Long-term future impossible to predict

Investors seem to be unable to make up their minds about whether or not they liked the Budget
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The Independent Online
It is always tempting to play the game of talking about how the stock market is thinking as if it were a human being with a coherent and rational point of view. But there are times when you realise why two of the greatest books ever written about the market were called The Crowd and Extraordinary Popular Delusions.

Crowds often move in herd-like ways, but there are also occasions when they seem to be pulling in three different directions at once, with nobody quite sure which way they should be going.

It has been just that sort of week this week, with investors not for the first time seemingly unable to make up their minds whether they liked the Budget or not. Having marked prices down the week before, the market- makers were busy marking them up again the day before Mr Brown gave his Budget in the Commons. After going down first thing on Thursday, share prices took off again for the rest of the day, helped as ever by the strength of Wall Street.

The noticeable increase in market volatility is not a total surprise. As I have mentioned before, Budgets never see the markets working at their best. There is too much information to absorb too quickly, and the lasting implications take time to sink in. Just about the only golden rule, in fact, is that the initial verdict of the stock market and the newspapers, whatever it is, tends to be the wrong one. Don't just take my word for it.

As it happens, I spent much of Wednesday afternoon with one of Britain's best- known and most experienced investment managers, talking about the lessons he had learnt from nearly 50 years in the business. He reminded me, quite voluntarily, of the fact that the way the market moves in the 48 hours before and after the Budget is normally a totally reliable indicator of the way the markets will go in future. Reliable, that is, but only in a contrary sense.

If everyone likes a Budget, he told me, then history's later verdict will be unkind. And vice versa. He didn't say you could bet your life on it, but that was the implication. He himself made it a rule never to make any lasting adjustments to his portfolio until the initial euphoria or disappointment has had time to evaporate.

I suppose the classic case was Geoffrey Howe's 1981 Budget, the one that left the "wets" in the Cabinet fuming, and prompted one of the chancellor's colleagues to call his Budget the "economics of the madhouse". It turned out to mark pretty much the turning point in the 1980/1981 recession, and the start of the biggest bull market the UK has ever seen. It was also incidentally the year when it was possible, for the first time in years, to make a big capital gain on gilts. Nobody foresaw either event at the time.

So where does that leave us now? The market's strength before and after Budget day does not, on this view, inspire much longer-term confidence. The initial reaction - putting share prices and the pound up, but gilts prices down - seems perfectly logical, as it always does at the time.

Most of the editorials in the newspapers were broadly favourable to what Mr Brown has done. But then it is clear that nobody really knows what the long-term consequences of ending the tax credit on dividends for pension funds and the parallel changes in corporation tax will be.

It is not that there are any shortages of calculations about what the theoretical consequences should be. If you assume that tax-exempt institutions account for around a third of the market, then cutting their future expected income flows by 20 per cent implies that the value of the market should fall by the order of 7 per cent. The fall in corporation tax acts in the other direction by increasing the potential value of all companies that pay it. But, of course, it is nothing like as simple as that.

How will the pension funds change their investment habits now that the bias in favour of dividends has been removed? How far will the surpluses that exist at the moment in many pension funds offset the need for companies to make extra contributions? And what difference will the change in the corporation tax rate make to companies' distribution policy?

Most of these questions cannot yet be answered for the simple reason that they are unknowable. They depend on behavioural responses as much as static point-in-time analysis. It highlights the fundamental flaw in the whole panoply of classical economic analysis, which assumes that the world is always moving from one state of equilibrium to another, rather than reflecting the reality of a world which is in constant, dynamic flux.

That is the world, for better or worse, in which we have to live. As it happens, I spoke to three well-known investment managers this week, who between them manage several hundreds of millions of other people's money, and they all said they did not yet know what impact the Budget would have in the longer term. They genuinely did not know.

One reason is that Budgets generally achieve much less than we all assume. Leaving aside the ACT changes for a moment, the actual changes in the overall tax burden announced by Mr Brown are very small beer measured against an economy the size of ours. That, paradoxically, is why the pound has been rising.

The implication is that, as the Chancellor has done so little to restrain consumer demand with tax increases, theBank of England will have to take on the job by putting up interest rates.

That in turn should be good for gilts and not so good for shares. Yet the market reaction has been to say that we can have a strong pound, a strong stock market and rising gilts yields. Does that really add up? Not really. My view is that the market is still mildly overvalued and that the strength of the pound is not helpful. The big positive is that long-term bond yields are still falling, which means investors believe the Labour government is not a serious long-term threat to inflation. But then if you want rational responses in Budget week, the stock market is not the place to go and look.

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