Hamish McRae: How long can the markets continue to ride on wave of global growth?

The surprise has not been that markets have risen, but that they have done despite oil prices
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The Independent Online

This so far solid performance in share prices raises the usual ritual responses. It may not have been a year when it would have been right to "sell in May and stay away" - quite the reverse - but people are now twitchy about the fact that market crashes always seem to come in October. But then there is always a tension in markets. At the moment, the tension is between those who are concerned about the strains that higher oil prices and rising US interest rates are putting on the world economy, and the fact that long rates are still low and company profits are high.

So there is all this talk of an economic slowdown and yet share prices, until at least the last couple of days, suggest the markets are still reasonably relaxed. What should the rational outsider make of all this?

I think the starting point should be that we are now seeing normal markets, after the excessive exuberance of the late 1990s' bull market and painful three-year correction that followed. ("Correction", with its Victorian connotations of cold baths and the cane, always seems to be more appropriate than "crash".)

In normal markets, you get a rational reaction to new bits of evidence as they come through. So as this year has progressed, it has become more evident that the Japanese recovery is secure and that domestic demand there is now reinforcing external demand. In the US, it has gradually become more clear that inflationary pressures will need to be controlled by a longer upward march in short-term interest rates. So Japanese shares have responded to better-than-expected news, while US shares have been depressed by worse-than-expected news - as you can see from the top left-hand graph, which shows how the Topix (Tokyo) index has outperformed the Standard & Poor's (US) one.

But why have UK and continental European markets done fine? The UK economy is clearly slowing, with retailers seriously miserable, while the eurozone has had an even worse growth performance than Britain.

Part of the answer, for Europe at least, is that while the domestic economies may be stagnating, the big companies are doing fine. They have cut costs by outsourcing and developed export markets. Germany is the largest exporter in the world, passing the US last year. As far as the UK is concerned too, the world market matters more than the UK one. According to UBS, some 60 per cent of the profits of FTSE 100 companies, excluding banks, come from overseas business. In addition, as the top right-hand graph shows, the London markets are driven to a greater extent than world markets by resources companies. Not only are oil and mining particularly important, so too is finance. So, other things being equal, higher oil and mineral prices and higher interest rates help the UK markets. One could make the further point that the UK is still, just, a net oil exporter, unlike all the other G7 members bar Canada.

There is a further factor: what constitutes value? There are any number of different ways of valuing companies and one of the features of that last bull market was the ingenuity with which the analysts developed new measures to justify the level of prices. But if you are simple-minded and just take the flow of income that is likely to accrue from the companies' profits, then you can argue that shares are not too badly priced at the moment. If you take the most common way of gauging that income flow, prospective price/earnings ratios, you can see that the UK market on a p/e of about 13 offers rather better value than share markets generally and much better than the US.

So what should we think? In recent weeks, most of the City analysts have been upgrading their forecasts for the FTSE 100 at the end of this year. Brewin Dolphin's chief strategist, Mike Lenhoff, who developed these graphs, now reckons 5,700 as a reasonable target. As he points out, the surprise this year has not been that the markets have risen but that they have done so despite oil and US interest rates. That target is towards the top end of expectations but few City houses now expect much of a fall from present levels, which is encouraging.

If that is the broad background, where do we go from here?

The bond markets think, rightly or wrongly, that inflation is dead. There is no other rationale for their willingness to lend huge amounts of money at very low interest rates to governments that are seriously indebted and whose taxpayers will struggle to repay the debts when they mature in 30 years. That explains, too, the markets' stoicism in the face of rising inflation this year.

But actually, this is pretty mad. Bond market mania now is analagous to the equity mania of the late 1990s. If you think that fixed-interest markets carry great risks that are not priced adequately at the moment, what do you do?

The fashionable response has, of course, been to slide money into hedge funds which, if they work out, do give much higher returns, or into commercial property. But these options are not available to all, or at least not easily available. Besides, the solid performance of shares this year has given a new sheen to an old form of asset. The moment, two years or so back, when people started to proclaim that the age of investment in equities was over was clearly the right time to buy them.

The fundamental point to understand, surely, is what happens in "normal" equity markets. The answer is that they deliver, on average, a total return of about 7 per cent. Part comes in dividends, part in capital appreciation. We had a once-in-a-generation bear market and since then have had three good years, which is exactly the sort of performance you expect. Now it is perfectly plausible to expect a bad year - or, if next year turns out to be another success story like this year, a bad one after that. That is not trying to be clever; it is just what happens in normal markets.

The underlying big issue, however, is how long this growth phase of the world economy will last and what will bring it to an end. If there are another three to four years of global growth, there will be quite a bit of time for people to make money in these normal markets - before the abnormal variety come round again.

The comforting thing about this year is the way in which markets have been able to take bad news in their stride, and yet have been prepared to show a touch of fear, as they have in recent days, when the bad news piles up a little higher than expected. That's showing common sense.

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