City: Budget boost for equities to end in tears

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The Independent Online
IT'S RARE for share prices to rise in the aftermath of a Budget; normally they either drift or fall. So when they achieve blast-off, as happened last week, it's worth analysing why and whether it's justified.

In part, it reflected relief that the Chancellor hadn't tried any further to interfere with the tax privileges of pension funds, a relatively painless revenue-raising measure that would have hit share prices hard and was much predicted by the pundits.

Kenneth Clarke's apparent sleight of hand in tackling the deficit without appearing to raise taxes any more than modestly also produced some rave reviews, from the press and the City's army of economists and equity strategists.

Nicholas Knight, chief equity strategist with Nomura, was typical of the response. 'The Chancellor's skill in picking a course through the maze of economic and political considerations . . . exceeded even our high expectations,' he gushed.

In truth, however, the Chancellor's witchcraft fooled the markets no more than anyone else. It was easy to be taken in by Mr Clarke's reassuring banter, but the reality is rather different. Initially the tax hike is modest, but as the years march on, it will become increasingly painful.

After adding in the delayed tax increases already announced by Norman Lamont and planned cuts in public spending, you are beginning to look at a very considerable belt-tightening.

Most of us are going to be quite substantially worse off. Can this really be compatible with long- term growth compounding at 3 per cent per annum, as Mr Clarke insists? Unless there's a dramatic upturn in Europe, or a very considerable recovery in corporate profits, I think not.

What's driving the market, however, is less the belief that such growth can actually be delivered than the view on what Mr Clarke will have to do to try to achieve it.

As tax increases and spending cuts begin to bite, the Chancellor will be forced into further big cuts in interest rates to try to sustain economic recovery. That's good news for bonds, and equities will adjust in sympathy, their onwards and upwards march sustained by the same phenomenon that's been powering them for the past year: the lack of viable investment alternatives. London share prices may look ridiculously overvalued and quite out of touch with economic realities, but measured against the alternatives - bonds, cash deposits and overseas markets - they are still relatively cheap.

Whether any of this justifies some of the sky-high forecasts now being made for the FT-SE 100 is a different question. Roger Nightingale, a veteran market guru, reckons 4,500 might be attainable by the end of next year, a prediction of such wild over-optimism that it makes the normally bullish Mr Knight look positively bearish. For the time being, there's reasonable cause for remaining mildly positive, but don't bank on it for too much longer; the proportion of companies issuing profit warnings or falling well short of analysts' forecasts grows daily. In all probability, it will prove extremely hard for companies to deliver the sort of upturn in profits that markets expect.