Great expectations are exorcised as the spectre of a 20-year slowdown stalks the stock markets

What happened to last year's recovery in share prices? Simon Hildrey looks to the future for investors

Just as it seemed safe to return to the stock market, investors have been faced with worrying news.

At the start of last week, the share price of the consumer goods manufacturer Unilever fell by 5 per cent, while Colgate-Palmolive tumbled 10 per cent after both companies issued profit warnings. In the technology sector, Samsung Electronics, the world's second-largest chip maker, warned that global chip sales were likely to grow at half this year's pace in 2005.

These warnings come after nine months of mostly flat stock markets. However, Ken Cox, manager of the Templeton Growth fund, puts them down to the over-optimistic outlook of investors after a recovery in earnings last year. He argues that the initial pace of this recovery from the bottom of the cycle cannot be sustained.

"Earnings growth has generally slowed but the profits warnings are more the result of expectations have risen so much," says Mr Cox. "These warnings are not as severe as they have been in the past."

Yet fund managers remain cautious. Many are predicting that returns are likely to be flat over the next few years.

On the plus side, companies have strengthened their balance sheets and increased cashflow. Mr Cox says that European companies had free cashflow of £116 trillion last year, compared with £34.14 trillion in 2000. In the US, 376 of the 500 companies listed on the S&P index have increased dividend payments to shareholders this year.

But not everyone is convinced that share prices currently offer investors great value. Mr Cox says European share prices are relatively cheap as they are trading at a 30 per cent discount to the US market, but some fund managers suggest the US market needs to fall by at least 10 per cent to provide attractive valuations.

William Pattisson, manager of the Liontrust First Large Cap fund, says the UK market would need to fall from its current level of around 4,600 to nearer 3,000 to offer attractive valuations, but he is not convinced this will happen.

His colleague Jeremy Lang, manager of the Liontrust First Income fund, believes markets will generally be flat from here to 2010. But Mr Lang argues that money can still be made in the UK by identifying sectors with medium-term momentum behind them, together with companies generating strong cash- flow and therefore dividend growth.

Keith Wade, chief economist of Schroders, thinks the US economy will grow by 3 per cent next year - a prediction he says relies on corporate spending. "If spending does not pick up, then we are looking at very low economic growth," he explains. "If the economy slows, companies may hold back. But profits are relatively high and we believe companies generally can afford an expansion in expenditure."

Fund managers are also concerned about the impact of inflationary pressures and a potential slowdown in economic growth caused by high energy and commodity prices. Mr Wade estimates that if oil remains at $40 a barrel, it will knock 0.5 per cent off global economic growth.

Other risks include a possible decline in consumer spending as interest rates rise in many developed countries, and a fall in house prices in major economies. In the US, we could see an increase in taxes, cutbacks in government spending and a weakening of the dollar. There are also issues such as how US companies will fund their pension liabilities; the risk of another major terrorist attack; and how the government will reduce spending while it is committed to having troops in Iraq and Afghanistan.

While he is optimistic about Asia generally, Mark Mobius, manager of the Templeton Global Emerging Markets fund, warns: "The deficits in the US may cause a further loss of confidence in the US dollar and treasuries [government bonds]. One of the biggest risks for Asia is a weakening in the US dollar, leading to a reduction in Asian exports which is not offset by an increase in domestic consumer spending. There is a 50:50 risk of this happening."

Hugh Hendry, manager of the Odey Continental European and Pan European funds, is more pessimistic because equities, bonds, property and collectables have all risen in value over the past 25 years, in some cases by 20 times. He argues that the loose credit policy of major economies cannot go any further, and all assets apart from commodities are expensive.

"The next 20 years will be very different from the last 20," he says. "Either there will be a sharp correction and then equities will reach attractive valuations again, or stock markets will remain flat for many years until earnings and profits grow to justify the current prices."