Economic View: We freewheeled on credit and we've been slapped on the wrists, but share prices haven't run out of road

While the markets returned to reality with a bump last week, the bull run should take the setback in its stride
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The Independent Online

So the markets have cottoned on to the fact that interest rates have gone up worldwide, that they may well go further, and that this will have disagreeable consequences. You always get bumps in share prices and what happened last week was a pretty big one.

But – take a breath – I don't think this signals either the end of the bull market in shares or a forthcoming global economic downturn. Rather, I think it is just the sort of return to reality – to an awareness there are risks that were not being properly assessed — that should have happened long before.

This does not mean the current period of equity weakness is past, for there are a number of reasons to expect further bumps in the coming weeks. But as argued here before, share prices are not particularly expensive by historical standards, with the global price/earnings ratio in the mid-teens. The world economy seems set to grow solidly for another year or two and that should underpin company earnings and hence share values.

The latest data certainly supports this view. The three largest sources of additional demand in the world are the US, Europe and China. On Friday we learned that the US economy had grown at an annual rate of 3.4 per cent in the second quarter – rather faster than had been expected. Eurozone growth seems set to be around 2.7 per cent this year, led by Germany, which is expected to grow by more than 3 per cent. And China? Well, the latest figures show it growing at more than 12 per cent a year – pretty astounding.

So plenty of growth, and that despite the drag in the US from a soggy housing market. Indeed, one of the real surprises has been the way American consumption has held up despite the property situation – something that may have implications here in the UK. How secure is this global growth? Some work by Goldman Sachs puts this expansion phase in its historical context. The current US expansion, at 66 months, is already somewhat longer than the post-1945 average.

On the other hand, the length of the cycles does seem to be increasing. Moreover, the growth of China in the world economy changes the whole equation. We still think in terms of a US-led economic cycle but my guess is that the trigger for the end of this one is more likely to be some event in China.

But in the months ahead the pressure of interest rates seems likely to increase. Even after the present round of rises, rates are only a tiny bit above their long-term average. The period between 2001 and 2005 was abnormal, when real rates were less than 1 per cent. We are now living with the consequences – in terms of soaring property prices in nearly all major economies – of what will, I think, come to be seen as a grave policy error.

That error is being corrected, and it is the correction that led to the sort of ructions we saw on the markets last week. Make money more expensive and the investments that only made sense in a period of zero or near-zero interest rates suddenly become less sensible. Until last week the fallout in the US sub-prime mortgage market had failed to influence share prices, but suddenly shares began to move downwards, too.

The particular reason for this contagion was the drying up of credit to finance buyouts of shareholders in large quoted companies. The fundamental reason for the continuing run of the bull market was, I still believe, the fact that shares remained quite good value vis-à-vis the obvious alternative asset classes such as property and fixed-interest securities. But the string of bids for companies from private-equity houses gave a spice on top of this generally well-grounded market. Take away that element of spice and it is unsurprising that share prices would take it badly.

If I am right and this tightening of global monetary policy still has some way to run, it would follow that private equity will be a less eager bidder for public companies for the rest of this cycle.

Support will, however, come from other quarters. The most obvious of these will be Asian and Middle East savings. Middle Eastern investors will remain active purchasers of global equities, while we know China is committed to moving out of US Treasury securities.

Think of the present excess of money sloshing around as coming from two main sources: that long period of very low interest rates, which encouraged excessive borrowing, and the build-up of savings in the Middle East, Russia and Asia.

All this suggests that the break in the markets last week was a correction rather than the start of a crash. Something else needs to go wrong before this cycle is brought to a close. The Treasury calculates that the economic cycle ended with the elevation of its previous Chancellor but that is childish; a cycle is a measure between peaks or troughs, not some arbitrary date.

What might go wrong? This is the game of "round up the usual suspects". It is possible that the present stress could lead to a serious financial failure in the developed world, probably the US. More likely, though, would be some inflationary shock – perhaps oil at $100 and staying there; that would force the central banks to hold rates up. Or it could be a shift in China away from saving and towards consumption; that would both push up commodity prices and cut the investment surplus that did until recently help prop up the dollar. But we have been living with these threats for several years and this global expansion has been the strongest in post-war history, arguably the strongest ever.

Indeed, given the strength of the world economy and the mass of liquidity, it is odd that markets have not been even stronger. Nothing is for ever but it feels as though the expansion has some way yet to run.