Let's hope Wall Street can land safely

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The Independent Online
Question: how do you let the air out of a balloon slowly when you have only got a pin in your hand? Answer: you see if someone else can manage to untie the knot.

It was the week when Wall Street wobbled but the long-awaited crash failed to materialise. The markets know very well that prices of US shares are overblown, but they have only the pin to deflate them. It looked last week as if they had pricked the bubble, but in the event the market recovered. Now they are hoping against hope that Alan Greenspan, chairman of the Federal Reserve, can untie the knot and let the pressure out gently.

That seems to be the rational way of thinking about what will, in the coming months, continue to be an unsettling time for financial markets. One of the things share prices do, albeit in a disorganised way, is signal the likely course of the world economy. For all the sophistication of governments and central banks there remains something called the business cycle. The sheer length of the expansion that the US has experienced inevitably prompts concern that somewhere, perhaps in 1998 or 1999, another recession looms.

It is simplistic to say that the 1987 crash "predicted" the 1990/1 recession, for the lags seem overly long and share prices in any case recovered. But the length of the time-lag and the recovery of share prices were partly the result of interest rate cuts in 1987 in response to the fall in share prices. When the bubble was pricked, the authorities pumped the air back in - with the result that the economic downturn, when it eventually came, may even have been worse than it would otherwise have been.

However, when it was clear the US was in recession, the US Federal Reserve drove down interest rates quickly and thereby helped engineer a rapid recovery, whereas European central banks failed to do so. (Remember, we only really recovered when sterling was cut loose from the ERM.)

So while weakness on Wall Street raises obvious investment questions, it also raises vital economic points. The answer to both sets of issues lies very much in the response of the Federal Reserve. Central banks are not all-powerful, but the Fed's judgement of the economic cycle is vital. It matters to Wall Street, but it also matters to the world economy. The Wall Street influence was very evident last week, for a few tough-talking words about inflation by Dr Greenspan in testimony to Congress managed to stop share prices falling.

What do we know about the Fed's current attitudes? Have a look at the chart on the left for it shows the psychology against which the Fed has to operate. The black line shows how through January and February share prices shot up, then how they reached a plateau until the end of June, and finally fell back sharply in July. Now look at the other line, which shows the yield on long-dated US securities. This rose steadily through the whole year. Higher bond yields are generally taken to signal concern about inflation.

So for the whole of this year the bond markets have been saying "hey, we are really getting more and more worried about strong growth and the pressure this puts on inflation." Meanwhile, for the first part of the year the stock market was saying "steady decent growth looks good for profits, so let's keep heading up", and then gradually it got more and more worried until now it has been saying "profits are not going to be so great after all, we really got a bit carried away, so let's panic now before everybody else does."

We know Dr Greenspan is very experienced at judging the pace of the US economy, cutting rates in January when growth seemed to be faltering. In his testimony last week he seemed to be paving the way for a reversal of that decision. So expect a rate rise in August. It will not in any case be big - just 0.25 per cent - but if it happens it will be a signal that if US costs rise in such a way as to threaten a rise in inflation, the Fed will push up interest rates and choke that off.

This is self-evidently important for the bond market, but it is also important for shares. An interest rate rise might not seem a good signal for share prices but allowing inflation to reappear would be worse. So long as there is reasonable confidence in the Fed's judgement there should not be any need for a Wall Street crash. It does at least become plausible that the Fed might manage to let the air out of the balloon slowly.

If it does then it is also plausible that the long growth phase of the US could level off without a serious recession. The cycle will still exist so it would still be reasonable to expect a patch of very slow growth towards the end of the century. If Wall Street were to bounce around, come back a bit, bounce some more, but not actually plunge, then that could be taken as a further signal that the US will manage to pull through the next cycle without catastrophe. If there is a plunge, the key question is to what extent the Fed factors this into its policy. Will it ease up to help Wall Street, or will it focus more on the economic signals rather than the financial ones? A plunge does not make recession certain, but it makes the response of the Fed both more difficult and more important.

What might all this mean for us in Britain? We have learned in the past few days, if we had ever forgotten, that UK share prices dance to the Wall Street tune. London shares have not risen by as much as US shares this year, so in theory we ought not to fall as far, but there is little doubt that bad news there is bad news here.

So, from an investment point of view, the aim should be how to seek best value, for that is the best buttress against an outside shock from across the Atlantic.

The other two graphs point to what has and has not been in favour among London shares over the past 18 months. The centre graph shows the extent to which large company shares have been downgraded vis-a-vis smaller company shares (the black line), and high-yielding shares have been downgraded against low-yielding ones (the other line). In the right-hand graph, you can see how companies which do a lot of business with continental Europe or with the US have been upgraded - with the European-oriented doing very well in the past couple of months.

So if one's investment attitude is to hunt for value (which probably makes sense since the principal concern about Wall Street is that it is bad value at the moment), perhaps one would look for large British companies without a particularly large business overseas.

But there is a bigger message to seek from the UK markets in the coming months, the UK equivalent of whether US share prices give a distant signal of recession. Can we catch any hint of the timing and scale of the next UK downturn?

Over the past 18 months the economy has continued to grow reasonably quickly with no evident surge in inflation. Unemployment has continued to fall, retail sales are solid, even house prices seem to be recovering. But there is no sign of a rise in inflation in goods and services. The target of the underlying RPI below 2.5 per cent by next spring seems quite possible.

Maybe another three years of steady, non-inflationary growth is in order. Maybe the next recession will not be nearly as serious as the last. No one should take markets too seriously as an indicator of future trends in the real economy, but a reasonably benign stock market performance through the autumn is good news for companies and their employees as well as for investors.