Just as the prospect of ‘stagflation’ depressed investors and thwarted attempts by the bulls to keep the FTSE100 Index heading north of 6,000 points, so its virtual arrival met an almost cheerful initial reaction. The index rose more than 80 points on the morning, which brought news of an increase to more than three per cent in the  Consumer Price Index and a forecast from the Bank of England of a likely further rise to four per cent.

Now that Bank governor Mervyn King has penned his letter to the government explaining how the rate of price increases has reached its highest level since 1997 – and speculation focuses on when and where UK interest rates will peak – the optimists are saying there is a pretext for tough action now, which could clear the way for a sustained easing next year. On past form, however, this suggests the darkest hour is before the dawn and should pave the way for a solid stock market recovery.

The darkest hour?
So the optimistic argument runs. The question is, however, whether this is the darkest hour or whether, as the credit crunch and surging energy and food costs seep their way through the economy, there is not much worse to come.

Surging oil and commodity prices are closing out many of the policy options available to the UK government to counteract the setbacks in the housing market and other sectors. Similar pressures apply in the USA, where an impending presidential election makes radical action unlikely; the EU is mired in yet another constitutional impasse and China’s course after the Olympic Games cannot be read with confidence.

With the FTSE 100 Index recently below 5,900, and closer to its 52-week low of 5,338.70 than its 6,754.16 high, special situations, defensive shares and long-term recovery plays (provided they sport decent yields) look the best bets. Plans by several international institutions to raise £10 billion to back the property sector suggest some big players reckon there is value to be had out there.

Those unburdened by borrowings are, if they act wisely now, in a position to make fortunes eventually, but those needing faster returns will have their work cut out. The Financial Services Authority’s moves to tighten up on short selling may be worthwhile in themselves, but they will not have much impact on major market trends.

Signs of support
Companies acting to restore their finances can find support. Barclays’ reassuring trading statement and the prospect of a £4 billion placing to strengthen the bank’s balance sheet has helped lift its shares 14 per cent off their June low to 349.5p, though they remain well below half their 790p high of February last year.

Investors welcomed Barclays’ intention to raise the money through a placing with sovereign wealth funds and other outside investors, as well as existing shareholders, rather than through the process of a rights issue.

RBS, understood to be looking at Sainsbury’s boardroom for its new boss, has also staged a modest rally, helped by selling its Angel Trains leasing arm for a near £300 million profit to a consortium led by Australia’s Babcock & Brown in a £4 billion disposal programme, though at 213.75p its shares are still 60 per cent off their 2007 peak.

Energy continues to hog much of the limelight, as oil flirts with $140 a barrel. Nuclear group British Energy, at 721.75p, is 90 per cent up from its 2005 low, though below its 785p peak of two months ago, after spurning as inadequate bids from continental groups EDF of France and RWE of Germany.

BP, embroiled in a war of words with its key Russian joint venture partner TNK, has been resilient at 593p, up almost £1 since March, though still below the 712p reached two years ago. The possibility of BP buying out its partner has been raised with the Kremlin.

Reserves of energy
Oil services group Expro International has benefited from the attentions of Umbrellastream, a private equity consortium led by Candover and including Goldman Sachs. Umbrellastream has upped its original bid to £1.8 billion, or £16.15p a share, but Expro shares, which languished at 418.8p three years ago, have sailed to £16.64p, with possible rival bidders, such as Halliburton, lately in the offing.

The energy sector is also one of the few where companies from around the world and their advisers still feel able to tap the London market for equity funding. Rock Well Petroleum of Canada is contemplating a £1 billion float on the LSE, and Cadogan Petroleum, a Ukraine-focused gas group, intends to raise more than £400 million on the LSE.  

Bid hopes at menswear group Moss Bros have revived with the emergence of Laura Ashley group as a 10.05 per cent shareholder. However, that stake was bought before Moss revealed deterioration in trading, which sees the shares below 40p, against 104p in 2005.

Building and construction sector woes are still taking their toll. At 91.75p, hard-pressed Barratt Developments, which has been hoping for a £400 million loan agreement, has fallen all the way from £12.89 early last year, while Taylor Wimpey, now offering to lend new-home buyers a quarter of the purchase price, has rallied modestly to 74.25p, but is still a fraction of the 518.5p it saw 14 months ago.     

Robert Tyerman is news editor of Growth Company Investor, the UK’s leading magazine for AIM and small-cap analysis.