Harsh facts beneath the market euphoria

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Too much has been written about the economic and political effects of the exchange rate mechanism's plight and not enough about the investment impact. So it has been left to the markets to give their verdict, which in the case of British equities was yesterday to push prices to yet another all-time high.

What should investors, aware that on most conventional valuations UK shares are pretty expensive, make of this?

It is very easy to see the line of argument behind the market euphoria. Before the recasting of the ERM, there was one big thing holding sentiment back. Everyone (well, more or less everyone) felt comfortable with the idea that the US economy would continue its uneven recovery, while the UK's more recent one seemed reasonably secure. The principal danger was that there might be a Continent-wide recession involving all the remaining members of the ERM.

With that danger now gone - there being little to stop the French and others cutting rates - equities could carry on their ride. Falling European bond yields would encourage similar falls here, further justifying share prices.

There is a lot of steam behind this market, so nothing that follows should be taken to suggest that the equity boom will fade this month or next: on the contrary, if the US market is any guide there could be many months yet of strong equity performance. When markets want to go up they will find some excuse to do so. But the argument that 'Britain left the ERM, cut its rates and secured the recovery, so France will now do so, and do not expect Germany to be far behind' overlooks several less agreeable facts.

First, while France is in theory free to cut interest rates sharply, as did Britain, there are at least five reasons to suspect that it will not. One obvious one is that the defence of the franc seems to have cost substantially more than the UK's defence of sterling, and so France needs to try to attract funds across the exchanges which the Bank of France can cream off and use to rebuild reserves and repay debts.

Second, it is not as easy to crank up demand in France by cutting short- term rates as it is in Britain. Neither the housing market nor the business community is quite so sensitive to short rates - longer-term rates matter more. Third, vestiges of the strong-franc policy remain, partly because of Gallic pride, partly because to allow a sharp depreciation of the franc would be to throw away much of the gain from several years of relative austerity.

Fourth, while France has greater freedom to cut rates than it did 10 days ago, Germany has greater freedom not to cut rates: the Bundesbank can follow whatever policy it thinks is right for Germany without having to worry so much about the effect on its neighbours. Maybe the effect of the loosening of the ERM will be for the average of European money market rates to come down a little more quickly than it otherwise would; but not much faster.

Last, the UK recovery started in the spring of 1992, well before the pound was forced out of the ERM. It was eventually boosted by sterling's fall and the cuts in interest rates, but these merely encouraged a process that was already under way. In neither France nor Germany is any recovery yet under way. In Germany the economy is still contracting at a frightening rate, with retail sales running about 4 per cent down year-on-year, and the prospect of another year of decline in real personal disposable income for 1994.

So the events of the last 10 days will not have nearly as obvious or immediate an impact on Continental Europe as the departure of the pound from the ERM seemed to have on Britain. The most likely outlook will be for France and eventually Germany to begin a hesitant recovery rather like that of the US, but this recovery will not be clear in the case of Germany until the second half of next year. Even when it does come, the recovery, like that of the US, may not feel much like one.

If all this is right, the changes to the ERM are little more than a convenient excuse for share prices to rise, rather than important new information that justifies a further climb. There are some genuine reasons to feel confident about the UK corporate sector, but these have little to do with the ERM and much more to do with the extraordinary structural improvements taking place within British industry and commerce.

This has been the only recession since the Second World War where companies have managed to hold down labour costs right through the trough: wages and salaries per unit of output are actually lower now than they were in the autumn of 1990. Companies have learnt, in adversity, to be lean.

This leads to a rather different question: why are the equity markets so eager to find excuses to go up that they latch on to the changes in the ERM in this way?

The main answer to this is to look at falling bond yields and say that this makes the yields on equities, while low by historical standards, high relative to the main alternative investment. But there are two other answers, as well.

The more optimistic is to say that, in Britain at least, structural change is so rapid that one can justify these low equity yields (or, of course, these high share prices) by much better- than-expected prospects for profits.

The more pessimistic is to say that we are in the classic late bull market, when any new event, whatever its long-term significance, will be seen as a reason to rush out and buy shares. On this view, the fun and games over the ERM came in the nick of time to save a faltering share market by giving it a half-respectable reason for heading into uncharted territory.