Outlook: Deflation remains the hidden dread of the stock market

Standard Life; Aberdeen Asset

Equity markets just cannot seem to lift themselves out of their doom laden state. Every time there is a rally, it peters out and the FTSE 100 plumbs new depths. Most forecasters feel instinctively that the market is oversold, that it is already well into overshoot territory, but it doesn't seem to do any good. Worries about war in Iraq, and more particularly, fears of a deflationary double dip in the US and European economies return to haunt every time the stock market attempts to bounce.

The excesses of the bubble are proving much more difficult to work out of the system than policy makers thought. In the US and Britain, the economy is being kept afloat on a sea of low cost consumer credit. Low unemployment and a buoyant housing market has maintained the illusion of a healthy economy. Beneath the surface, we are in the depths of one of the worst business downturns in living memory. Business investment has plummeted and as long as returns remain so poor, it won't be coming back.

As the stock market falls, the gap between the yield on shares and that on bonds grows ever smaller. By historic standards, it is almost incredibly small. The yield on the FTSE 100 is 3.7 per cent, on a 10 year government bond 4.4 per cent. Rarely since the cult of equity was born in the late 1950s has it been smaller. Even allowing for the fact that there are still lots of dividend cuts to come, shares look exceptionally good value by past standards.

So is this the time to buy, or is there something really nasty still lurking in the undergrowth? The hidden fear is that of deflation. Japan has had it for years, and there are worrying signs of it taking root in Germany too. Is it really conceivable that an economy as flexible and innovative as the US could catch the same disease? Conventional wisdom is to assume not, but by falling so low, the stock market is beginning to think the unthinkable.

Let's hope it is wrong.

Standard Life

Don't panic, says Iain Lumsden, chief executive of Standard Life, Europe's largest life assurer. Everything is still just fine. We remain one of the most solvent life assurers in the land and even after yesterday's cuts in final bonuses, our rates of return on 10 and 25 year policies are some of the best in the business.

He might be right, but for a life assurer that has made the absence of a market adjuster or hitherto any cut in terminal bonuses one of its main selling points, yesterday's admission that it is just like everybody else and cannot afford to keep paying out as it has done is a bit of a come down.

Policyholders on the verge of maturity are left fuming. They will be 10 per cent worse off than those whose maturity letters have already been sent out. As for savers who need to cash in early, from today there is a big penalty when previously there was none. Many will be wondering why they listened to their board and voted against conversion when Fred Woollard, a Monaco based fund manager, was campaigning for it two years ago.

Standard insists that the fall in the value of its with profits fund in the six months to the end of last June is no worse than anybody else's, but however clever the company has been in its stock selection and hedging activities, the punishment taken since the stock market peaked at the turn of the century must be extreme.

With more than 70 per cent of the value of the fund in equities even as late as last June, Standard Life has a greater exposure to the collapse in the stock market than anyone else. The only reason it has been able to hold the fort as long as it has is because of its huge capital reserves. At 15 per cent of the value of the fund as of the last filed solvency return, these reserves provide a formidable cushion against falling equity values.

Even so, Mr Lumsden is being like King Canute in believing he can hold back the tide for ever. Standard's pockets are a good deal less deep than they were. Whatever existed a year ago will be fast depleting, given the rate at which stock markets are plummeting and Standard Life has been adding new business. If the carpet baggers were to return today, it is not clear there would be much left to plunder.

The bear market has impoverished even the most asset rich of life assurers. Standard's very financial strength may have counted against it by encouraging and allowing the fund to stay largely in equities much longer than others. The relative lack accountability in a mutual may have had something to do with the misjudgment too. In staying the course, Standard must have burnt up more capital than anybody else. Only a mutual could be so stubborn and stupid, critics will claim.

The Standard board says it is still wholly committed to mutual ownership, but the bear market is working hard to undermine one of the last true standard bearers of the mutual faith. If things got really sticky, Royal Bank of Scotland Group, which has no long term savings business, might be prepared to come to the rescue of its Edinburgh cousin. How much it would be prepared to pay is another question entirely.

Aberdeen Asset

Aberdeen Asset Management is desperately trying to rehabilitate itself. The founder and chief executive, Martin Gilbert, has agreed a cut of a third in his basic salary, and so too have his right hand man, Chris Fishwick, and others. The payment of deferred bonuses has been postponed for at least a year, fund managers are being fired left right and centre, and the group has attempted to pre-empt the Financial Services Authority by proposing a scheme that would compensate unit holders in the Progressive Growth fund with £30m of its own money if markets do not recover over the next couple of years.

Is it enough to save Mr Gilbert? And what of Mr Fishwick, the architect of the group's disastrous entanglement with the split capital investment trusts scandal? Those who have lost their shirts on Aberdeen's split caps not only want their money back, they want retribution too. Aberdeen's own institutional shareholders are pretty hot under the collar about it all as well.

Mr Gilbert is suitably contrite, but insists that fund managers can be no more immune to the delusions of the boom than anyone else. The Progressive Growth trust was marketed as "the one-year old that lets you sleep at night". Damning stuff, but there have been much worse examples of mis-selling by the financial services industry that have gone largely unpunished. Outside the split caps, Aberdeen's performance as a company has been relatively good, with some well timed diversifications away from equities into property and bonds.

Unfortunately for Mr Gilbert, in a bear market it is by your mistakes rather than your achievements that you are remembered, and though nothing to write home about by City standards, some of the bonuses that were about to be paid seemed positively obscene from a company so deep in the mire. The fact that they were agreed in better times, and then deferred as a way of keeping senior executives, has become a fact entirely lost in the split caps maelstrom.

Exceptionally high rates of pay in fund management is hard enough to justify at the best of times. Many managers expected seven figure salaries merely for trouble of keeping up with the index and excessive levels of remuneration among the people managing our money became as much a cause of the bubble as it was among analysts and fee hungry investment bankers. Mr Gilbert seems to be doing the right things to redeem himself, but there's a big appetite for vengeance and if the FSA proves awkward, the excesses of the boom could yet end up destroying him and his company.

jeremy.warner@independent.co.uk