Record oil prices bring inflation fears to fore

UK and European equities shuddered to their lowest levels since 2005 yesterday, a bleak end to a torrid week, as record oil prices fuelled inflation fears and sent investors fleeing to safety.

With US markets closed for the Independence Day holiday yesterday, shares in Asia and Europe felt the brunt of the selling. The FTSE 100 fell 1.2 per cent to close beneath the lows seen as Bear Stearns imploded in mid-March, bringing its losses over the week to 2.1 per cent. The pan-European FTSE Eurofirst fell 1.3 per cent.

The Dow Jones Industrial Average and the Nasdaq fell into official bear market territory this week – a 20 per cent fall from the recent peak – while the S&P 500 and the FTSE 100 teetered on the brink.

“A big inflation spook has enormous power – this is the first time people in our generation have felt the full force of oil prices on equities,” said Robert Quinn, equities analyst at Standard & Poor’s. “We’ve fallen into the third and final phase of this bear market . . . inflation will dominate concerns for some time.”

A profit warning from UK retailer Marks and Spencer, and fears General Motors in the US might collapse, also hit confidence.

Analysts at Citibank said that, post sell-off, equities were looking fairly cheap. “Although the market now offers good value for the long-term investor, there are precious few long-term investors to take advantage of such opportunities,” they wrote in a note to clients.

Research from State Street showed money that flowed out of equities this week in what many market participants said was the biggest flight to safety since the height of the financial market panic in March.

Credit markets also took a turn for the worse. The Markit iTraxx Crossover index of “junk-rated” credits – a much-watched barometer of risk appetite – rose 8 basis points over the week to its highest level since April. Investment-grade spreads in both Europe and the US also widened.

Emerging markets witnessed their fourth consecutive week of heavy outflows.

South Korea’s Kospi index fell 6.3 per cent over the week while Thailand’s shares lost 4 per cent after inflation in both countries hit 10-year highs.

Most analysts expect the trend to continue. More than one in four of the world’s economies now have double-digit inflation, analysts at Morgan Stanley worked out, all of them emerging markets.

Investors turned against Pakistan, in spite of efforts by the Karachi stock exchange to stem a sell-off. Last week, the exchange banned short-selling for a month and tightened the daily limits for share declines, giving the market a short-lived boost. But yesterday shares fell for the sixth session in a row, bringing its losses over the week to 3.2 per cent.

Trading volume in Karachi has become very thin, with just 4.13m shares changing hands yesterday.

Oil trading dominated commodity markets again, with the price of crude surging more than 3 per cent this week after a surprise fall in US crude stockpiles and simmering tension between Israel and Iran.

Brent crude punched through $146 a barrel on Thursday but eased back slightly yesterday to $144.95 a barrel. Nymex August West Texas Intermediate, which hit a record of $145.85 a barrel, yesterday fell $1 to $144.25 a barrel.

Elsewhere, lead prices slumped 12 per cent on the week, leading other base metals sharply lower.

In currency markets , the euro was flat against the dollar yesterday in light trade, having taken a tumble against the dollar on Thursday after the European Central Bank disappointed euro-bulls by not being as hawkish as expected.

The ECB became the first of the large central banks to raise interest rates since the credit crisis began, but bank president Jean-Claude Trichet stressed in his post-decision press conference that he now had no bias on interest rates. That sent the euro 1.2 per cent lower against the dollar. It lost 0.6 per cent over the week to $1.5695.

The dollar was also boosted by US jobs data on Thursday, which, while poor, did not paint the gloomiest scenario some had priced in.

Many were left unsure as to where the dollar-euro rate would move next. “There can be little doubt that the euro-area is witnessing a sharp decline in economic activity, but we also believe that markets are too optimistic about the outlook for the US,” said forex strategists at Danske Bank. “Neither the financial crisis nor the housing recession seem likely to be resolved any time soon.”

In government bond markets , the yield on the US 10-year Treasury rose 2.1 basis points to 3.99 per cent over the week as investors took a gloomy view about inflation, although risk-aversion sent the yield falling earlier in the week.

The yield on the German 10-year bund, Europe’s benchmark government security, fell 7 basis points to 4.49 per cent yesterday. Over the week the yield was down 3 basis points.