Herd mentality distorts market: Economics

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The Independent Online
Most people, depending on their ideological bent and predisposition to cynicism, regard financial markets in one of two ways. Supporters believe they promote economic growth by moving money from those who have it to lend to those who need it to invest; detractors dismiss them as disruptive casinos fuelled by fear, greed and the basest of human instincts.

Both views have something to recommend them, although it can be difficult to tell which is more important at any given moment.

For example, currency speculators were demonised, wrongly, by Church and State alike in the aftermath of Black Wednesday simply for pointing out that the Government's attempts to fix the level of the pound too high against other currencies militated against common sense and threatened to grind the economy into a depression unrivalled this century.

And now the slide in stock and bond markets since the beginning of the year is being explained as an efficient response by traders to looming inflation and shortages of capital with which to finance world economic recovery. But it probably has as much to do with the curious psychology of crowds.

The London stock market has fallen by 18 per cent since the FT- SE index of the top 100 stocks peaked at 3,520.3 on 2 February, cutting the total value of shares quoted on the market by pounds 140bn.

Gilts - the interest-bearing IOUs the Government sells to meet the shortfall between what it spends and what it raises from taxes - have fallen, too, reflecting a rise in the rate of return that investors demand. The return (or 'yield') on a 10-year gilt has risen from a little over 6 per cent at the beginning of the year to nearly 9 per cent now. Cheap fixed-rate mortgages have been withdrawn as a result.

So why has this happened and when will it stop? Why isn't economic recovery boosting share prices when it is improving the ability of companies to earn profits and pay dividends? Similarly, why should gilts be falling when inflation is at its lowest rate for a generation, ensuring that there is little prospect of rapidly rising prices eroding their value? And why have bonds and equities fallen in several markets whose economies are at very different stages of recession and recovery?

One reason is that while inflation is low for now, investors fear it will not stay that way. Comparing the yields on ordinary and inflation-proofed gilts shows the market's long-term forecast for inflation has risen from about 3.25 per cent at the beginning of the year to nearly 5 per cent.

Given the fate of numerous promises by this and past governments to keep inflation down, a degree of caution is entirely appropriate. But it is curious, as the Chancellor of the Exchequer complained in his Mansion House speech, that the dealers who buy and sell in the markets are a lot more pessimistic than the 'teenage scribblers' - the economists who are paid handsomely to tell them exactly what the economy is going to do.

The fall in world bond and stock markets has been driven from the United States, where rapid economic growth early in the year has provided more concrete cause for fears of future inflation. Unemployment has fallen to near the level at which it will stir up inflationary pay rises, and the economy's capacity to supply goods and services could soon be outstripped by demand. The US Federal Reserve validated these fears by raising interest rates for the first time in five years in February, and three times since.

The US is a year further down the road to economic recovery than Britain, and perhaps 18 months ahead of the rest of Europe. So the markets have concluded that where the US central bank has led, others will soon have to follow. Some economists have argued that the travails of the bond markets are a reaction to expected rises in interest rates rather than looming inflation. But this argument is entirely circular: interest rates are being raised, or will be raised in future, precisely because central banks want to head off an expected acceleration in prices.

Last week's bloodbaths in the markets are a case in point. Bonds and equities suffered as the dollar fell to a post-war low against the Japanese yen, notwithstanding the multi-billion dollar support-buying operation launched on Friday. A weak dollar threatens inflation in the US and makes another rise in US interest rates more likely.

But the changes in interest rates expected in Britain by the gilts and money markets still seem somewhat pessimistic, pointing towards a rise in base rates from the current 5.25 per cent to more than 6 per cent by the end of the year.

This seems unlikely. Forecasting base rates of more than 6 per cent by December amounts to betting on a sterling crisis. Although never impossible, a crisis seems unlikely while the current account deficit is at a seven-year low.

Worries about inflation have also been stirred by rising oil and commodity prices. These are not as important a component of companies' costs as they were when they triggered the great inflations of the 1970s and early 1980s, but many analysts nonetheless regard them as a warning light.

The message from commodity prices is difficult to interpret because they have been boosted by speculative buying among aggressive 'hedge funds', such as the George Soros Quantum Fund. But Leo Doyle, at Kleinwort Benson, has argued that even correcting for any speculative activity, the current breadth of commodity price rises is consistent with growth in world output of 4 per cent a year - easily enough to ignite inflation.

However, some economists reject the 'inflation fears' explanation of the markets' malaise, preferring instead to blame fierce competition for capital. Savers are being asked to pay for growing investment spending in the US, Britain and the rapidly developing economies of Asia and eastern Europe, as well as to finance massive government borrowing.

The numbers do look frightening. Despite tighter budgetary policies and the soothing influence of economic recovery, European governments are expected to borrow dollars 350bn ( pounds 230bn) this year, on top of the dollars 400bn borrowed in 1993. The top seven industrial nations are borrowing more than at any time for a decade.

But this explanation only satisfies up to a point. Chris Dillow at Nomura Research argues that demand for capital should create its own supply - investment boosts output and incomes, which automatically provides the savings to pay for it. Mr Dillow rightly points out that it is a damning indictment of the global financial markets if they are unable to ensure that this process takes place smoothly. Both fears of inflation and worries about excessive demands on the world's savers clearly play an important part in explaining why the stock and bond markets have suffered. But psychology is perhaps more important still.

It is important to remember that the recent falls in bond and equity prices have not been the result of big institutional investors dumping their assets in the market to raise cash.

Trading has often been light, with the falls in prices driven by the futures markets. Here dealers can bet big stakes for big prizes on future market movements. With futures pushing prices around, the institutions are keeping out of the way. This generates a self-reinforcing crowd psychology: people will not buy until prices stop falling, but prices cannot stop falling until people buy. The process will only end when the institutions call the futures markets' bluff.

This will happen eventually. Pension schemes are becoming increasingly mature, which means they need long-term bonds to provide steady flows of income. Last year, bond and equity prices were pushed to absurdly high levels by the hedge funds. This meant yields were too low for the institutions, as they did not produce a big enough flow of interest to make pension or life assurance payments.

But as yields rose in the first quarter of the year, pension funds bought pounds 3.3bn of gilts, more than in the whole of 1993. As bonds become more tempting, the institutions should be more willing to defy the futures market, risking short-term losses for long-term value. The wise policymaker will not try anything drastic to pull the markets back in line, but sit and wait for nature to take its course.