Equity markets stage recovery on back of bullish outlook

Analysts say indices on both sides of the Atlantic are rising on solid economic fundamentals - not hot air
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The first crisp breath of autumn has sent investment managers back to work in an upbeat frame of mind after their summer holidays. On both sides of the Atlantic the main stock market indices have run back up towards their New Millennium peaks, or even further in some cases. And while the technology indices are still well below their earlier highs, they too have staged an impressive recovery.

The first crisp breath of autumn has sent investment managers back to work in an upbeat frame of mind after their summer holidays. On both sides of the Atlantic the main stock market indices have run back up towards their New Millennium peaks, or even further in some cases. And while the technology indices are still well below their earlier highs, they too have staged an impressive recovery.

If there was a key trigger for the improvement in market sentiment, it was the second-quarter US productivity figures, published in August. While GDP growth in the US has slowed enough to rule out a rise in interest rates for now, a surge in growth of output per hour to 5.2 per cent made it apparent the New Economy miracle had plenty of steam left. Corporate profits had continued to grow at 17 per cent year-on-year, due to strong demand and widermargins.

However, many analysts say the current optimism does not hang on the slender thread of swings of mood. According to Bob Semple, market strategist at Deutsche Bank: "People have come back from their holidays to a stream of gradually better news. And the institutions have had plenty of cash coming in over the summer." He pointed out that Old Economy stocks have been creeping up over the past few months, taking the FTSE 250 and small cap indices to new highs. The upturn in technology indices is more recent and, he argues, less robust. "This is sentiment rather than anything fundamental, and we shouldn't get carried away."

Kevin Gardiner at JP Morgan agrees, saying: "The bounce in the technology, media and telecoms (TMT) sector is not to be relied on." However, he argues there are reasons to feel, if not optimistic then at least less pessimistic than earlier in the year.

Even though short-term interest rates might still rise a bit further, long-term rates look set to stay low. "Long-term rates matter most in valuing equities," Mr Gardiner says.

What's more, the outlook for growth and inflation is pretty rosy, certainly for economies that have both already clocked up expansions of record length. Economists are for the most part predicting a gentle slowdown.

Some concerns do make the inflation outlook more unsettled. Chief amongst them is the high oil price, which has already fed through to retail prices for petrol products. The rise in the price of oil, and less dramatic but still worrying increases in other commodity prices, come at a time when the tight jobs market has perhaps started to nudge up pay pressures. In the UK a weaker pound will also contribute to inflationary pressures.

For such reasons the Bank of England's latest forecast showed inflation most likely to be above the 2.5 per cent target in two years' time. But the minutes of last month's MPC meeting reveal its members to be divided about the inflation outlook, in a split expected to make this week's interest rate vote a close-call. One camp, with DeAnne Julius its strongest advocate, argued it is reasonable to suppose New Economy factors will boost productivity growth in the UK. The beneficial supply-side effect of e-commerce was not captured by the official Bank forecast, on this view, and inflation is likely to turn out lower than predicted.

The opposing camp responded that there was no evidence of any systematic squeeze on prices and profit margins as a result of e-commerce. The Bank forecast already incorporates an assumption that there will be a compression in profit margins, the implication of this hawkish outlook being that the New Economy view had already been given the benefit of the doubt.

What's more, as many sceptics about stock market exuberance have pointed out, even if the Net is bearing down on prices by squeezing profit margins, that will be bad for corporate profits and ought if anything to dent shares. To justify high share prices, true believers need to argue companies can capture the benefits of improved productivity themselves without being forced to pass them on to customers - and in that case they cannot also claim inflation will be lower than otherwise.

Richard Jeffrey, chief economist at Charterhouse Securities, adds that at this stage of the business cycle the benefits of growth are more likely to flow to the workforce than company profits. "If that does lead to higher interest rates, then you get slower demand growth too," he says.

However, there seems little risk of a return to high inflation. The debate about inflation and interest rates concerns differences in the outlook that are tiny by comparison with past experience. Interest-rate pessimists think the MPC might have to raise UK short-term rate to a peak of 7 per cent, from a June 1999 low of 5 per cent. Steve Wright, an equity strategist at CSFB, argues that the fact investors are no longer having to take a gamble on the general state of the economy makes them more willing to buy into companies with a potentially volatile share price. "The stability of growth and inflation is keeping interest rates low. That makes companies that might deliver 20 per cent profits growth much more attractive."

Other, short-term factors have also played a part in lifting the market. Institutions have plenty of cash to invest. Even though the professionals shied away from TMT stocks earlier in the year, many individual investors did not, and inflows into the growth funds among the US mutuals has continued to rise. If nothing else, the liquidity will continue to boost share prices and could make the final months of this year as sparkling as 1999.

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