Economic View: Yet again, markets take a battering in stormy weather, but one bad summer doesn't make a recession

In 1987, it was a hurricane; in 2007, it's floods. But don't expect another crash this time – the strong global economy can cope with a downturn

In October 1987, a freak gale decimated Britain's trees in the same week that a stock market crash wiped billions off share values. July 2007 has seen a similar conjunction of bad weather and falling share prices. The market downturn, though less severe than in 1987, has been bad enough to raise doubts about the durability of the current bull market, which started (like the Iraq war) in March 2003. Is this just an overdue correction, or a change in trend?

Twenty years ago, the stock market crash was expected by many to usher in an economic recession. But Wall Street regularly predicts recessions that never happen. If policymakers respond to falling share prices by cutting interest rates, a stock market slump can lead to rising growth. That is exactly what happened in the late 1980s, when the post-crash monetary easing contributed to the vigorous and much-maligned Lawson boom. Today, after more than three years of rising interest rates, the world monetary authorities can afford to cut rates again if need be.

However, we are a long way from that. The current turmoil in financial markets is not on the 1987 scale. Global stock markets saw losses in July of around 5 to 7 per cent, peak to trough, compared with a savage 23 per cent fall in the FTSE in October 1987. Monthly falls of 5 per cent happen regularly in bear markets: there were 10 in the FTSE 100 between 1999 and 2003. But they are also surprisingly common in upswings. In the long bull market between 1987 and 1999, there were no less than 12 monthly declines of 5 per cent. One bad month does not make a bear.

There is no shortage of explanations for the present correction. We are living through a global mergers and acquisitions boom, led by the private equity houses and financed by debt. Periods of frenetic M&A activity invariably lead to speculative buying of shares in potential bid targets. That has happened in this boom, adding significant bid premiums to many shares. Any doubts about the durability of the M&A boom will blow off this froth.

Such doubts are raised by the recent upturn in US long rates, and the ongoing crisis in the US market for so-called sub-prime mortgages – essentially housing loans to people on relatively low incomes. As interest rates have risen, some of these loans have, predictably, gone bad. The resulting publicity has triggered a wider re-examination of riskier loans. Some lenders have decided to pull out of the market for a while. Others are charging more for riskier business. So the sources of credit fuelling the M&A boom are either drying up or becoming more expensive.

These market developments reflect a crisis of confidence in the credit markets, but the underlying economic fundamentals remain strong. Perhaps the most extraordinary sign of the strength of the world economy today is how little effect record oil prices have had on inflation. The historical pattern, first established in the two great recessions of 1975 and 1980, is that a hike in oil prices leads to a rapidly accelerating price-wage spiral. The authorities then raise interest rates to curb inflation and the economy tips into recession. Oil prices are not usually seen as the main cause of the recessions of 1990 and 2000, but there were oil price spikes on both occasions that were undoubtedly a contributing factor.

Oil could be our undoing again, but there is, so far, little sign of it. Inflation is low and there are two good reasons for believing that it will remain low. The first is that in the 1990s control of monetary policy around the world was steadily taken out of the hands of politicians and placed in the care of independent central banks. The result has been regular, early and decisive action to control inflation which, people have come to believe, will always remain moderate. As a result, temporary price blips no longer spark off, as they once did, wage increases, which then push up core inflation.

Low inflation in the UK is also supported by economic fundamentals: cheap imports of goods from the industrialising Far East (the China phenomenon), the outsourcing of services to English-speaking Asian countries (the Indian call-centre phenomenon) and the influx of cheap labour from EU accession countries (the Polish plumber phenomenon). Similar arguments apply in the US, substituting Mexico for Eastern Europe.

Low inflation, and especially low wage inflation, is a crucial factor in determining share prices. Western economies have benefited, in the Nineties and Noughties, from increasing access to a huge new pool of industrial labour in China, India and the former Soviet Union. This has kept wages down and profits up. Shares, which are driven by expected future profits, have risen accordingly.

US profits (see left) are currently high by historical standards, and their strong rise since 2001 underpins the current market upswing. Dividend yields have followed bond yields downwards, and at 2 per cent are low. Shares, as always, are a bet on continued growth of earnings. The IMF, World Bank and OECD all see continued world GDP growth of 3 to 5 per cent in real terms. US company earnings should grow at least in line with nominal GDP over the next few years at around 5 to 7 per cent. Total expected return on equities (dividend yield plus expected growth) is thus around 7 to 9 per cent, compared with a safe bond yield of under 5 per cent.

Put in those terms, shares still look a reasonable bet, although the 2 to 4 per cent risk premium over bonds is less than equities have commanded in the past. It may not be enough, given that US profit growth seems to have stalled. For these reasons, I don't expect to see an early resumption of the bull market. Sideways and more volatile is probably the order of the day, and in those conditions we may see a shift into those higher-yielding stocks that have significantly underperformed the market in recent years.