Hi-tech stocks, electric shocks

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The Independent Online

Higher returns generally entail greater risks. This basic investment maxim applies today as much as it ever did. The "new economy" - fuelled by technology-driven productivity gains - has opened up vistas of higher rates of return. But equally it carries enormous risks.

Higher returns generally entail greater risks. This basic investment maxim applies today as much as it ever did. The "new economy" - fuelled by technology-driven productivity gains - has opened up vistas of higher rates of return. But equally it carries enormous risks.

This is partly a reflection of the uncertainty that surrounds any phase of major technical change. Yet it also reflects the financial markets revolution which has accompanied the new economy.

Two big and ugly words describe the forces behind this revolution: disintermediation and globalisation. The former is the shift away from traditional bank financing towards explosive growth in activity in the securities markets.

This has led to a switch from a yield focus to the pursuit of capital gains, which has reinforced the pressure on governments to reduce inflation and on the corporate sector to improve short-term profitability (or to be PC, "shareholder value"). The globalisation of portfolio flows has spread this discipline worldwide.

The rise of the new economy, first in the US and now in Europe and Asia, has in turn fuelled the growth in the financial markets. Low inflation, strong profits growth, a surge in business start-ups and a boom in mergers and acquisitions have kept the markets happy.

Moreover, the new information and communications technologies have been swiftly applied in the financial markets, cutting costs and spurring innovation.

Yet even best friends can have arguments. The markets are increasingly banking on the new economy to deliver rapid profits growth, and low inflation now, and also in the longer term.

Likewise, the new economy is more dependent on the smooth functioning of the financial markets, to direct new capital, or redirect old capital, towards its rapid growth sectors.

The problem is that amid the technophoria, the potential for market volatility is clear. As US Federal Reserve chairman Alan Greenspan mused last month, we may be witnessing both "a once-in-a-century acceleration in innovation" and a "speculative bubble".

The sky-high stock market prices on internet start-ups carry an obvious risk of disappointment if the hoped-for rapid growth in profits fails to materialise. More generally, the rich valuations placed on other technology, telecom and media companies have been partly fuelled by the blind-faith buying of momentum investors and index tracker funds.

But the stock market bears are probably looking in the wrong direction. The story that the stock market is about to run into trouble because of weaker growth in the US economy and profits may prove to be no more true this year than it was over the past three years. Recent strong profits reports in the US suggest that stock markets may again surprise us on the upside this year.

History shows that it is not profit disappointments that trigger crashes, but higher interest rates. Here again, the outlook is encouraging.

True, the Fed, the European Central Bank, and the Bank of England all have further interest rate rises up their sleeves. But with inflation under control, the rate rises are unlikely to be any greater than the markets are currently expecting. This suggests that bond yields are close to their peak, and that stock market investors can sleep easily in their beds.

Unfortunately, the financial markets revolution suggests that a rude awakening could come from a completely different quarter. Recall that the stock market setback in the autumn of 1998 stemmed not from a profits downturn but from a default in Russia. It was triggered not by stretched equity valuations but by credit risk.

Though the financial markets revolution has fuelled an enormous increase in turnover in the stock, bond, currency and derivatives markets, crisis conditions can see the depth and liquidity of the markets disappear.

The combination of disintermediation and the pressure to deliver "shareholder value" means that banks have to take bigger risks to make money and are less likely to support borrowers in distress. As the collapse of the LTCM hedge fund demonstrated, the heavy use of leverage through derivative contracts or through short selling of securities can multiply supposedly "safe bets" into risky ones.

The turmoil in the US Treasury bond market over the past month is a reminder of the potential for market volatility. The US Treasury is reducing insurance and buying back bonds, courtesy of budget surpluses. Good news? Well, the market has been caught on the hop, and the relative prices of differing bonds have swung wildly as traders have tried to speculate precisely which will be bought back. So far there has been no news of casualties - and there has been little impact outside the US bond market: however, this is a timely illustration of the potentially dangerous dynamics of the markets.

Policy-makers do try to learn lessons from past crises. Moreover, investors can take comfort from Mr Greenspan's proud record of responding quickly to financial markets turmoil. Yet central banks' readiness to offer a safety net by providing liquidity or cutting interest rates may make investors complacent and so store up problems for the future. Investors are right to be optimistic about the potential returns from the new economy, but they should not forget the risks.

* Mark Cliffe is chief economist of ING Barings

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