Old fears haunt the markets again

There is a clearly discernible feeling that inflation is edging back into investor awareness

Life, said the philosopher Kierkegaard, is lived forwards but understood backwards. This has always seemed to me to be one of the two definitive statements about the perils of stock market forecasting. (The second being the economist JK Galbraith's observation that forecasters make forecasts not because they know but because they are always being asked).

The point is that while it is often easy to see the direction in which a market must in due course go, it is next to impossible to determine at exactly what point any decisive change in direction will be triggered. Understanding the turning points in what drives bull and bear markets is a luxury available only with hindsight.

Those who have been arguing over the last few days that we are seeing an important turning point in market expectations on both sides of the Atlantic are therefore more likely to be wrong than right. What is not in doubt, however, is that the run-up to the Budget next week and the latest bout of jitters about Wall Street is beginning to focus minds yet again on what is the appropriate level for the stock market.

It is not every month that the London stock market falls six days in a row, as it did up to and including last Monday. While the main factor behind the market's nervousness is (as I said last week) concern about what Gordon Brown will do to present taxation, there is also a clearly discernible feeling that inflation fears are beginning to edge back into investors' consciousness.

Tim Congdon, a leading UK monetary economist, this week raised again the possibility that inflation is about to rear its head again, not just here but in the United States as well. His view is that while the markets are still convinced the US is enjoying a rare and sustainable period of falling unemployment and low inflation, the growth of the US monetary aggregates strongly points to a period of higher inflation ahead. He paints a similar picture for the UK.

His conclusion is that financial markets are "blissfully complacent about inflation". The differential between index-linked gilts and conventional gilt yields in the UK, for example, has fallen to under 3.5 per cent, pretty much the lowest it has been since index-linked gilts were first issued in 1981. Wall Street also looks more highly valued than ever, he argues.

As my chart shows, Professor Congdon is worried that the ratio between gilt yields and stock market dividend yields is in danger of going off the top of the scale. The yield on US government bonds is more than four times that on the S&P 500 share index. This compares with an average over the past 15 years of 2.5-2.75, and the previous peak - briefly above 3.5 times - seen in the summer of 1987, weeks before the crash in the autumn.

The evidence of this ratio points at some point soon therefore to either a sharp fall in the level of the stock market, or to a further decline in bond yields. The market bulls will hope for the latter: the inflation bears will fear the former. Since he thinks inflation is poised to start rising soon, Mr Congdon is in the second camp. He points out that if the bond/dividend yield ratio is to revert to its former level, it implies a correction on Wall Street of the order of 30 per cent.

The position is not quite the same in the UK, where the comparable gilt/market yield ratio is well within its normal historical trading ratio. But with the money supply growing quite fast, and consumer spending buoyant, the inflation outlook is also less promising, in Professor Congdon's view, than the markets currently expect.

This brings us back to Mr Brown and his Budget. He is still basking in the success of his decision last month to grant control of interest rate decisions to the Bank of England. The combination of that important decision and the continued strength of sterling - which puts downward pressure on inflation - are behind investors' feelings here that the traditional threat of inflation under Labour is receding.

If you look at the break-even rate of inflation implied by the differential between ordinary and index-linked gilts, it has fallen recently - and, significantly, by more at the long end of the market than at the short. In other words, the feeling has been that there has been a change for the better in Britain's long-term inflation prospects.

So far that seems to remain the dominant view among investors, but the doubters are beginning to come out of the woodwork again, for the kind of reasons that Professor Congdon has articulated. The Budget will be the next test of Mr Brown's intentions, with all attention focused on how far he feels the need to raise new taxes.

That he will feel the need to do something is not in question.That he will do something about the tax treatment of dividends, at least for tax- exempt institutions, also seems pretty inevitable to me.

The interesting thing for ordinary investors will be (a) whether he decides to extend any changes so that they affects PEPs; and (b) how far he wraps up any changes in the wider context of an overhaul in the whole tax treatment of savings and investments. Labour is known to be interested in the idea of scrapping the whole panoply of Tessas, PEPs and so on in favour of a single, consistent taxation formula for savings, perhaps linked to the introduction of individual savings accounts for retirement.

Since, strictly speaking, the Budget is only an interim one designed to introduce the windfall tax on privatised utilities and clear a path for the promised unemployment reduction measures, there is no need for Mr Brown to do anything about this until his first full Budget, in either the autumn or next spring.

