also been picking up in recent months.

While another quarter point increase in interest rates is being discounted for the early part of next year, this may not be the end of it. The risk for the equity market, if it begins to ponder over whether interest rates need to go up by more than expected, is that 2007 proves to be a joyless year.

But let’s not spoil the seasonal cheer with anything so downbeat. In a recent note which looked ahead at the prospects for markets (see 2007 – A year of Grinding Onwards! 7^th December 2006), we took the view that the consensus was underestimating the momentum in the global economy and that the growth surprises could be on the upside. This is potentially good news for the UK equity market given the broad geographic exposure of its leaders to the global economy. It is partly why we set our sights on 6550 for the FTSE 100 by year-end 2007.

However, we are conscious of two things. One is sterling and the other is UK interest rates. Taking sterling first. Its strength against the dollar, if it continues, could impede the progress of the blue chips.

Reading across from the weakness of the dollar, there are translational risks for those UK companies with high dollar earnings but low dollar borrowings and/or sterling or Euro based operating costs. There are translational risks for investors in those UK companies which base dividend payments in dollars. More seriously, there are transactional risks resulting from the enhanced international competitiveness of dollar-related producers.

UBS Investment Research estimates that 70% of the sales of the non-financial FTSE 100 are derived overseas. Of this, the direct exposure to North America is estimated to be around 27%, that to Europe around 22% and that to the rest of the World about 21%. To the extent that a good part of the latter is dollar-related, the exposure of the FTSE 100 companies to the dollar, either directly or indirectly, could be as high as 40 to 45%.

As for UK interest rates, if the MPC is forced to raise them by more than expected, the mid caps could come under pressure because of their greater exposure to the domestic economy. Again, UBS Investment Research estimates that around 66% of the sales of the non-financial FTSE 250 are UK based.

What all this means is that the UK equity market could take a hit from all sides. While sterling’s strength against the dollar is potentially a hindrance to the performance of the leaders, higher interest rates are potentially a hindrance to the performance of the second liners.

It is likely that the leaders would outperform in this environment. The second liners are much more cyclical than the leaders and are likely to react sharply if it suddenly dawned that the MPC needs to raise interest rates by more than expected. However, even if the large caps were to outperform, we suspect this would not be because they would enjoy a stellar year. Rather, it is likely that their defensive qualities would appeal and that their favourable valuations would prove supportive.

So much for risks. Let’s end on an upbeat. As the New Year beckons, we are cautiously optimistic. While 2007 may be a trying year for the equity market, as it was for a while in the middle of this year, we are hopeful it will end up being a good year, as it now looks to have been this year. Our target of 6550 for the FTSE 100 implies a rise that is more or less in line with the earnings growth expected for next year.

It may mean more leveraging, but we also think the focus of corporate activity - mergers, takeovers - could shift increasingly towards the large caps. Our year-end FTSE 100 target may prove to be conservative.

Importantly, we expect the US equity market to do well (see On the Fed Funds Rate and the S&P 500 for 2007! 12^th December 2006). By the end of 2007, if not before, we think the S&P 500 will be challenging its former peak level of 1527 set in March 2000. That should put the stuffing into equity markets!

* The information contained in this report has been taken from public sources and is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not necessarily the views held throughout Brewin Dolphin Securities Ltd. No Director, representative or employee of Brewin Dolphin Securities Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchases or sale of such securities from time to time. In addition we reserve the right to act as a principal or as agent with regard to the sale or purchase of any security mentioned in this document. Prices, values or income may fall against the investor’s interests. You should therefore be aware that you may get less back than you invested. Past performance is not necessarily a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio, you should seek the advice of a qualified investment adviser.