Bill Jamieson: Is light at end of Footsie tunnel an oncoming inflation train?

Congratulations to Keith Skeoch, head of Standard Life Investments, on his January prediction that the FTSE100 would break the 6,000 barrier. It closed on Christmas Eve up 12.8 at 6008.92, the first time above 6,000 since June 2008.

The forecast did not look too bold back in January when the FTSE100 was trading around 5,400. It seemed positively racy when the index sank to 4805.75 in the summer with the deepening eurozone debt crisis.

But he bravely stuck with it. Strong performances by developing economies, a steady improvement in corporate balance sheets and better-than-expected company earnings through the year helped equities to a markedly more resilient performance than most had counted on.

But the paradox behind this is that there has been little improvement in the underlying worries that kept most investors on the sidelines until the final weeks of the year. Huge sovereign debt problems still overhang the eurozone, with a rating agency downgrade of Portuguese government debt last week providing a reality check. The US budget deficit and overall debt continues to defy gravity: no investor can look on this and be in any way sanguine. The Asian boom story is being clouded by concerns about financial stability in China and further rises in official interest rates to try and curb inflation.

Here in the UK, we may take comfort that we have passed the worst. But have we? Third quarter growth numbers have been shaded down, the trade deficit is awesome and the rebalancing of the economy away from consumption and towards exports has yet to begin.

Most worrying of all is that while the coalition government has proclaimed its good intentions on deficit reduction, figures last week showed the worst November deficit on record and government spending still rising by 10.9 per cent on a year ago. On the basis of these figures, the era of public spending austerity has yet to begin.

Why, then, has the stock market hit 6,000? Those better company earnings have certainly helped. Unemployment did not reach the depths that were feared. A much-predicted "double dip" has been avoided and business confidence surveys point to a continuing improvement in the New Year. But growth forecasts overall point to a notably subdued recovery.

What I suspect has driven the equity market rally of the past two months is not a rosy upward reappraisal of our prospects but a deepening apprehension about inflation. This has caused investors to shift out of bonds into equities where the total return is more likely to offer better protection. Inflation on the official CPI measure has hit 3.3 per cent. With the hike in VAT to 20 per cent next week and petrol prices continuing to rise, that rate is likely to graze 4 per cent in the coming months. The headline Retail Price Index looks on course to break 5 per cent.With ten-year gilt yields barely above 3 per cent a few weeks ago, it was hardly likely that investors were going to sit tight and do nothing.

So the forces pushing up equities reflect fear as much as hope about what 2011 will bring. A scramble is developing to find the asset class that will offer a better protection against 5 per cent inflation than government bonds.

A notable feature of the UK market in recent weeks has been strength of the very sector that looked to be utterly toxic two years ago: commercial property. In Christmas Eve trading UK property giant Land Securities gained 7.5p to 673pxd while British Land climbed 4p to 537p. Concern over inflation prospects is re-igniting interest in a sector that has long been seen as an inflation hedge - even though it was one of the biggest casualties of the bursting bubble.

Ironically, 2010 has turned out better for property sector investors than hoped. Ahead of last week's rises the sector was showing a twelve month gain of 17.6 per cent on a total return basis, compared with an 11.5 per cent gain in equities and a 4 7.1 per cent return on gilts on the same basis.

By contrast 2011 is not looking good for commercial property. The sector is dogged by prospects of banks shedding more unwanted properties from their impaired loan books. And rental income is expected to weaken. But a resurgence of inflation may help rekindle buyer interest.

Property-focused investment trusts likely to benefit include TR Property Sigma (at 77.9p on a discount of 23 per cent yielding 2.5 per cent and Henderson Global Property Trust (at 60p on a discount of 12 per cent yielding 5.3 per cent). ISIS Property Trust and Standard Life Investments Property Income Trust both offer attractive yields but are standing at a premium to net assets, so beware of chasing.