"The markets are generally less successful at calling political events than the prospects for company profits or interest rates"

Click to follow
The Tory leadership election has underlined an old truth: that stock markets don't respond well to being taken by surprise. This election is, admittedly, more difficult than most to call. Some would say that the Tory party at Westminster is second only to the medieval college of cardinals in its claims to be the least frank electorate in history. Nobody can, or should, believe a word of what MPs say they are going to do.

Even 10 days into the contest, the range of outcomes - a Major victory, a Heseltine, Redwood or Portillo success, or an early general election - is stil dramatically wide. This contest will have a crucial bearing on which party wins the next election, and with what sort of majority. It is the kind of event, in other words, that shows the City in its starkest light: self-interested and uncertain about what is going to happen next.

There is no surprise that gilts and the pound should have fallen since John Major announced his dramatic ploy. It is the standard response to sudden, destabilising events of this sort, though the movements are hardly exceptional so far.

More surprising is that share prices have fallen quite sharply too. The clearer it has become that the outcome was going to be less clear-cut than at first seemed likely, the more negatively the markets have reacted. This is not, as is often said, because the markets hate uncertainty and confusion.

On the contrary, for part at least of the City's constituency, the brokers and traders, uncertainty is their very life-blood. As long as prices are moving, the more opportunity there is to earn commission, or to take a profitable position. The direction in which the prices are moving is an important but secondary consideration. Volatility and rumour are the lifebloods of an exciting market.

But, given that the markets have fallen since the announcement, should investors let the weakness of share prices worry them? Past experience suggests that political dramas tend to cause a lot of febrile excitement in the short term, but the longer-term impact is usually less dramatic than it appears.

History suggests the markets are generally less successful at calling political events than they are the future prospects for company profits or interest rates. They are, for example, frequently confounded by the outcome of general elections.

The marking down of share prices in the past week reflects no sudden deterioration in prospects for the country's economy.

It is true that the prospect of a change in leadership has re-ignited fears that the Government will now throw caution to the winds and embark on another pre-election inflationary boom of the kind that has caused so much damage throughout Britain's post-war history.

But that concern was already, tangibly, in the air. The Chancellor's decision to overrule the Governor's call for an interest rate increase sent alarm bells ringing on that score. His decision also to modify the Government's inflation target to allow for the possibility of slightly higher inflation before the next election has also been widely interpreted as indicating that policy will be loosened to help the party's chances of re-election.

A pre-electoral bout of tax cuts and public spending increases to curry favour with the voters has happened all too often before. The main uncertainty therefore is not whether the leadership election has introduced the risk of a pre-electoral boom. The risk is more about the scale of any such boom, when it will start and how long it will last. To the extent that the Tory crisis brings a general election closer, and with it the likelihood of a Labour government, it does mark a genuine change in the political climate.

But until we know who has won, and with what degree of authority, most of the speculation remains idle froth. Recent experience suggests that the best tactic when the Conservatives are in power is to buy shares as nervousness about the outcome of the election rises and sell them once the result is known. On most measures however the market here, unlike that in the United States, does not look overvalued and there is little reason to think - yet -- that the Tory election result will fundamentally change this outlook. It is worth remembering that pre-election nervousness was going to be with us soon anyway.

Looking for credit card or current account deals? Search here