City & Business: The City can't continue in splendid isolation

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The Independent Online
TO MOST people, the City has always seemed a world apart - a theatre of the absurd quite out of touch with ordinary concerns and the vicissitudes of the real economy, a self-contained money-making machine of questionable value to anyone other than those who work there.

Two linked phenomena - the spectacle of million-dollar bonuses raining down on favoured employees like confetti, and markets that daily achieve new record highs - have reinforced that view.

Oblivious to an economy still deep in the doldrums, the City is booming - or at least those parts of it concerned with securities and currency trading are. Helped by explosive growth in new derivative-based financial instruments, markets have rarely been more conducive to money-making, nor those who work in them better paid.

To the outside world, the City must seem like a state within a state, a square mile of prosperity in an economic wasteland. It is this bizarre contrast that marks out the present City boom from the last. In the mid to late 1980s everyone seemed to be making money hand over fist; the City wasn't alone. This time round financial markets are on their own, quite out of sync with what's going on elsewhere in the economy. It doesn't matter how many ingenious arguments are concocted to explain and justify the phenomenon (there's certainly no shortage of them being advanced) - it still looks odd and anomalous. I know that stock markets are meant to be counter-cyclical, that shares always tend to perform better during recession than in times of growth, that prices like to anticipate the next stage of the cycle. But what's happening at the moment surely goes beyond that.

Why has the City so dramatically lost touch? In part, it is explained by the fact that the City is no longer the cosy little domestic market it once was; the abandonment of foreign exchange controls, deregulation and liberal tax arrangements have changed it out of all recognition. It has become a key part of a vast global market; what's going on in New York and Tokyo is infinitely more important than what's happening in the Potteries. When markets around the world are booming, the travails of the domestic economy, provided the situation isn't terminal, are always bound to seem largely irrelevant. The huge sums of money being earned by the London partners of Goldman Sachs and others derive from the City's position as a centre for international trade; they have little or nothing to do with traditional British stocks and shares.

I don't want to go into the rights and wrongs of bumper City pay in too much detail. Most of those on mega-bucks are the best in their fields. They make huge amounts of money for their - mainly American - employers and they work hours that leave them with little or no life outside the office.

Many of them are comparable to genuine entrepreneurs: their ideas and trading methods generate extraordinary wealth and they attract vast sums of foreign capital and investment to Britain. They are also one of the chief reasons why London is still Europe's pre-eminent financial centre, streets ahead of its nearest rival. People have never gone into financial markets with any other purpose in mind than to make money; job satisfaction doesn't really enter the equation. Salaries like these are the way of the world.

But what of share prices in British companies? Why are they booming alongside everything else? At the least, they should surely reflect underlying economic realities - instead of which they are being swept along on the same crystal dreamer as everything else. Higher and higher they go, a case of 'another day, another record' - as the FT's Lex column put it last week - apparently oblivious to world events such as the onset of fascism in Russia, oblivious to the growing number of companies issuing profit warnings or falling well short of expectations, oblivious to everything except the rallying call of lower interest rates. Since the Budget they are up 5 per cent, and for the year as a whole, the total return on equities is more than 25 per cent.

With more interest rate cuts in prospect, it is easy to see why it's happening; whether it's justified is another question. Bonds and equities are being marched higher in step as if bolted together at the hip. As interest rates fall, bond yields fall with them and equities move in sympathy so that the traditional yield gap is preserved. Investors continue to pour money into equities not because they think them good value but because there is nowhere else for the money to go; the yield on shares may be at an historic low, but against the alternatives it still looks good.

It's hard to believe, however, that this can be a reasonable long- term basis for valuing shares. Nor is the present sustained bull market of much use to anyone outside speculators and traders. We are now at the stage where pension funds positively dread the next pronounced upward shift, since it makes it progressively more difficult to find new investments with sufficient yield to cover actuarial needs. Furthermore, the markets don't yet seem fully to have appreciated the extent of the Lamont/Clarke fiscal squeeze over the next two years. As the Chancellor admitted last week, it equates to about 7p in the pound, wiping out all the tax cuts of the late 1980s.

Regardless of all this, for the short term at least share prices are set to carry on rising - for technical reasons if no other. There are said to be at least two large houses that need to cover vast derivative- based positions through stock market purchases before the New Year. With market-makers still short of stock, that's good for at least another 100 points before the year end. But watch out thereafter. Once the technical prop is removed, reality could come home with a vengeance.

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