Jeremy Warner's Outlook: Excess liquidity keeps stock markets riding high, but what happens when it's withdrawn?

Europe should not decide Liffe's future; Blow to the Treasury in Lords tax ruling
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The Independent Online

Stock markets continue to defy the doomsters who saw in last May's wobble the beginnings of a new bear market. Prices have been recovering virtually ever since and are now comfortably higher than they were at the start of the mini-correction. The turn-of-the-century, all-time high for the FTSE100 again beckons. It's little more than 10 per cent away now. The FTSE250 is already trading at record levels.

As regular readers of these columns will know, I've been arguing the case for this new bull market in shares ever since it began back in March 2003. The May wobble failed to shake my confidence. But though I see no particular reason for changing this stance quite yet, doubts are none the less beginning to creep in as shares march ever higher.

Support for the market at present valuations comes from two related phenomena. The first and most important is that corporate profits are exceptionally buoyant and don't look like going into reverse any time soon. What marks out this particular boom in profits from previous ones is that valuations remain relatively low too.

So even if you take the view that profits have reached the natural limits of the present expansion, it doesn't necessarily mean share prices are going to fall. Corporate profits were booming at the end of the last cycle in the late 1990s too, but back then valuations were exceptionally stretched. Falling profits and high valuations are a lethal combination. This time around, that's not the case. Valuations already discount a slowdown in profits growth.

Yet the other reason why share prices are buoyant is less reassuring. Despite the tightening bias in monetary policy being pursued by central bankers, the world is still awash with money. There is something of a paradox here. Central bankers have been raising short-term interest rates to choke off inflationary pressures, but the debt markets in general remain exceptionally benign. Long-term interest rates are being kept low by excess liquidity.

With buoyant corporate profits, equity is therefore made to look cheap compared with debt. Or put another way, the cost of buying equity is a good deal lower than the returns that can be generated from it. This state of affairs has instructed the growing boom in highly leveraged takeover bids we see both in European and American markets. One of the latest examples of this is Tata Steel's bid for Corus. The deal has been billed as one of unarguable industrial logic. In fact it is much more like a private equity buyout than an industrial merger, with Tata borrowing heavily to buy Corus and then securing the debt against Corus's own cash flows. Other major transactions in the UK stock market, such as Ferrovial's £11bn acquisition of BAA, have followed a similar pattern.

When the same thing was done by Malcolm Glazer to Manchester United, the fans called it buying the company with its own money. They were right. Enlarge this wheeze a million times over, and that is broadly what is happening to stock markets as a whole. Share prices are being kept afloat on a sea of debt.

Is this dangerous? As long as the profits keep flowing and debt remains cheap, probably not. But if central bankers are eventually forced to reign in this excess liquidity to tackle inflation - which broadly means putting up interest rates a lot more than the markets are expecting - then things might get difficult. Profits will fall and valuations will no longer look as cheap as they do now.

Periods of economic expansion rarely die of old age; instead, they are killed off by the anti-inflationary actions of central bankers. That threat has by no means gone away. Indeed, it may be more potent now than it was when these fears last got the upper hand back in May.

Europe should not decide Liffe's future

The never-ending soap opera that is the story of who's doing what with whom among national stock exchanges is again reaching fever pitch. However, as with all soaps, the denouement may still be some distance off. In the latest turn of events, pressure is once more mounting on Euronext, owner of the Paris bourse, to abandon its planned merger with the New York Stock Exchange and opt for Deutsche Börse instead.

Support for this all-European solution comes both from the politicians who like to promote national, or in this case, European, champions, and from the largest shareholder in the two exchanges, the hedge fund manager, Christopher Hohn.

Yet unfortunately for them, the City has a say in the matter too, for Euronext owns Liffe, the London-based futures market. If Deutsche Börse were allowed to merge with Euronext, it would crunch together the only two serious futures markets in Europe - Deutsche Börse's Eurex with Euronext's Liffe - giving the combined entity more than 90 per cent of all on-market derivatives contracts traded within the EU.

Factor in the over-the-counter market, and the proportion would fall to something far less alarming, but even so the effect is to bring about an unacceptably high level of concentration in on-market trading.

Deutsche Börse says it would maintain Liffe as a stand-alone platform in competition to its own. Eat my shorts, as Bart Simpson would say. Quite apart from the obvious illogicality of having competing businesses under the same management, failure to fold Liffe into Eurex would reduce the synergies of the merger from the hundreds to the tens of millions. It would scarcely be worth doing the deal at all.

It matters not a fig to the City where the Liffe trading platform is located; provided it works, it could be in Timbuktu for all the traders who use it care. But it does matter that rival exchanges are maintained to keep prices low and ensure systems and product innovation. Supporters of the European solution wax lyrical about the benefits of creating single pools of liquidity and similarly self-serving mumbo jumbo. In truth, any such "merger" would be just a conspiracy against the public. Deutsche Börse would end up with a monopoly of trading, clearing and settlement.

Unfortunately, we cannot rely on European regulators, to whom the job of vetting this monstrously anti-competitive proposal falls, to do the decent thing and throw it out of court. If it helps further Frankfurt's aim of rivalling the City as Europe's pre-eminent financial centre, they might even approve it.

In London, the mutterings of concern about the future of Liffe have grown to a roar. If Deutsche is allowed to absorb Liffe, the City must be ready to counter with an alternative, start-up futures exchange, complete with the clearing and settlement systems necessary to make it possible. It would not be lacking in support. An entrepreneurial opportunity, perhaps, for Icap's Michael Spencer.

Blow to the Treasury in Lords tax ruling

The Chancellor likes to present himself as a champion of tax competition in Europe against the tax harmonising instincts of the eurocrats. It's one of the reasons he's so hated out in Brussels; much of what Europe does is presented as an attack on British tax privileges. The reality is that an awful lot of what comes out of Europe is quite useful in reducing the tax burden of doing business in Britain.

A case in point is yesterday's ruling from the House of Lords, giving backing to judgment already made in Europe that tax perks cannot be confined within national boundaries but must be applied indiscriminately across Europe. The decision could potentially cost the Government billions of pounds in tax rebates. A ruling that began in Europe has thus resulted in a considerable reduction in the tax burden of companies operating here. There have been a number of other cases like it in recent years.

Unfortunately, the end result may not be as beneficial as it seems. With each ruling, the Government legislates with dispatch to limit the damage. Business taxes also tend to obey the water bed principle of life - squeeze them down in one area and they only bounce up somewhere else. Hey ho.