Outlook: Boom times are back; inflation not far behind

Equity withdrawal; False tunnel hope
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The Independent Online

Blink and you would have missed it. The outlook for the world economy seems miraculously to be turning on a sixpence. Lingering concerns about excessive domestic and public debt, America's burgeoning current account deficit and the gyrations of the foreign exchange markets have melted away like snow in summer this past couple of months, to be replaced by a degree of business and consumer confidence not seen in years.

Blink and you would have missed it. The outlook for the world economy seems miraculously to be turning on a sixpence. Lingering concerns about excessive domestic and public debt, America's burgeoning current account deficit and the gyrations of the foreign exchange markets have melted away like snow in summer this past couple of months, to be replaced by a degree of business and consumer confidence not seen in years.

This is not so much green shoots of recovery anymore as an all of a sudden, fully grown corn field, with growth in nearly all the world's major economies accelerating away strongly. The only major exception is Germany, but even here there are unmistakable signs of life. The European Central Bank may even summon up at last the courage to cut interest rates, which would further underpin any nascent recovery in the European hinterland.

While the European tortoise plods hesitantly forward, the hares of the world economy are already leaping away. Here in Britain, the Bank of England has dramatically increased its growth forecast for this year and next, from under 3 per cent last November to something close to the top of the Chancellor's target range of 3-3.5 per cent. It's hard to recall any upward revision as large. Retail sales growth has, meanwhile, returned to levels not seen since the boom of the 1980s. It can't go on like this, say the doomsters, but even for them it's with a growing lack of conviction.

It's like crying wolf once too often. The end of the world has been falsely proclaimed so many times over the past four years that those preaching economic gloom and doom no longer have any credibility. Business planners have determined to throw caution to the wind and ignore them entirely.

But perhaps the biggest new ingredient in the economic turnaround is Japan, the laggard in the world economy for more than a decade now. Figures published this week show that real GDP grew by 7 per cent in the final quarter of last year, the strongest rate of growth since the boom years of the late 1980s. Real growth is flattered by the fact that the Japanese economy is still deflating, but even in nominal terms - adjusting for deflation of 4.4 per cent - growth was at a respectable 2.6 per cent. Kazumasa Iwata, the Bank of Japan's deputy governor, proclaimed that this year might mark the turning point in Japan's battle against deflation.

The reflationary policies being applied to the Japanese economy seem finally to be working, underpinning the new mood of economic self confidence that is sweeping Eastern Asia. Across the region as a whole, conditions haven't been so buoyant since the Asian financial crises of 1998. It's wild out there, perhaps too wild.

I'm not joining the doomsters, I promise, but a word of caution. In my view, there's definitely a big inflation coming on. Thanks to the boom in China, commodity prices are taking off like a rocket. In the US, both monetary and fiscal policy have quite plainly been too loose for too long. There's little evidence of these pressures feeding through to higher inflation in the major industrialised countries yet, but monetary policy acts like a piece of elastic; it stretches and stretches under the weight of old influences, and then suddenly bounces with a vengeance.

Equity withdrawal

The last time I met Sandy Crombie, then deputy chief executive of Standard Life but since elevated to the top job, he advanced the following explanation of why the Edinburgh insurer had remained overweight in equities right through one of the worst bear markets in living memory. Yes, he conceded, shares are more volatile than other assets, but because equity investors demand a higher rate of return than from bonds, property and cash for the greater risk of holding these riskier assets, they will in time always outperform.

Intellectually, I've always had some difficulty in grasping this argument, if only because if equities always outperform over time, then investors wouldn't want to hold anything else and the so-called equity risk premium would disappear. Ah, said Mr Crombie, but over shorter periods of time equities can horribly underperform. In some cases, where the company goes bust, shareholders will lose everything. You therefore need to be a very long-term holder to get the full benefit of the extra return equities must offer to persuade investors to buy them.

The news this week is that over the past month Standard Life has been forced to dump £7.5bn of shares, reducing the exposure of its core life fund to equity markets to 35 per cent - down from 59 per cent at the end of last year and 77 per cent at the end of 2002. Mr Crombie readily admits that it was one of the toughest decisions he's ever had to make, for it plainly goes against everything he preaches about the relative merits of equities over bonds and other forms of investment. Having courageously, some would say foolishly, held onto an overweight equity position right through the bear market, it looks stupid and premature to be bailing out now, just as the markets are beginning the long road back to previous heights.

Only it wasn't Mr Crombie's decision. Instead, he's been caught by tough new FSA solvency rules that require life companies to be in a position to meet all their liabilities at all times even in the most extreme of circumstances. With the Equitable Life debacle scarred on its memory, the FSA wants to regulate away all remaining risk from the with-profits life business. In so doing, it is condemning Standard Life and other with-profits policyholders to much poorer rates of return than they might otherwise enjoy, thereby further reducing the attractions of what used to be Britain's most popular form of saving.

What this is about, of course, is back covering. If policyholders are to hold us liable for compensation when things go wrong, say the Government and its agents, then we are going to make damn sure there's no risk left in the system at all, and if that means driving life funds out of high-risk equities into bonds and cash, then so be it. It's regulatory madness, but you can see how it has come about. Compensation culture is reinforcing its natural bedfellow, the nanny state, and everyone ends up the poorer.

Still, in every cloud there's a silver lining. The forced selling of the life assurers and pension funds has created some bargain basement prices for those of a risk-taking disposition. With the overhang of the Standard Life re-weighting now removed, the stock market is moving sharply upwards again. Mr Crombie and his policyholders can only look on and cry.

False tunnel hope

As a company, Eurotunnel is a dead parrot, yet hope always springs eternal among equity investors and for some reason the company's share units continue to put an £850m value on the enterprise. Eurotunnel admits it's deep below the water with no hope of even servicing its £6.4bn of debt, let alone repaying it. Yet it continues to pray for an "industrial solution", with the major users of the tunnel perhaps taking big equity holdings in return for lower charges.

One interested party is London & Continental Railways, builders of the yet to be completed high-speed rail link between London and the tunnel. Quite who has been twisting whose arm is not clear, but the suggestion has gained currency that there could be contracts in it for LCR on the projected Crossrail link if LCR agrees to help out on Eurotunnel. Don't hold your breath. Nobody in their right mind would get involved in Eurotunnel's problems, which in the end can only be resolved by debt holders taking a haircut, all but wiping out the remaining value of the equity in the process. All the rest is just sound and fury signifying nothing.

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