Stephen King: Why the stock market has flattered only to deceive

Persistent declines in equity prices provide an incentive for savers to hold their assets in cash and bonds

Eng-er-land, Eng-er-land, Eng-er-land. There, that's got the good news out of the way. Now for the bad news. While we've all been sitting there, marvelling at Beckham's boys, celebrating the Queen's golden jubilee and bopping to the musical pomp and pageantry of rock stars on the verge of receiving their free bus passes, our savings have been going down the pan.

Actually, this is not strictly true. In the absence of significant inflationary pressures, some assets – cash, bonds – have at least held their value. Others, most obviously housing, continue to motor along at an extraordinary rate although, to the extent that consumers have been borrowing against their gains, there is not a lot of "net" saving going on. But there is one asset class that, in the late 1990s, promised so much and, over the past two years, has delivered worse than very little. I'm referring, of course, to equities.

The Nineties were a decade that focused very much on the "cult" of the equity, originally conceived by George Ross Goobey in the Fifties. It was frequently argued that equities were the only real vehicle for pension funding and for medium-term saving. This view partly stemmed from the nasty inflationary experiences of the Seventies, when equities provided a useful hedge against the ravages of inflation. It also stemmed from a view that equities provided a way for savers to get access to the New Economy. Finally, it reflected an argument that, faced with pension shortfalls over the longer term, there simply had to be some vehicle out there that could deliver the necessary returns. Equities seemed to be a very likely candidate given their excellent performance in earlier years.

The reality, of course, has been very different. Equities have been falling persistently since 2000. Take, for example, total returns on the US S&P 500 index of leading shares. Returns amounted to minus 9.1 per cent in 2000, a further minus 11.9 per cent in 2001 and, in the first five months of this year, minus 23.5 per cent at an annualised rate. The decline has, of course, continued in June. On their own, these numbers are bad enough. They're even worse, however, set against earlier history. If equities are down at the end of this year, this would mark the third consecutive year of losses, an undistinguished feat not seen since the onset of the Great Depression at the beginning of the Thirties.

Over the past two and a half years, the losses on equities have been offset by a very good performance from bonds. Taking the US as a benchmark, bonds gave a total return of 14.5 per cent in 2000, followed by a further gain of 3.8 per cent in 2001 and, on an annualised basis, 4.6 per cent in the first five months of this year. To be fair, bond returns on this scale have not been uncommon throughout the past 20 years. The difference this time around, however, is that bond returns have remained positive when equities have fallen by the wayside.

What does all this mean? When bonds and equities were giving positive returns, there were some obvious factors at play. In particular, the move from a high inflation environment to a new, lower inflation, world meant lower short-term interest rates – good for bonds – and hopes of greater economic stability and predictability – good for equities. That move, however, is now in the past. Whether you look at the US or the UK, France or Finland, Germany or Japan, inflation has structurally declined to rates that are either desirable or, specifically in Japan's case, too low.

The arrival of low inflation on at least a semi-permanent basis leaves economies exposed to new challenges. The shift from equities into bonds may be telling us something about these new challenges. Bonds offer safety, equities supposedly offer capital growth. So why is it that safety has been chosen? Why it is that capital preservation has suddenly become more relevant than capital growth? Or, why is it that people are no longer convinced that equities will be able to deliver the appropriate capital growth?

These are not just trivial questions. Capital markets play a very important role in modern economies. They bring together different groups of savers with different groups of investors. The rates of return generated on different asset types vary depending on the amount of risk that is being taken on board. Generally speaking, rates of return would have to be higher on things like equities – companies, after all, can go bust – than on cash and government bonds, where there is a greater degree of capital security.

The peculiarity of the Nineties was that the argument was bizarrely reversed. Instead of arguing that equity returns had been higher in recent years to reflect their inherent risk, people started to argue that the inherent risk of equities in recent years must have been lower because, year in, year out, equities persistently outperformed other asset classes. This fallacy encouraged a lot more people to enter the equity market, beginning to believe that it presented a "safe haven" option for their savings, providing they were spread over a wide portfolio.

The dramatic slide in equity prices over the past two years suggests that people are beginning to come to their senses. When it comes to long-term accumulation of financial assets, free lunches do come along from time to time but it is a bit of a lottery: on other occasions, you may end up being presented with the kind of bill that would leave you with chronic indigestion.

If people are beginning to change their view, there are a number of key – and potentially disturbing – implications.

First, the boom in capital spending in the late 1990s may have been a response to the "easy money" environment associated with persistent equity appreciation. If it turns out that the equity gains were unjustified, it may also be that we've simply had too much capital spending. That's potentially bad news for growth and corporate profitability.

Second, persistent declines in equity prices provide a strong incentive for savers to hold their assets in the form of cash and government bonds. For the whole economy, however, this approach may ultimately choke off growth and point towards the emergence of deflation. At the limit, if your cash stays in your wallet or purse, any economic expansion may prove to be short-lived.

Third, if there is a global shift away from risk, those that depend on others taking risk will be in trouble. The risk-loving Nineties made it very easy for the US to fund its current account deficit because investors thought that the New Economy was a one-way bet. That view is now unwinding rapidly and, finally, is bringing dollar weakness along in its wake. A fall in the dollar, under these circumstances, might have damaging effects on competitiveness both in Europe and Japan.

Hopefully, these nasty events will be avoided. As a start, there has been good news in the form of the cyclical upturn that has affected much of the world economy since the start of this year. However, in the same way that England's defeat of Argentina is no guarantee that Sven's men will win the World Cup, so too is this latest cyclical upturn no guarantee that economic health has been fully restored. Ultimately, the changes in saving and investment behaviour implied through the falling equity market cannot be lightly dismissed, raising a whole series of structural risks for the future health of the world economy.

Stephen King is managing director of economics at HSBC.