Analysis: If this is good news,why does it feel so bad?

Beware of extrapolating from rising share prices to the real world.

By Oliver Ralph, May 11, 2011

Those who view life through the microcosm of the stock market might be forgiven for thinking that all is well with the world.

Shares have done well, with the FTSE 100 rising by 22 per cent in 2009 and seven per cent in 2010, albeit after a disastrous showing in 2008. And the companies whose shares are traded on the stock market are, by and large, looking healthy. The corporate financial problems caused by the recession in 2008 and 2009 are largely at an end, leaving most firms on a strong financial footing. Profitability is up - according to data from the Office for National Statistics, company profits improved steadily in 2010 - after hitting a trough in 2009.

But out in the real world, life doesn't look so rosy. The full impact of government spending cuts is about to hit both the people employed in the public sector and the companies contracted to government bodies. Rising inflation is already starting to hit consumer spending power and the likely rise in interest rates will reduce consumer spending still further. The threat of a double-dip recession - or at least another tough year ahead - looms large.

This apparent divergence - strong corporate profits but an uncertain outlook - is giving the boards of UK companies some pause for thought. As we approach the third anniversary of the financial crisis, companies can look at their own accounts and feel confident. But they are, by and large, wary about backing that confidence with cash and investing for the future. The result is that investment, be it money put into new equipment or staff, or money spent on acquisitions, is proceeding at a cautious pace. Large-scale acquisition activity, a hallmark of boom times, is thin on the ground and those that attempt it have to tread with care - Prudential was embarrassed last year when shareholders objected to the price offered by the company to buy AIA, an Asian rival. And BHP, the mining group that is one of the five largest companies in the world by market capitalisation, was rebuffed by regulators when it tried to buy Potash Corp of Canada.

Those companies that are investing are targeting areas that offer the most secure prospects for growth. Geographically, that means emerging markets. By industry, it means commodities, energy and natural resources. Diageo, the drinks giant that owns Guinness, Baileys and Smirnoff, is a good example. In February it agreed a £1.3 billion deal to buy Mey Icki, the leading manufacturer of a spirit called raki in the growing Turkish market. Rio Tinto, the mining group, is another. It has committed to spending £12 billion on new projects since the start of 2010 to improve its ability to supply metals to China and other high-growth markets.

With domestic demand relatively weak (the employers' group, the CBI, expects GDP to grow by 1.8 per cent this year) few companies are planning major investments in the UK. With the exception of Kraft's acquisition of Cadbury last year - a deal which owed as much to Cadbury's position in emerging markets as it did to its UK heritage - the era of foreign raiders snapping up UK corporate titans has come to a halt.

The story is similar further down the size scale. Cautious investment in carefully selected growth markets is de rigueur. Construction group Carillion, which usually focuses on large-scale engineering projects, is investing just over £300 million in Eaga, a Newcastle-based business which supplies and installs energy-saving services. And Ashmore, a fund management group, in February announced the $246 million acquisition of Emerging Markets Management, which specialises in investing in emerging markets shares.

Across the board, companies are hoping that this cautious approach pays off. While chief executives may see a headline-grabbing deal as a surefire way to secure their legacy, the combination of austerity, inflation and rising interest rates should be enough to dampen the enthusiasm of even the most ambitious management teams for the rest of the year.

Oliver Ralph is UK companies editor at the Financial Times

Last updated: 4:00pm, May 11 2011