Hamish McRae: Markets are not doomed to collapse when governments withdraw support

Economic View
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The Independent Online

A pause for thought, a quiet moment before the general election is called – and an appreciation that the global economic cycle has shaped our lives far more than the twists and turns of our politicians. There has been an economic recovery just about everywhere in the developed world, while most of the emerging nations were barely touched by the downturn. The costs of the recession, though, have yet to be fully calculated and no start has been made, here or elsewhere, to pay back the bill.

What has happened, however, has been a solid recovery in confidence, evident not just in economic output and in business surveys but most notably in the financial markets. Just over a year ago share prices world-wide hit bottom and the mood was so bleak that I recall, when sketching a strongly positive outlook for share prices, that I felt I had to start with a public health warning. I had to acknowledge that my optimism might prove completely wrong.

Now the "phew!" period is coming to an end. Concerns now focus on the durability of the recovery and in particular the extent to which it is artificial in the sense that it has been puffed up by huge budget deficits and negative real interest rates. That inevitably leads on to concerns about the durability of the stock market recovery and the extent to which it too has been inflated by policies that are unsustainable in the medium term. What can one sensibly say about this?

I think the first point to make is that differential growth in the world economy will affect markets in different ways. It is a two-speed world. The emerging nations are racing on, dragging up demand for commodities and for energy. So the oil price is likely to remain pretty strong. That strength, together with the pressure on commodities, will help a few developed nations, such as Canada and Australia, but for most of us, this upward pressure on raw materials will restrict growth. If you have to pay more to fill up the car you have less to spend on other things. Here in Britain there is the further pressure on fuel prices as a result of the weak pound. Our exporters may be gaining from the fall of sterling but we consumers inevitably lose out.

The next point is that you have to remember that exchange rates affect equity values. The FTSE 100 Index climbed last week beyond its most recent highs, but that is because share prices are in sterling. If you adjust for the fall in the pound the performance does not look so good. Of course there has been a huge recovery over the past 12 months, but in dollar terms the FTSE 100 index is still below its January peak.

It is worth making this point because though we think of the FTSE as representing the value of large British companies, something around two-third of the profits of those companies come from abroad, either in exports or remitted profits from overseas subsidiaries. So it's actually a snapshot of the world economy, seen through the prism of a sterling investor.

So how will global business fare in the months ahead? The graph shows what a terrific blow the recession has given to the profitability of European, US and British companies. The steady rise over the previous 30 years gave investors no precedent, no preparation, for what was to hit them. You might argue that the peaks were boosted in an artificial way – a lot of the published profits of the banks were not real profits – and insofar as that is the case, you could argue that we are getting back to some sort of long-term trend growth. At any rate reported earnings have turned the corner, most evidently in the UK.

That is the past; what about future earnings? Well, Evolution Securities, who pulled together the graph, notes that British equities are forecast to deliver an increase of 33 per cent in earnings this year and another 22 per cent next. That would get British earnings, though not European ones, back to their previous peak. These forecasts may be too optimistic but Evolution notes that the upward cycle in corporate earnings has in the past normally lasted between five and seven years.

So while in the short-term it may well be that the markets have got a bit ahead of themselves, which I personally think they have, if past experience is any guide and company profits do grow steadily for another five years or so, then share prices too have several years of growth ahead. Or perhaps it would be better to put it this way. Insofar as share prices ultimately reflect the profitability of the corporate world, the prospects for both look reasonable for the next five years.

But of course all that is predicated on there being a typical upswing in the world economy, lasting between seven and 10 years. That brings the argument back to the shape of the economic cycle, a cycle from which we have proved unable to escape.

The conventional take is that there will be a recovery, and we are seeing the early signs of this right now; however it will not get going securely until next year and it will be a relatively weak one. I think that is probably right though I'm not sure it is very helpful to speculate on the shape and strength of the recovery given that most of us got the depth of the recession wrong. Some of us did, on the other hand, get the timing of the recession right, so maybe we are right to warn that we may only have seven years of decent growth ahead in which to sort out public finances and build a strong position ahead of the next downturn.

But when it comes the performance of the world's great companies during this upturn, we can, I suggest, have some confidence. It has been really interesting to see how well the global corporate world has coped with a really vicious period. There have been casualties of course and there are the walking wounded now. But, to make a general observation, if the banks have coped with the downturn much worse than might have been expected, companies have surely coped rather better.

To some extent the recovery in financial markets' and in property prices, must have been the result of the exceptional measures governments and central banks around the world have taken to boost the economy. If you print hundreds of billions of extra money, as the major central banks have in effect been doing, that money has to go somewhere. So asset prices in most areas have risen sharply. The policies that turned the markets round will now be reversed, everywhere. But to think that, once these props are taken away, shares will just flop back, is surely to see a half-full bottle as half-empty. It ignores the fact that during the recession companies have worked hard to lift their performance, and as a result, their profits. Investors may have become complacent and it would be surprising if there were not some sort of reappraisal in the coming months. But if company earnings continue to rise, so too will share prices.

Why India's Tata could take company management in a new direction

Will Indian managers be different? India has become the second-biggest source of investment into the UK, after the US. We have had a generation or more of American management applied here and our own methods of management have been hugely influenced by that. The truth is that if a British firm is taken over by a foreign-owned one, the management attitudes and techniques of the parent will prevail. Not that this should be seen as a bad thing – the UK car industry has learnt much from Japan, for instance.

But now we are learning from India. Both Jaguar and Land Rover are owned by Tata, the most significant overseas investment by the group. If it works, it will have an influence far beyond those two brands. So what might be different?

In a new study, The India Way, published by Harvard Business School Press yesterday, four management professors from The Wharton School of the University of Pennsylvania interviewed more than 100 of India's leading business leaders to give a picture of why Indian management is different.

Professor Peter Cappelli, the lead author said: "Indian companies not only survived the current economic crisis but prospered – all without focusing their attention on shareholder interest. Indian executives have concentrated on deeply rooted company values and have mobilised workforces with a sense of mission. They are committed to their people and consider employees an investment. They are willing to engage in trial-and-error methods and have proven highly adaptable."

The sharpest contrast between Indian business practices and those of the Western model, is in attitudes toward the workforce. Western firms focus on cutting costs, while Indian companies tend to see their employees as capital investments to be supported and managed.

Too good to be true? Well, wages in India are much lower than in the West and firms there can afford to carry staff and train them up. But some elements of the system may migrate here and it is certainly to our advantage to try to learn from it.

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