As a footnote, it is only fair to say that not everyone shares Professor Congdon's view that the stock market here and in the United States may be getting carried away. This week Wayne Angell, a former governor of the Federal Reserve, gave his view that there is no reason why Wall Street could not continue its current bull run for another two years at least.

He says the Dow Jones index could well rise from its current level (in the low 7,000s) to hit 10,000 by 1999. Mr Angell is now the head of Bear Stearns, one of the biggest US broking firms, and presumably has a vested interest in seeing the market go on rising, but as I said at the beginning there is no reason to suggest that he, any more than anyone else, can call the turns in the market with anything like certainty. But watch that bond/dividend yield ratio with interest.

News
Susan Sarandon described David Bowie as
peopleSusan Sarandon reveals more on her David Bowie romance
Sport
Arsenal supporters gather for a recent ‘fan party’ in New Jersey
football
Sport
sportDidier Drogba returns to Chelsea on one-year deal
Arts and Entertainment
The Secret Cinema performance of Back to the Future has been cancelled again
film
PROMOTED VIDEO
Have you tried new the Independent Digital Edition apps?
Life and Style
Balmain's autumn/winter 2014 campaign, shot by Mario Sorrenti and featuring Binx Walton, Cara Delevingne, Jourdan Dunn, Ysaunny Brito, Issa Lish and Kayla Scott
fashionHow Olivier Rousteing is revitalising the house of Balmain
News
people
Arts and Entertainment
Christian Grey cradles Ana in the Fifty Shades of Grey film
filmFifty Shades of Grey trailer provokes moral outrage in US
News
BBC broadcaster and presenter Evan Davis, who will be taking over from Jeremy Paxman on Newsnight
peopleForget Paxman - what will Evan Davis be like on Newsnight?
Life and Style
fashionCustomer complained about the visibly protruding ribs
Voices
The new dawn heralded by George Osborne has yet to rise
voicesJames Moore: As the Tories rub their hands together, the average voter will be asking why they're not getting a piece of the action
Sport
Dejan Lovren celebrates scoring for Southampton although the goal was later credited to Adam Lallana
sport
News
newsComedy club forced to apologise as maggots eating a dead pigeon fall out of air-conditioning
Arts and Entertainment
Jo Brand says she's mellowed a lot
tvJo Brand says shows encourage people to laugh at the vulnerable
Life and Style
People may feel that they're procrastinating by watching TV in the evening
life
Finacial products from our partners
Property search
Sell it with flowers: competition is 'intense' for homes with outside spaces

Gardens add a tenth to the value of your home

A London estate agent yesterday put a price on having a garden. David Pollock of Greene & Co reckons it can increase a property's value by a tenth.

Spectators at the Isle of Wight music festival watch the World Cup on the big screen. Betting promotions were a feature of the tournament
Lenders have been accused of persuading vulnerable people to borrow expensive credit

Payday loan firms accused of bombarding vulnerable people with nuisance phone calls

Payday loan firms have been accused of bombarding financially vulnerable people with nuisance phone calls, after a debt charity reported that a third of its clients were plagued by the messages.

The foundation proposed that the Government sets up a scheme to help people avoid losing their homes

Mortgages: 'Homeowners could trade down to shared ownership to defuse rate rise timebomb'

A plan to defuse a “mortgage debt timebomb” when interest rates rise is published today amid warnings that 2.3m households could struggle with their repayments.

Current accounts are too costly and confusing, says CMA as it announces investigation into Britain's biggest banks

Competition regulator to investigate market where it's hard for customers to make comparisons and the big banks' charges can be set too high
All the signs have been pointing up for buy-to-let, but there are clouds on the horizon

Buy-to-let: is it a boom or a bubble fit to burst?

People borrowing to be landlords could face the same restrictions as homebuyers, with MPs voicing fears that property speculation may be overheating the market

Moment of truth for payday lenders: Watchdog plans to curb cost of short-term loans

The chief of the City watchdog, Martin Wheatley, spoke exclusively to The Independent's Simon Read about its attempts to control the worst excesses of unscrupulous high-cost credit companies

Consumers given power to choose a green deal

How would you like to be able to choose how your electricity is made and even where it come from? It may sound futuristic and fanciful but the independent supplier Co-operative Energy has made it a reality this week.

