Market Report: Age of austerity sparks concern about Babcock

Babcock International was under pressure amid worries about the impact of public spending cuts last night. The defence services group fell by 11p to 597p after Bank of America Merrill Lynch warned that, with the bulk of its revenues related to the public sector, Babcock's margins may be squeezed in an age of fiscal austerity.

Merrill also voiced disquiet about the company's recent acquisition of VT, arguing that while the deal made "sound strategic sense", Babcock had "paid a full price". "We see the deal as around 10 per cent [earnings] accretive in the second full year due to £50m [in] synergy benefits, but there is a risk this will be mitigated by top line and margin pressures resulting from a slowdown in the public sector," the broker said, resuming coverage with an "underperform" recommendation and 580p target price.

On the wider FTSE 250 index, Connaught, which recently warned on the impact of cutbacks in public spending, was far and away the biggest loser among the mid-caps. The company, which maintains social housing and helps workplaces comply with health and safety rules, saw its shares slide by an eye-watering 69 per cent, or 70.64p, to 31.46p after warning of an "urgent requirement for additional funds to meet the current and ongoing needs of the business". Connaught went on to say that it was set to breach its banking covenants, sparking an exodus from the shares.

Among the brokers that weighed in, Collins Stewart swiftly switched its stance to "sell", while Investec suspended its target price, saying that it was awaiting "absolute clarity on debt levels, accounting policies and potential contract losses". The latter recommended switching into Mears and Mitie, both of which, though higher, failed to make much headway, edging up 1p to 241p and by 0.2p to 209.1p, as the news from Connaught dampened sentiment across the sector.

overall, the FTSE 100 firmed up 38.5 points to close at 5,351.12, while the FTSE 250 rose by 44.45 points to 10,138.12 as American indices gained ground in response to some positive US home sales data. Pharmaceutical stocks were under pressure, with GlaxoSmithKline easing by 15p to 1,172p following a report that it had made an informal approach for the biotech group Genzyme. AstraZeneca was also held back, relaxing by 20.5p to 3,126p as investors awaited the release of its half-yearly results later this week.

The banking sector was higher, with Barclays gaining 315.65p, up 13.65p, Lloyds adding 2.48p to 66p and the Royal Bank of Scotland climbing to 46.67p, up 1.34p, as analysts went over the results of the European stress tests, which were released after the close on Friday. Though some market watchers questioned whether the tests were stringent, and thus credible, enough, the analysts at Barclays Capital said the answer was "a qualified 'yes'". "The absence of testing for full sovereign default is understandable, but new disclosure allows investors to conduct their own stress test," they said.

Evolution Securities was less convinced by the exercise, saying: "We think the tests should have been tougher, and we feel the whole exercise lacks credibility."

Evolution went on to add that it did not see the tests as "a strong positive catalyst for equity investors", though it conceded that the exercise was likely to "help in the gradual normalisation of funding markets".

Elsewhere, Tullow Oil rallied after unveiling a discovery off the coast of Ghana. Tullow said it had found a major new oil field, driving its shares north by a healthy 60p to 1,239p. Earlier, the stock touched a session high of 1,249p, up nearly 6 per cent, as investors welcomed the announcement. In the wider sector, the FTSE 250-listed oil prospector, Dana Petroleum, fell prey to a bout of profit-taking, easing by 16p to 1,690p, as the market awaited further news on the Korean National Oil Corporation's bid proposal. Back among the blue-chips, ARM Holdings, the semiconductors group which soared on the back of a new licensing deal with Microsoft at the end of last week, eased by 7.2p to 346.1p as investors banked profits and Panmure Gordon turned negative.

The broker said that while the Microsoft agreement was indeed positive, it did not change its long-term forecasts for the group. Moreover, as far as the smartphone and tablet computer markets were concerned, the broker argued that the shares were already pricing in the prospect of large market share gains. "The risk therefore moves to the downside if there are any stumbles along the way," Panmure added, keeping its target price for the stock unchanged at 275p, but downgrading its recommendation to "sell" from "hold".

further afield, the nightclub operator Luminar, a favourite of the speculators, was fired up, surging by 20 per cent or 2p to 12p amid rumours of bid interest. The details were thin on the ground, with no suitor being mentioned, though some highlighted talk of a possible management buyout. The rumour mill was also in motion around Telecity, which has added 3.8p to 440.1p amid renewed chatter of interest from a bigger peer.