In this week’s bulletin:

  • The first major takeover tussle of 2011 started as Smith & Nephew were rumoured to be of interest to US company Johnson & Johnson 
  • BP announced a deal with Russia that results in new shares being issued amounting to 5% of the company. 
  • The impact of increasing global food prices is discussed 
  • Interest rates in the UK were held, but analysts are starting to see signs that a rise could be imminent 
  • Hugh Young, manager of the St. James’s Place Far East funds, gives his opinion on the outlook for Asian markets 
Activity picks up
After a relatively quiet first week of the year for the FTSE 100, last week saw an increase in trading activity and market rumour. The leading UK index retreated late in the week from its 31-month high as commodity stocks were undermined by China’s decision to further tighten monetary policy, causing the index to close the week at 6002.03, still an increase of 1.7% since the start of 2011. Elsewhere, the US and Europe also saw gains of over 1% as, overall, equity markets concentrated on encouraging quarterly earning reports from the likes of Intel and J.P. Morgan, rather than less impressive economic data such as an increase in US unemployment.

Last week also witnessed the beginnings of the first major takeover tussle of the year, according to The Sunday Times. One of America’s biggest healthcare companies, Johnson & Johnson, is understood to be examining a fresh takeover approach for Smith & Nephew, the UK maker of hip and knee replacements, with the US firm looking to put together a revised bid worth at least 800p a share, valuing the UK company at around £7 billion. Not only has this news put the Smith & Nephew board on alert, with it stating “we are not engaged in any discussions which could lead to a merger or takeover involving the company”, but this would also test the coalition government’s determination to scrutinise bids by foreign companies; since after the sale of UK confectioner Cadbury to the American foods group Kraft last year, Vince Cable announced a review into the “short-termism” of the City.

Johnson & Johnson, which has a market value of £109 billion, has been encouraged by market reaction to the reports, with shares in Smith & Nephew rising to 750p on the first trading day after the news was leaked; and with massive cash levels of around $6.5 billion at its disposal, the US company certainly has the financial firepower to launch a formal bid. It remains to be seen whether a formal offer will be forthcoming but Richard Oldfield, manager of the St. James’s Place High Octane funds, sees it as a good acquisition for the US firm. “A company like Johnson & Johnson continues to look greatly undervalued, and it is odd that there should be such valuation anomalies at the larger end of the market. Within equity markets, waves of enthusiasm and gloom sweep through different parts at different times, but we can see with reasonable confidence that this company will provide good returns over several years. While by no means finalised, the deal with Smith & Nephew would increase worldwide sales, but if it doesn’t go through as planned, it shouldn’t change the long-term prospects of the stock at all. There is no real downside to the attempted acquisition.”

‘British’ Petroleum
On Friday, BP unveiled a $16 billion share-swap that will see the company issue new shares equivalent to 5% of its stock, in exchange for a 9.5% stake in Rosneft, the Russian oil giant. The deal would potentially make the Russian company, which is 85% controlled by the Kremlin, BP’s largest shareholder. The deal is part of a wider alliance between the two companies that will see them explore for oil in the Kara Sea in the Russian Arctic (an area the size of the North Sea), as Bob Dudley, BP’s chief executive, hailed it as a new model for co-operation between publicly traded companies and government oil companies. Looking to the future, Mr. Dudley has not ruled out Rosneft adding to its 5% stake if the project goes well, though it is important to remember that should everything go to plan, production from the region would not begin for another ten years. It is unclear how existing investors will react to the deal, which will see their shares diluted by the Russians’, but the size of the issue means that no investor vote is required. The deal has been seen initially as a coup for the British oil company and a blow to US rivals such as ExxonMobil, especially as it is believed that Vladimir Putin has promised BP the “most favourable tax treatment” during the project. The announcement brought mixed responses globally as the share price rose 4%; but environmentalists slammed the move into new exploration areas, while the reaction from the US was for politicians to express concerns; while The Sunday Times reported that Michael Burgess, a Republican congressman from Texas, said, “The national security implications of BP America being involved with a Russian company requires scrutiny”.