'Scrap the trap': calls for change grow as banks are told to play fair with loyal savers

City regulator says existing customers suffer worst rates

Motor insurers divided on proposals for whiplash ban

MPs want medical evidence for claims. Will this bring higher premiums?

British Gas repays £1m for mis-sold deals

British Gas was yesterday forced to pay back £1m to its customers after mis-selling them energy deals.

Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Senior Risk Manager - Banking - London - £650

    £600 - £650 per day: Orgtel: Conduct Risk Liaison Manager - Banking - London -...

    The benefits of being in Recruitment at SThree...

    £18000 - £23000 per annum + Comission: SThree: SThree, International Recruitme...

    Test Analyst - UAT - Credit Risk

    £280 - £300 per day + competitive: Orgtel: Test Analyst, Edinburgh, Credit Ris...

    Trainee Recruitment Consultants - Banking & Finance

    £20000 - £25000 per annum + OTE £40,000: SThree: SThree Group have been well e...

    Day In a Page

    Evan Davis: The BBC’s wolf in sheep’s clothing to take over at Newsnight

    The BBC’s wolf in sheep’s clothing

    What will Evan Davis be like on Newsnight?
    Finding the names for America’s shame: What happens to the immigrants crossing the US-Mexico border without documents who never make it past the Arizona desert?

    Finding the names for America’s shame

    The immigrants crossing the US-Mexico border without documents who never make it past the Arizona desert
    Inside a church for Born Again Christians: Speaking to God in a Manchester multiplex

    Inside a church for Born Again Christians

    As Britain's Anglican church struggles to establish its modern identity, one branch of Christianity is booming
    Rihanna, Kim Kardashian and me: How Olivier Rousteing is revitalising the house of Balmain

    Olivier Rousteing is revitalising the house of Balmain

    Parisian couturier Pierre Balmain made his name dressing the mid-century jet set. Today, Olivier Rousteing – heir to the house Pierre built – is celebrating their 21st-century equivalents. The result? Nothing short of Balmania
    Cancer, cardiac arrest, HIV and homelessness - and he's only 39

    Incredible survival story of David Tovey

    Tovey went from cooking for the Queen to rifling through bins for his supper. His is a startling story of endurance against the odds – and of a social safety net failing at every turn
    Backhanders, bribery and abuses of power have soared in China as economy surges

    Bribery and abuses of power soar in China

    The bribery is fuelled by the surge in China's economy but the rules of corruption are subtle and unspoken, finds Evan Osnos, as he learns the dark arts from a master
    Commonwealth Games 2014: Highland terriers stole the show at the opening ceremony

    Highland terriers steal the show at opening ceremony

    Gillian Orr explores why a dog loved by film stars and presidents is finally having its day
    German art world rocked as artists use renowned fat sculpture to distil schnapps

    Brewing the fat from artwork angers widow of sculptor

    Part of Joseph Beuys' 1982 sculpture 'Fettecke' used to distil schnapps
    BBC's The Secret History of Our Streets reveals a fascinating window into Britain's past

    BBC takes viewers back down memory lane

    The Secret History of Our Streets, which returns with three films looking at Scottish streets, is the inverse of Benefits Street - delivering warmth instead of cynicism
    Joe, film review: Nicolas Cage delivers an astonishing performance in low budget drama

    Nicolas Cage shines in low-budget drama Joe

    Cage plays an ex-con in David Gordon Green's independent drama, which has been adapted from a novel by Larry Brown
    How to make your own gourmet ice lollies, granitas, slushy cocktails and frozen yoghurt

    Make your own ice lollies and frozen yoghurt

    Think outside the cool box for this summer's tempting frozen treats
    Ford Fiesta is UK's most popular car of all-time, with sales topping 4.1 million since 1976

    Fiesta is UK's most popular car of all-time

    Sales have topped 4.1 million since 1976. To celebrate this milestone, four Independent writers recall their Fiestas with pride
    10 best reed diffusers

    Heaven scent: 10 best reed diffusers

    Keep your rooms smelling summery and fresh with one of these subtle but distinctive home fragrances that’ll last you months
    Commonwealth Games 2014: Female boxers set to compete for first time

    Female boxers set to compete at Commonwealth Games for first time

    There’s no favourites and with no headguards anything could happen
    Five things we’ve learned so far about Manchester United under Louis van Gaal

    Five things we’ve learned so far about United under Van Gaal

    It’s impossible to avoid the impression that the Dutch manager is playing to the gallery a little