Jeremy Warner's Outlook: Stock market rides the liquidity bubble, but what happens when the taps are turned off?

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The Independent Online

The economic news was a little better yesterday than we've seen for some weeks now, with surveys on both the service and construction sectors pointing to an uptick in activity last month. Even the usually gloomy British Retail Consortium reported that the downturn in high street sales seems to be easing. Whatever. Few would predict a rapid bounce back in the economy just yet.

The outlook in Europe remains dismal, and a pronounced slowdown in both China and the US, up until now the bright spots of the world economy, now looks inevitable. Yesterday's news has again lengthened the odds of an interest rate cut this week, but even if the Bank acts, it seems unlikely it would bring the consumer and housing markets storming back.

So how come the UK stock market keeps rising? Despite the gathering economic gloom, UK shares have had an outstanding year so far. Both the Dow Jones Industrial Average and the S&P 500 are down on the year. The FTSE 100, on the other hand, is nearly 8 per cent up. Why the optimism? In part, it's the expectation of lower interest rates, which in theory are good for corporate profits. Around a quarter of UK listed company profits are in dollars, so a weaker pound is a boost to earnings too, as well as exports.

Yet neither of these factors can explain the stock market's current show of strength. Indeed, many traditional sources or support for UK equities seem this time to be entirely absent. Pension funds and insurance companies if anything seem still to be net sellers of UK equities, while the private investor has yet to be tempted back in significant numbers. Sales of unit trusts and ISAs have been pathetically low.

Support comes instead either from the companies themselves, many of which are engaged in significant buy-back programmes, or from overseas. It is to this latter category of investor that we must look to see the most significant inflows into UK equities. Today they account for about one-third of the ownership of UK plc and rising, hugely up on 10 years ago.

What is the value they see in the UK which our own investors apparently can't? Much of the disengagement by British institutional investors from UK equities is structural. The big pension funds are sellers because they are maturing, and therefore need to secure their members' pensions with safe, low risk assets - mainly Government bonds. Insurers have had the selling forced on them by more demanding solvency regulation. For private investors, meanwhile, bricks and mortar have seemed far more alluring. By depressing the value of UK stocks, this absence of support from home has created something of a buyers' market for overseas investors.

That discount has now been largely eroded. After the rally of the last two months, the UK stock market is back to fair value, with the forward earnings multiple at about 13 and the dividend yield at 3.6 per cent. Relative to other asset classes, however, and particularly Government bonds, UK equities still look cheap. Indeed, despite strongly rising equity prices we are again approaching that pivotal investment moment, last seen in the run-up to the Iraq war and prior to that not since the late 1950s, when the yield on equities is higher than that on 10-year gilts. The bond market has been climbing even more rapidly than the the FTSE 100, narrowing the yield gap to just 0.6 percentage points.

What's going on here? Bond yields virtually the world over are approaching a level which points unambiguously if not to outright deflation, then certainly to a prolonged period of very low growth and subdued prices. And if that's the case, then ordinarily it would spell big trouble for equities. The exceptionally difficult economic climate pointed to by low bond yields would cause some companies to go bust, while others might be forced to cut their dividends.

Yet there is little to indicate that this is what's about to happen. To the contrary, dividend cover is high, and many companies, encouraged by exceptionally low interest rates, are financially robust enough to engage in extensive buy-back programmes or other forms of capital distribution. Either bonds are mispriced or there is something else happening here.

One answer must lie in loose monetary policy. Put plainly, there is just too much money slopping around the system chasing a decent return. As the opportunities to invest in safe assets with a respectable return grow ever more limited, investors reach out along the yield curve into riskier assets - longer bonds, emerging market bonds, junk bonds and equities.

UK equities may be at fair value by historic standards, but they look cheap relative to gilts, and relative to US equities and Treasuries, even cheaper, hence the foreign interest in the UK stock market. There are some special factors too. New sources of demand for oil and natural resource from the fast industrialising regions of Asia have buoyed these sectors, with their relatively high weightings in the UK stock market.

Any disruption to the exceptionally loose monetary conditions that have ruled for the past five years would never the less put all these asset valuations at risk. A monetary expansion of the magnitude just witnessed would normally have resulted in rampant inflation. The fact that it hasn't is largely down to the disinflationary effect of Asian industrialisation, Eastern European labour migration and corporate outsourcing. Crudely, the money has instead gone into assets - into property, bonds and now even UK equities. All this looks a peculiarly unsafe foundation for a sustained bull market. A pause for breath is the least we can expect.

Railtrack bandwagon shamefully joined

Rather than pick a fight with the Government after it shunted Railtrack into administration four years ago, big institutional investors chose, in their usual pusillanimous fashion, to leave it instead to a retired engineer from Reading to take up the cudgels on behalf of aggrieved shareholders. The institutions settled for 252p a share.

Yet now that there is the merest hint of Geoffrey Weir and his 49,000 fellow small investors actually succeeding in their class action case against the then transport secretary, Stephen Byers, and extracting more compensation, they can suddenly scent another pay day and are subtly shifting position.

Crispin Odey of Odey Asset Management, one of the funds which chose to accept the original offer in return for dropping the right to sue, puts it thus: if Byers is found guilty of misfeasance then that equals fraud and if fraud took place that renders any previous deal with the Government null and void.

Strictly speaking this may be correct but while fund managers may be under an obligation to extract the maximum they can on behalf of their pension trustees, it is shameful to see the big battalions of the City piggy-backing on small investors, who have so far taken all the risk.

In their craven anxiety not to upset the Government, institutional investors found they had better things to do when the Railtrack Private Shareholders Action Group was formed three years ago and began preparing a case against Byers and Co. Nor were they ready to stand up and be counted a few months ago when the Government attempted to bounce the case out of the courts, not on its merits but by exhausting the action group's fighting fund.

The chances of Mr Weir succeeding when all is said and done remain slim. A very high burden of proof will be required to demonstrate that Mr Byers deliberately abused the powers of his office in order to rob Railtrack shareholders of their company.

But at least the private investors have had the guts to try. In so doing, they've laid bare the cynicism with which the Government went about renationalising Railtrack. They've also proved once again that when it comes to good corporate governance, no lessons should be taken from lily-livered fund managers.