Business Analysis: US gloom depresses stock markets, but a little bid action could lift spirits

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The Independent Online

It all seemed to be going so smoothly. Rock-bottom interest rates had kept consumers spending, while companies worked off their hangover from the pre-millennium investment spending boom.

It all seemed to be going so smoothly. Rock-bottom interest rates had kept consumers spending, while companies worked off their hangover from the pre-millennium investment spending boom. Corporate profits had since snapped back, and economic growth accelerated sharply. Companies looked ready to invest in their business, or splash out on mergers and acquisitions, giving a vital boost to economic activity just as debt-burdened consumers took their breather. Everything was on the rails, corporate profits could continue on an upward trajectory, and stock markets around the globe could continue their recoveries.

And then share prices began to crumble, as markets succumbed to an attack of the glooms. In the UK, the market has fallen 4 per cent since its peak on 21 February, when the FTSE 100 stood at 5060.8. Yesterday the index was 4,864.9. In the US, the fall has been even greater, more than 6 per cent.

"What has changed compared with a few months back when the market looked a lot firmer is investors have lost their feeling of certainty about the future," says Richard Jeffrey, the head of research at Bridgewell Securities. "There is now a lot of nervousness about the progress of the US economy, and indeed about the European and domestic economies. Nervousness about whether the pace of growth can continue and whether inflationary pressures are growing. Nervousness about whether the economic cycle is coming to an end prematurely in the US, and about the pace of US interest rate increases."

This is more than just the market jumping at shadows. Paul Ashworth of Capital Economics cites economic figures from the US over the past few weeks which have given rise to concern, on employment, retail sales, house-building activity and consumer confidence, and the index of leading indicators, which suggested a forthcoming economic dip. The blame is laid squarely at the door of the high oil price.

"Last week's data only added to the impression that the wheels dramatically fell off the US economic juggernaut in March," Mr Ashworth said. "The hope is that as energy prices fall back to more normal levels, the economy will gather momentum again, in the same way that the slowdown in growth last year proved ultimately to be a temporary dip. But our concern is that this soft patch could develop into something more serious and persistent if confidence does not bounce back sharply."

When core inflation, which strips out volatile energy prices, was revealed to have risen at its fastest rate in two and a half years in March, it sent the Dow Jones index down more than 100 points on one day last week. There is a feeling that the Federal Reserve has been behind the curve in raising interest rates in the US, and that these may have to be increased rapidly from here to choke off inflation - with the risk that it will also smother growth.

The bears have been able to point at some high-profile disappointments over the past few weeks as US companies reported their earnings for the first three months of 2005. IBM, the computers group, came out with a profit warning, and there was terrible news, too, from General Motors and Ford.

Gerard Lane, a strategist at the fund manager Morley, said: "For 2005 and 2006, economists in the City see capital expenditure picking up to take over from the consumer, but if profit growth slows then there may not be a return to investment spending, so the risks are skewed to the downside on our analysis."

But is what has happened to the stock market since February a fair reflection of those risks? Worries over the outlook for the UK consumer ensured retailers were among the worst-performing sectors of the UK market since the February high, down 8 per cent. Worries over the outlook for global demand meant miners were off 8 per cent as well, and that Corus, the steel maker, was the worst individual performer in the FTSE 100. The heavyweight banking sector, exposed to both the consumer and the corporate sector, has seen its shares tumble 9 per cent.

Mr Lane thinks that the correction since February has been just what is required and, last week, Morley abandoned its negative stance on the UK equity market, moving some of its money out of gilts and investing it in shares. Longer-term, the jury is out, but the correction has gone far enough for now.

Others think that the stock market has actually overreacted to bad economic news and should snap back from here. Roger Cursley, an equity strategist at Investec Securities, said: "The US corporate earnings season - with a few high-profile exceptions - has actually been quite good." The chip maker Intel and Coca-Cola are among many companies to have comfortably beaten forecasts.

Traders have also been overplaying the imbalances in the UK and US economies, according to Bridgewell's Mr Jeffrey. Consumer debt in the UK and the budget and trade deficits in the US are "nagging at people's confidence again", he said.

"While we have been ignoring them, they have not only failed to go away, they have gotten worse. These imbalances do make the economies that have them more vulnerable to economic shocks, but my view is that, more often than not, economies muddle through."

Britannic Asset Management's Philip Graves thinks the UK market has been unfairly tarred with the same brush as the US. He expects a 5-10 per cent rise by UK shares by the end of the year, and that Allied Domecq will not be the last bid target. Merger and acquisition activity will be a continuing theme, Mr Graves said. "Cash-flow rich companies with good balance sheets will be vulnerable to further private equity bids which still have lots of money."

The relatively lowly valuation of the UK market - on less than 13 times 2005 earnings, compared with 15.5 times for the US market - also underpins the UK market. Mr Cursley of Investec said: "The equity market fall we have seen over the last couple of months is the result of a belated realisation that growth rates on both sides of the Atlantic are returning to more normal rates. My view is that this is something temporary and I am still quite happily forecasting 5,400 as my year-end FTSE 100 level."

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