Outlook: A justified rally in shares, but don't expect more of the same

Drug discovery; Kingfisher/Kesa
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The FTSE 100 has bounced 27.5 per cent since equity markets hit seven year lows shortly before the invasion of Iraq, making it one of the most remarkable stock market rallies of recent times. The war was won in predictably double quick time, yet the world can hardly be said to be a noticeably safer place than it was - to the contrary, the war may have profoundly unsettled the whole region - so what's happened to justify the bounce?

Cheaper oil is one reason, which economically was always likely to be the big positive from an Iraqi war. The deflationary bogey, so much talked of just a couple of months back, also seems less of a threat than it was. Deflation is already a reality in large parts of the Far East and it is quite likely to become so in Germany too, but the generalised, worldwide deflation anticipated by some now looks to have been exaggerated as a potential threat to the world economy.

In Britain, the paralysis in activity caused by the build-up to the war has been replaced by clear signs of a revival in business and consumer confidence. By the skin of his teeth, the Chancellor seems again to have escaped a recession, and this alone might justify the bounce. Personally I thought a recession, as defined by two quarters of economic contraction, a certainty three or four months back. Fortunately, I've been proved wrong. Equally important, at it's nadir, the stock market had plainly overshot, with the yield on equities significantly higher than that on gilts for the first time since the late 1950s. This made no sense unless you believed the deflation story, so some kind of an upwards correction to bring the market back to fair value seemed inevitable. After a day of blind panic, the market finally bottomed out on 12 March, at which point, dear reader, this column advised you to buy.

All that said, we've probably had the best of the rally, for the time being at least. The world economy may no longer be heading for Armageddon, but then it never was. The less dramatic but always more plausible prognosis was for a prolonged period of sluggish growth, and I see no reason to think this outlook has changed. As for the stock market, the post bubble problems of the corporate world are not going to be magicked away by the blitz on Iraq. It may be many years before the stock market recovers sufficiently to break unambiguously through its turn of the century peak.

Drug discovery

When the last great wave of pharmaceutical mergers took place - the biggest of which was Glaxo Wellcome's marriage to SmithKline Beecham - much was made of the argument that in order to succeed in research and development, pharmaceutical companies needed to be much bigger than they were. The bigger the better.

The good old days when drugs would be discovered by chance or serendipity by boffins sometimes working alone in their garden sheds, were long gone, it was suggested. The name of the game was systematically to chuck money at particularly promising compounds until a route to market could be found. For those with the spending power, it was claimed, breakthroughs in genomics promised an unprecedented era of drug discovery.

Unfortunately, it's not working out that way, or not yet at least. True enough, the costs of taking a product from concept to market launch have soared, with the risk of failure along the way meaning that only the biggest and most solvent companies can afford to back their hunches. Yet the fact remains that the efficiency of research and development spending by pharmaceutical companies has declined enormously, despite the ever growing size of the pharma companies.

To most of us, this might seem a predictable outcome. The bigger the department, the more bureaucratic and less innovative it is likely to become. None the less, it has come as a surprise both to the industry and the City, and it's fair to say that unless the big pharmaceutical companies can sort it out soon, they will lose their raison d'être.

Over the past twenty years, R&D spending across the industry as a whole has risen 17 fold to around $35bn per annum for no noticeable increase in the pace of drug discovery and development. Indeed it might even be starting to go backwards. The most famous drug of the modern age - Viagra - was discovered not by applying the latest technologies to the solution of a particular medical condition, but by chance, when a group of students trialling a heart condition drug found it had a peculiarly pleasing side effect, and kept on coming back for more.

We know some of the reasons for this failure. The seemingly endless process of consolidation has resulted in over arching bureaucracies, poor morale and infighting in many research departments. This is presumably a problem that can be solved. GlaxoSmithKline claims already to be achieving some dramatic increases in productivity by decentralising its research function, allowing its scientists a greater degree of freedom than they have enjoyed in the past.

As a result, the number of products reaching Phase 1 trials has more than doubled compared with three years ago while the numbers getting as far as Phase 2 has tripled. Whether the company can significantly improve on the rate at which products make it the whole way from concept to market, traditionally around 10 per cent, remains to be seen, but early indications seem encouraging.

Even so, the deeper concern is that the pharmaceuticals industry is just running out of puff. Increasingly, new product launches seem merely to be copycat versions of existing drugs. The low lying fruit of drug discovery may already have been plucked. The bounty is likely to get a good deal more complex, difficult and costly to harvest from here on in. Patience, say the big pharma companies, yet they know better than anyone that it is already a quarter to midnight and without exciting new products coming through the pipeline soon, they face certain death by a thousand generic cuts. Jean-Pierre Garnier, chief executive of GlaxoSmithKline, promises to give the City a full update on the company's R&D progress in December. It better be good.


The announcement of Kingfisher's "value enhancing" demerger of Kesa Electricals has gone down in the City like a lead balloon. This is often the case with demergers, for although it is surely right for companies to "focus" their attentions on what they are supposed to be good at, doing the splits will always shine a torch into previously hidden areas of the corporate empire; what's exposed is often unpleasing.

In this case, it is just how reliant Kesa's UK profits are on the sale of extended warranties. With a Competition Commission report on the sale of warranties looming, Kesa has decided to account for them more conservatively than it has in the past, depressing earnings accordingly. The bulk of Kesa's profits will come from Darty in France, making the stock something of a curiosity for Kingfisher's largely British shareholder base. Some will think Kesa a foreign weighting they do not need, even though the company will be listed in London as well as Paris, and has a British chairman.

Darty has long seemed a natural target for Dixons, but Dixons commanding position on the UK high street means the UK competition authorities would not allow it to buy Kesa without also disposing of Comet. In any case, Dixons has said it plans to focus all its attentions on getting the proposition right in the domestic market after an unsettling profits warning six months ago. Foreign expansion plans have been put on hold.

With internet and supermarket competition continuing to blossom, electricals retailing doesn't look like the best of businesses to be in right now. Market conditions meant Kingfisher had to abandon plan A to IPO Kesa in Paris. No one can blame Francis Mackay, Kingfisher's chairman, for pushing ahead with the alternative demerger plan, but as with the earlier demerger of Woolworths, it may take time to pay dividends.