All eyes turn to the upper slopes

One of the notable features of the London equity market has been its ability to shrug off bad news. The scale of the Tory defeat in the local council elections and the Chancellor's apparent oversight in failing to put up interest rates when advised to do so failed to stop the FT-SE 100 index of leading company shares breaching the 3,300 barrier.

The market has had a strong run since the beginning of March, with the FT-SE 100 adding more than 6 per cent. Moreover, the outlook based on fundamentals looks good. Dividend prospects remain rosy and the market remains reasonably valued, both internationally and relative to gilts.

The total return from the UK equity market in 1995 has been 8 per cent compared with a negative return of 6 per cent in 1994. Long gilts have made a return of 5.5 per cent after a loss of 12 per cent last year.

The City consensus is for a continued rally in both markets. "We expect to see continued strong gains with equities remaining ahead of gilts,'' says Richard Jeffrey at Charterhouse Tilney Securities. SG Warburg Securities agrees "all seems set fair for a market comfortably on track for a mid- year FT-SE 100 target of 3,350 with 3,500 in view for the year-end''. Nevertheless, Warburg will be "holders rather than aggressive chasers'' of equities this summer.

Societe Generale Strauss Turnbull predicts a year-end FT-SE index of between 3,500 and 3,700 with 4,000 possible before the end of 1996.

The conundrum at this point is how the stronger than anticipated performance on Wall Street will affect London. Traditionally, US and UK equity markets have been closely linked. But with Wall Street regularly breaking new ground, the US market has pulled away from London.

"The question is whether we go forward or the US comes back,'' a broker said.

One argument is that if the economy does show signs of slowing, Kenneth Clarke may yet get away without putting up interest rates again. "If the pound steadies and the Chancellor can show there is no domestic need for another rate rise, we could move forward very sharply,'' the broker said.

The City is confident that the growth in corporate earnings will remain strong. While turnover growth is expected to be broadly in line with growth in gross domestic product, there appears to be more scope for growth in profit margins. But with wage costs near to the floor, it is not yet clear how much margin growth will affect prices and ultimately interest rates.

But the downside for equities must still be the uncertain politcal landscape in Britan - which has not yet been fully discounted by the markets - and the potential for overheating in the US economy.

Signs of inflationary pressure in the US during the second half of the year could lead to a sharp about-turn on the other side of the Atlantic. "Given the historical correlation between the two markets, any underperformance in the US market would probably be translated into weakness in the UK market as well,'' Strauss Turnbull says.

SG Warburg has also pointed to some trimming of analysts' 1996 forecasts last month, supporting the view that some forecasts were a little optimistic.