Long-awaited stagflation is now well and truly upon us. As investors digest Bank of England Governor Mervyn King’s bleak forecast of an inevitable ‘quarter or two of economic contraction’, bulls have pushed the FTSE 100 share index up some 12 per cent since July in the hope that recession fears will force a downward trend in interest rates.

The Footsie remains more than 1,000 points, or 18 per cent, off its 6,751.7 October high and 20 per cent below its all-time high. Bargain hunters are talking up safer high-yielding shares, and bolder spirits are detecting value among better-quality banks, insurers and even builders.

All eyes on inflation
Risk takers might profit by emulating them. But they should remember that some of this could prove premature, despite the City’s immediate consensus that the Bank of England’s Monetary Policy Committee (MPC) was signalling just such a rates downtrend.

It is true that deflationary signals abound, suggesting that it is time for a policy of monetary stimulation. But, unfortunately, there is no sign so far that inflation is likely to abate, and the credit crunch continues to work its malign way through business life.

Housing starts are down to levels last seen 18 years ago, house prices are off ten per cent since August, business confidence continues to ebb and unemployment rose in July at the fastest rate since 1992, to 1.67 million people. However, UK inflation is at a 16-year high of 4.4 per cent (even using the flattering Consumer Prices Index) and King himself sees it rising to five per cent.

King speaks of the need for a ‘painful adjustment’ as the UK economy contends with energy and food prices rising noticeably faster than that. The weapon of interest rates is a blunt instrument when recession and inflation coincide and, while many players now assume it will be used to alleviate the former, the Bank and the MPC still have the formal obligation to use it to squeeze out the latter.    

If the price is right
Sterling is looking tottery, with the pound falling almost six per cent in a month against the US dollar, in its steepest decline since the recession of 1993, touching levels not seen for two years. Its trade-weighted value has hit an 11-year low.

Indications that many metal prices are on the slide from previous peaks reflect a distinct economic slackening on both sides of the Atlantic, though agricultural commodities remain strong. Oil’s near $30 a barrel retreat from recent peaks still leaves fuel uncomfortably expensive, though gold’s recent wobbling below $820 an ounce suggests the doomsters are not having it all their way.

A dash for cash among some key market movers is also on the cards. Hedge funds are understood to be facing record redemptions this month. Natural resources continue to provide much of the excitement in the market. Platinum miner Lonmin’s robust defence against Swiss-based Xstrata’s £5 billion takeover bid has seen its shares top £34, £1 above Xstrata’s offer price – and more than 40 per cent above Lonmin’s pre-bid price.

Base metal miner Rio Tinto, subject of recent bid attention from mega-miner BHP Billiton, is hovering around £48, respectably up from 2005’s £19.36 low but well below May’s bid-induced high of £70.78. In oils, Imperial Energy warmed to £11.45 as investors contemplated a bidding war between China’s Sinopec and Oil & Natural Gas Corporation of India.  

Powering on
In the power sector, nuclear generator British Energy, which had doubled in 14 months to 785p on UK government-supported bid interest from France’s EDF, has settled back to below 710p. Key shareholders have thwarted the French, and gas supplier Centrica, now 309p, ponders making a possible £22 billion merger approach.

Among beleaguered construction groups, Balfour Beatty has demonstrated the advantages of dealing with the public sector during a business slowdown. With first-half pre-tax profits up by £19 million to £95 million, the company has lifted its order book of infrastructure projects 14 per cent in 12 months and looks more resilient than many at 417p, though still £1 below its price last December.

Property itself is still nervous territory, with a 21 per cent rally on interest rate hopes clipped by a gloomy review from Morgan Stanley analysts, emphasising falling rents and bank foreclosures on highly geared property vehicles. Hammerson, with interests in the UK and continental Europe, has rallied more than 80p in a month to 911p, despite a six-month loss of £417 million, but is still little more than half its March 2007 level.

Bargain hunting
As we have already noted, bargain hunters have caused faint stirrings in the hard-pressed financial sector, though the news is mostly bad.

Royal Bank of Scotland, which had to abandon the sale of its Australian and New Zealand businesses when Commonwealth Bank of Australia pulled out, has rallied 38 per cent in a month to 229.25p, still a long way down from last year’s 617.7p peak.

HBOS, Britain’s largest mortgage lender, which previously dismayed investors with a 72 per cent drop in interim profits to £848 million and saw them mostly shun its £4 billion rights issue, has staged a similar rally to 309.75p, after slashing jobs and closing one of its five mortgage brands, TMB, for new business, though its price remains a mere fraction of the £11.65 seen early last year.

Finally, the appointment of Harvey McGrath, former head of heavyweight hedge fund manager Man Group, to chair insurance giant Prudential, has helped put a shine on the shares at 555p, still 256p off last year’s high.

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