The Sunday Telegraph opined that the planned Arctic exploration will allow BP to regain its global prominence following the Gulf of Mexico oil spill which saw half of the company value lost in the space of months, although the share price has recovered around 70% since then. The paper reported that, nine months after the incident, this partnership is seen as a statement that the company still has friends in the world and does not intend to give up its position at the forefront of deepwater drilling in the face of US hostility. The outlook for BP in America has improved slightly, but remains uncertain. The publication of Barack Obama’s oil-spill commission report savaged BP for “failure of management”, but spread the blame among its partners as well. The likelihood of BP having to pay out several tens of billions in damages has diminished as a result, but the company’s brand in the US remains tarnished in a market that was central to its growth plans, and it remains unclear as to whether it will be granted new licences in the Gulf of Mexico.

Any salvation for savers?
This week, the Office for National Statistics is due to announce its Consumer Prices Index figure for December, which was 3.3% for the previous month. It is fully expected that the inflation rate will rise even higher due to the increasing price of petrol and utility bills, with economists believing that it will rise above 4% within months. According to The Daily Telegraph, savings rates are now so low that, taking these inflation figures into account, there are only three instant access accounts paying a real rate of return, with the average account paying just 0.23%. However, data from the financial markets indicated last week that interest rates could rise by early summer, following surprise at the steep rise in inflation. Most economists had not expected an increase until the end of the year, and a rise in the Bank of England base rate would end a two-year period of stability of rates at 0.5% aimed at rebuilding the flagging UK economy. Mortgage companies are already beginning to pull their best fixed-rate deals, with analysts seeing this as another sign of anticipation of a rate rise; but some leading economists are warning that the Bank of England must hold its nerve. According to a report in The Sunday Times, Ernst & Young is suggesting that inflation is being temporarily affected by rising commodity prices, and that the Monetary Policy Committee should “keep base rates where they are until it is clear that the economy is taking the fiscal adjustment in its stride”.

A global problem
With inflation talk high on the agenda, The Independent on Sunday felt it important to emphasise that this was a global issue, and not just confined to the UK. While we are all too aware of rising oil prices, it was also announced last week that global food prices are now on average 32% higher than they were six months ago. In a developed country such as the UK, food generally accounts for around 15–20% of household spend, whereas in most of the emerging world the figure reaches the heights of 50–75%; therefore a rise in food prices is felt much harder. This is one of the factors that has already caused civil unrest in parts of North Africa, with several governments in the region taking steps to control food costs. The Indian government has already placed a ban on certain vegetable exports, China has had to cut road tolls for food transportation, and the Korean government has actually had to take the steps of distributing emergency stocks of meat, fish and vegetables. There are a number of reasons to believe this trend will continue, including a rising global population, a global shift towards more meat-eating, and the higher costs of fuel and fertiliser. While globally we are highly likely to adapt to increasing the food supply, the paper warned that with the emerging world having more impact on global prices, food inflation may not be a short-term trend. It is difficult to see an increase in UK interest rates as a solution to this global phenomenon.

Global inflation concerns seem to have taken over from worries over the eurozone in global markets, with commodity prices rising again last week. The Financial Times reported that several agricultural prices are now at 30-month highs and oil is pushing back towards the $100 per barrel level once again. Within Asia, South Korea and Thailand raised their benchmark interest rates, while China increased its reserve ratio requirement for banks for the fourth time in two months. Closer to home, Jean-Claude Trichet, president of the European Central Bank, felt the need to comment on the inflation problems (2.2% in the eurozone), which the markets interpreted as increasing the chances of a rise in eurozone interest rates. This had the effect of pushing the single currency to a one-month high and its best week for a year.

But what does this necessarily mean for equity markets, particularly in the less developed regions of the world? Hugh Young of Aberdeen Asia, manager of the St. James’s Place Far East funds, is relatively positive on the shorter-term outlook, reporting recently, “Economic growth in Asia appears well underpinned in the next 12 months, having rebounded last year to pre-crisis levels. Although inflation has risen steadily since mid-2009, it has stabilised in recent months. However, many central banks have been slow to normalise monetary policy and their reluctance is due partly to the huge capital inflows into Asia that have caused regional currencies to appreciate. Policymakers also seem doubtful about the region’s robust recovery, concerned perhaps that the US and Western European economies remain vulnerable. To us, it appears that Asia is decoupling from its developed counterparts, finding its own sources of supply and demand. Corporate sentiment is upbeat, which reflects not only the strength of their balance sheets but also those of Asian consumers. With corporate profits well supported and real interest rates remaining low, the outlook for regional stock markets appears reasonably positive.”

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