All clear as mud in the age of uncertainty

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The Independent Online
IT HAS been a busy week for those who earn a living from talking about the markets: not such a good one for those who try to work out what is actually likely to happen as a result of the Tory election contest.

The combination of a grossly devious and untrustworthy electorate that says everything but what it really intends to do, a byzantine voting system that allows for a bewildering choice of possible outcomes, and the absence of much more than soundbite manifestos from the two declared candidates has offered few hard facts.

Most of the pundits have been at sea in their attempts to analyse who is likely to win. Most investors are scarcely wiser, if you believe the past week's behaviour in the markets. Once it was clear that Mr Major was going to be challenged, it did not take long for the markets to react in a predictable way: gilts and the pound off, and some half-hearted attempts by brokers to bounce their clients into worrying over much about an early general election.

The yield on the benchmark 10-year bond, for example, is up from 8 per cent to 8.5 per cent. The pound is down, but not as sharply as some feared. Implied forward interest rates have edged up. All three are indications that investors are worried about the implications of the leadership battle.

The only surprise has been the sharper- than-expected fall in the stock market. Of course, the election contest reinforces fears that the inflationary genie will be let out of the bottle by whoever emerges asvictor. It may also be that the contest has brought forward the date of the next likely general election - and with it, the high probability of a Labour government, something that the City traditionally fears in haste and grows accustomed to at leisure.

But this explanation overlooks the fact that equities, tend to cope quite happily with inflation. After all, it is not as if the markets were not already starting to fret about how rigorous the Chancellor will be about inflation as the election approaches.

First, in May, he slapped down the Governor's calls for an interest rate rise: then, last month, he allowed it to be known that his new "much the same" sort of inflation target in fact allowed for the possibility of inflation exceeding the 4 per cent upper limit before the next election. That expectation, in other words, was beginning to be factored into gilt yields well before Mr Major's gesture 10 days ago.

Another common theory advanced last week - that the markets were suddenly having to face the prospect of a Labour government sooner than expected - sounds plausible, but does not bear serious analysis. Look at the recent weakness of utility shares; or the opinion polls; or Mr Major's state of mind. A lot of that is surely in the price already.

The key test for investors is not whether there will be some loosening of policy before the election, because the smart money had already assumed as much. Nor is it whether a Labour government suddenly looks likely: only a Martian could doubt that the prospect has been real for some time.

Those who doubt that the economy is now firmly entering "political territory" take comfort in the fact that the spending booms of Mr Maudling (1963) and Mr Barber (1972) both failed to win the subsequent election for the Tories. Might this give Mr Clarke and whoever takes over at No 10 pause for thought? It seems unlikely.

Both results were desperately close, and the better parallel is with the one Chancellor in recent history who did put fiscal rectititude ahead of electoral calculation - Roy Jenkins in 1970. He was rewarded with defeat. It is easy to forget that Nigel Lawson was feted for his efforts in winning the 1987 election: it was only later, when the bill came in in the shape of higher inflation, that everyone started blaming Lawson.

No, the key question to ask about the leadership election is whether any conceivable outcome will materially reduce either the current political uncertainty or the outlook for the economy.

It is not an easy question to answer: but the truth of the past 10 days' furious debate is the simplest one of all: that nobody, inside or outside the Tory party, really has the first idea.

The problems faced by the Government - an inadequate majority, a recovery that makes nobody feel happy, the party divisions over Europe - looked pretty intractable before, and still do. A victory for Mr Heseltine in round two would certainly make investors more nervous, since he is widely assumed to have the fewest scruples about putting inflation at risk if it will bring the prize of electoral victory in sight.

In all the excitement, it is easy to overlook the fact that our political uncertainty is not unique to us. In Japan, the fate of the stock and bond markets depends on when - and how - a weak government can bail out some of its crippled banks.

In the United States, too, all eyes are on the Fed, which meets this week to decide whether it now needs to cut interest rates to avert a recession. The political worry here is not so much about the Clinton Administration but about the internal politics of the Fed. The chairman, Alan Greenspan, has his job to consider.

Next year is election year in the United States, always the hardest phase of any Fed chairman's tenure. Greenspan himself comes up for reappointment shortly, and it is no secret that not everyone on the Fed board sees eye to eye on what kind of treatment the US economy now needs. Sentiment last week was moving towards the view that an interest rate cut was no longer likely this week, given the run of stronger economic data towards the end of last week. The economy is clearly slowing down fast, however, and my hunch is that the Fed will ease sooner than the markets now expect.

What is not in doubt is, first, that what the Fed does over the next six months is likely to have a bigger impact on the UK stock market than almost any conceivable outcome of the Tory leadership election. Secondly, if you are worried about political uncertainty affecting your investments, start putting cash under the mattress.

For the next few months are going to be full of uncertainty, both here and overseas. We are now in that kind of world.

It is one of the prices investors must pay for the pleasure of living in a low-inflation era, where debt actually has to be paid off, not inflated away by spendthrift governments.

Patrick Hosking is on holiday

How the City's punters saw it last week

Number of votes for each candidate

Tuesday Wednesday Thursday Friday

Major 192-197 183-188 182-187 189-194

Abstentions 55-60 60-65 65-70 65-70

Redwood 77-82 73-78 71-76 66-71

Source: City Index