Jeremy Warner's Outlook: Equities look cheap, but sentiment is dire

Diggers wades into non doms tax debate; Disaster of Metronet shows sham of PPP
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The Independent Online

Here's an instructive statistic from the equity strategists at HSBC; after another week of extreme volatility in world stock markets, the implied equity risk premium – that is the premium that investors demand for holding equities over less risky assets such as government bonds – is now at an all time record. At 5 per cent for US equities, it is higher than it was even in 2003 in the run up to the Iraq war, which marked the bottom of the last bear market.

Put another way, US stock markets now look as cheap on this measure as they were expensive at the height of the internet bubble at the turn of the century. Regrettably, this doesn't necessarily mean that stock markets are a raging buy. As with betting, there is no system capable of reliable prediction when it comes to the movement of stock markets. Let no one tell you otherwise.

The old adage of "lies, damned lies and statistics" applies as much to the equity risk premium as anything else, with a quite wide divergence of opinion on exactly how high or low it is depending on how you calculate the number. The bears would argue that it is still nowhere near its record, implying that the market can fall quite a bit further before it starts to recover.

In any case, the equity risk premium can be read either way. The fact that it is high doesn't necessarily mean the market is mispriced. Equally possible is that dividends are about to be slashed, returning the risk premium to more normal levels. This is indeed precisely what the bears argue, with a recession driven collapse in corporate earnings and rise in bankruptcies likely to lead to a considerable fall in dividends.

Yet however you calculate the figure, or interpret it, there is no doubt that the risk premium has widened abnormally in a manner which may not be justified by the fundamentals. According to folk law, you should never in stock markets attempt to catch a falling knife.

Sentiment right now is dire, with even those with money to invest and think the markets now cheap unwilling to commit while conditions are so volatile. A rocky start to the year was always in prospect. As long as investors think there might be a recession, stock markets will find it impossible to stabilise. Watch out for next week's January retail sales figures from the US. These ought to confirm one way or the other whether the US consumer has gone on strike.

The decoupling argument has a lot to commend it, but even so, if the US consumer stops spending, then the world economy is very definitely in trouble. Despite very rapid emerging market growth, US consumption is still six times higher than that of China and India combined. However much growth momentum these developing countries have, they are in no position to fill the void that would be left by a significant fall in US consumption.

Diggers wades into non doms tax debate

Now there's a surprise. Diggers has been speaking his mind again. The Trade and Investment minister warned that he wouldn't be gagged when he first joined the Government in June, and he's been as good as his word, first criticising the Treasury's capital gains tax proposals and now separate plans for a tax crackdown on non-domiciled foreigners (non doms) living in the UK.

In wading into the non-doms debate, he's actually only echoing the concerns of the business lobby he used to work for as director general of the CBI. He's also merely airing in public what he has long said in private.

The more interesting issue is not Lord Jones of Birmingham's departure from the official Government line as whether he is actually right in asserting that the non dom issue is dangerous to the the health of the City and the wider UK economy. As yet, there is only quite limited anecdotal evidence of any kind of an exodus, let alone the mass desertion that has been threatened.

But that doesn't mean it won't happen, still less that that there will be no noticeable adverse effect on Britain's leading position in the financial services industry if the Government pushes ahead.

I've spoken to a number of wealthy financiers with non-dom status who say they might leave and one or two who actually are, the most popular destination for this type of practitioner being Switzerland. The ship broking industry may be as good as its word.

Beyond the stereotypical view of the non dom as Russian billionaire or Continental hedge fund manager, there is a whole swath of extraordinarily talented foreigners from Swedish software specialists to Italian futures traders, all vital to the health of the City, who make their home here at least in part because it involves paying so little tax. This labour is very mobile, and much in demand, the world over.

The billionaires, for whom the proposed £30,000 yearly charge is but a rounding error in annual earnings, meanwhile complain of the intrusion into their affairs involved and the likely accounting cost and hassle of compliance. They too don't need to live in London. For the Government, it is an extraordinarily delicate issue. For at least the past 10 years, public policy has been deliberately set to nurture the City and persuade foreigners to invest there.

Favourable tax treatment has been a key factor in establishing the City's present, pre-eminent position as an international financial centre. The upshot is that finance and related business services are today a very considerable part of the UK economy as a whole, bigger as a proportion of GDP than any other developed country in the world.

Many Britons may resent the conspicuous wealth of the City, but the country as a whole would be bust without it, and frankly, in a fast-developing world, dependency on financial services is almost certainly a better place to be than reliance on manufacturing, which can only go one way as low-cost competition from China and India becomes ever more intense. Most other countries would kill to have what we've got going for us in the City.

Nonetheless, there is nothing worse than an inequitable tax system, or one that allows wealthy foreigners to benefit from the social and political stability it provides without having to contribute to it.

The problem, as Lord Jones says, is not so much the attempt to tax non doms as such, as the muddled and ill-thought-out manner in which the Government intends to go about it. After years of trying to sweep the problem under the carpet, Labour was embarrassed into action by the Tories, who perversely had the courage to come up with proposals for tapping non doms before the Treasury. The Government now shows every sign of making a right old horlicks of it all.

Disaster of Metronet shows sham of PPP

Anyone who takes the Tube to work in London would be well aware of the abject chaos into which the transport system descended this week as a result of power failures on the Jubilee line. Even so, the news that the Government is to pay off the consortium of banks which have been funding Metronet, the private sector consortium responsible for modernising a large part of the London underground, with £1.7bn of taxpayers' money, received only limited publicity.

This must have come as a relief to the Prime Minister, Gordon Brown, who as Chancellor was the architect of the Public Private Partnership on the Tube. With Metronet's collapse into administration six months ago, the Tube PPP was shown to have been an expensive failure. Just how expensive was manifest in this week's figures. The Metronet loans would have been much cheaper to finance had the whole thing been done through the public sector, yet under the terms of the PPP, the Government was obliged to redeem the great bulk of them in any case.

The primary justification for the PPP – that it would transfer the risk of the project on to the private sector, be more efficient and enable expenditure that the public sector couldn't otherwise afford – was shown to be a sham.