Rising Oil Prices Are Fuelling the Rise of the UK Equity Market

By Mike Lenhoff

EQUITY markets have come a long way since April, but the surprise has not been the rise as such. The markets were oversold back then and due for a rebound.

Instead the surprise has been the concurrent increase in oil prices and US interest rates, and the unyielding character of the rebound in equity markets.

Higher oil prices are proving to be a more permanent feature of the overall investment background than expected and this has been especially good for the UK equity market.

Not only does the UK have an above average weighting in oil stocks but the sectors also account for nearly a quarter of the market following the recent listing of Royal Dutch Shell.

However, the more interesting development is that equity markets that dont have lots of oil stocks have been doing well too and, indeed, better than those that have.

In the euro zone the weighting of oil stocks is less than that for the UK and still the Dow Jones Euro Stoxx Index has been outperforming the FTSE 100.

Japan has a tiny weighting in oil stocks and yet, as the chart above shows, the equity market has leapt ahead of its peers to become the top performing major market in the year to date.

But equity markets generally have performed well. The earnings news flow has been better than expected.

The distribution to shareholders by way of dividends and share buy backs has been greater than expected. Corporate activity has been stronger than expected and, together, the combination has been powerful for equity markets.

And then there is the valuation. Corporate earnings have continued to climb steadily but equity markets have lagged behind the rise in earnings since the middle of last year and the upshot is that prospective p/e ratios are where they were around the time of the Baghdad Bounce and even lower for Wall Street.

Looking at the UK equity market one has to remember that the relevant investment backdrop is not the UK economy but the global economy. The UK economy accounts for no more than 30 to 35% of the sales by the big blue chips in the FTSE 100. The remaining 65 to 70% is accounted for by sales overseas and, on this score, the global outlook remains promising.

Still, one cant help feeling that, with the persistence of higher oil prices and further rises in US interest rates, some downgrading in the outlook for economic growth and corporate earnings is likely.

But it has been a mistake to underestimate this years trends and, on the face of it, the UK equity market does not appear ready for turning.

The oil and mining sectors may lose some, but not much, of their momentum but the pharmas are picking up again. If there is a return of interest in the banks, which have been underperforming for nearly three years, and offer a dividend yield in excess of gilts, this would be enough to drive the FTSE 100 considerably higher.

Mike Lenhoff is chief strategist at Brewin Dolphin