Outlook: Another difficult year ahead, but shares may recover a little

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The Independent Online

I was broadly correct in my outlook for stock markets this time last year (at best they would trade sideways, I said), so the law of averages alone would suggest that I'm going to be wrong this time around. The following column therefore comes with all appropriate health and wealth warnings.

I was broadly correct in my outlook for stock markets this time last year (at best they would trade sideways, I said), so the law of averages alone would suggest that I'm going to be wrong this time around. The following column therefore comes with all appropriate health and wealth warnings.

I'm pessimistic about the economy, certainly in the short term and I'm not so sure further out either. As ever, the big unknown is the flow of geopolitical news. I've long regarded war against Iraq as inevitable. It's a mystery to me why so many British commentators thought otherwise. The Republican victories in the mid-term elections will have only strengthened the President's resolve, and I'd be surprised if America isn't officially at war by the end of this month. We are already seeing the beginnings of the consequent spike in oil prices, which will be accentuated as the war gets under way.

The effect of higher oil prices is to subdue demand and raise inflationary pressures at the same time, giving central bankers a real headache in knowing how to respond. Should they cut interest rates further to compensate for the higher costs to industry and consumers of oil, or should they raise them to choke off the consequent upward pressure on product prices?

The correct policy response, perhaps, is the latter, but it is a brave central banker who would raise rates with the world economy still so fragile. As we enter war in Iraq, we can therefore expect more interest rate cuts, certainly from the Bank of England and the European Central Bank. The US has already reduced to as low as 1.25 per cent, giving a negative real rate of interest. With inflationary pressures mounting as a result of weakness in the dollar, it's hard to see how the Federal Reserve could justify cutting them any further.

The Chancellor has forecast growth this year for the UK of between 2.5 per cent and 3 per cent. I'd be amazed if he gets close even to the bottom end of the range, let alone the top. Admittedly, he has the support of much higher levels of public spending, which will provide a useful counter to the likely slowdown in consumer spending growth. But the Chancellor also assumes a revival in business investment. Few industrial leaders I've spoken to in the past few months give any support to that view. OK, so they may change their minds if the war against Iraq proves short, sharp and successful but, as things stand, the Chancellor will struggle to meet his forecast.

Economic growth that relies entirely on increased public spending is in any case not sustainable for any length of time. It is the private sector which is the wealth generating part of the economy, and provides all the tax revenue. The public sector just inefficiently spends it. A growing public sector is ultimately incompatible with a shrinking private sector.

One of the most striking factoids to have emerged from the past year is that average pay in the public sector has overtaken average pay in the private sector once the deferred income benefit of pensions is taken into account. That it pays more to work in the unproductive part of the economy than the productive part is in itself a deeply unhealthy development. The end result could easily be that the productive bit will have to be ever more heavily taxed to fund the unproductive side, eventually leading to the sort of economic stagnation being experienced in Germany and some other parts of Continental Europe.

One of the curiosities of the present business downturn is that it has so far had so little effect on the health of the wider economy. Consumers and most economic forecasters remain relatively upbeat, but business leaders are more down in the dumps than I can ever remember them.

Cheap and easy credit, a buoyant housing market, and close-to-deflating product prices has kept consumer demand and confidence strong. Excess capacity and very poor levels of external demand has by contrast ensured poor levels of business spending and confidence. It is hard to see what's coming up that might change this pattern, unless it be higher public spending, which will create some demand for business to satisfy.

Meanwhile, the boom in the housing market is already over. At the top end of the London market, prices are falling, and even lower down, it is becoming common practice to bid 10 per cent less than the asking price. A further cut in interest rates early in the new year might give the market a second wind, but eventually prices will fall steeply. Bubbles never end in plateaued prices, as the mortgage lenders insist this one will. Eventually there is always a sharp correction. It is only a question of when and just how sharp. That in turn will put a break on growth in consumption.

Higher personal taxes, which kick in from April, will further compound the effect. There is also a danger of what John Maynard Keynes once called the "paradox of thrift". This is the propensity of people, when confronted by a period of economic uncertainty, to save more for a rainy day, thus exaggerating the effects of the downturn. The realisation that more saving is necessary to fund a decent income in retirement could reinforce the phenomenon.

The best growth this year will once again come from the United States, but as the strong dollar policy of the Clinton years becomes a distant memory, it won't help the UK or Europe very much. Everyone needs a weaker currency, to help boost export demand and make imports more expensive. By definition, not everyone can have it.

In summary, I just don't see much of a recovery coming through this year. The US economy, which has been the engine of world growth for much of the last 10 years, could even get quite difficult. The Bush Administration seems to believe it can walk on water in promising lower levels of federal tax while public spending goes through the roof. The consequent budget deficit is bound to require higher interest rates, as indeed will the weaker dollar once its inflationary impact starts coming through. And as for Europe, there will be no seventh cavalry riding over the hill to help Germany and France out of their economic malaise.

So another difficult year? The only thing which might make things turn out differently would be a swift resolution of the Iraqi war followed by a rapid cooling in international tension. Neither of these outcomes are impossible. George Bush is betting strongly on the first. If the war is "won" without undue disruption to oil supply, then the initial oil price spike will be short lived and prices could eventually settle at significantly lower levels. Unfortunately, these are big ifs.

This does not necessarily mean the stock market is heading for a fourth successive year of negative returns. I'd be surprised if the stock market fell again this year, if only because it is the job of stock markets to look through the gloom to the sunny pastures that lie beyond. By the end of this year, stock markets should at long last be looking forward to better times ahead.

Equities are not yet at bargain-basement levels, especially in the US, where some valuations have yet fully to come to terms with reality. But the earnings multiple on the FTSE All-share is back to its long run average, and although the dividend yield is still poor by historic standards, it has rarely been better relative to bonds or the rate of inflation.

Both Shell and BP yield 3.7 per cent net, which is better than anything you'll get from a high street bank after basic rate tax has been deducted. A good yield is often an indicator of a dividend cut to come, but Severn Trent at 6.8 per cent has said the dividend is safe at least until 2005 and it is hard to imagine that either HBOS (4.6 per cent) or HSBC (4.9 per cent) are about to slash their payouts. This seems as good a time as any for those buying shares for the long term.

jeremy.warner@independent.co.uk

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