Markets: Goldilocks and the fairy-tale economy

Inflation, if it's not quite dead in Europe, is certainly stunned. That means Europe looks poised to enter the kind of golden age for investors the US has enjoyed for two years now, and for the same reasons: inflation is low and interest rates, while they might bobble about as central banks fine-tune their monetary policies, are unlikely to surge in the near term.

Economic bulletins last week from four countries - the UK, the Netherlands, Germany and France - underlined the lack of inflationary pressures in Europe's economy. All four said inflation remained subdued in July.

UK retail prices were unchanged last month from the month before. They actually fell in France, by 0.2 per cent. In both Germany and the Netherlands, prices went up 0.5 per cent for the month. In all four cases, the consumer price rises were as or better than expected. Europe is beginning to mirror the "Goldilocks" economy of the US, where growth is not too hot, not too cold, but just right. "Inflationary pressures across Europe remain benign," says Andrew Milligan, an economic advisor to General Accident. "We may have reached the Goldilocks scenario."

Low inflation means low official interest rates. Germany's Bundesbank last week held its main money market rate, the securities repurchase rate, at 3 per cent, the record low it has sat at for the past year. That rate may actually rise this week, although an increase by the German central bank would be inspired by a desire to bolster the mark, not because of any concern about inflation. Even in the UK, base rates of 7 per cent compare with an average rate of about 9 per cent in the first six years of this decade, and are less than half the 15 per cent peak seen in 1990.

With inflation slow and interest rates stable, bond yields remain low. That is driving investors to the stock markets because that is where they can find the best returns. So stock markets across Europe are booming, even though economies are barely growing in much of the continent. "You don't have to be clever to want stocks in this environment," says Paul Whyman, an investment manager at Matheson Investment Management Ltd. "I can't see this liquidity being turned off until we see higher interest rates."

Benchmark 10-year government bond yields in the four European states that reported on inflation last week range from just over 7 per cent in the UK to 5.6 per cent in France, the Netherlands and Germany. So far this year, the total return on those bonds in local currency terms ranges from just over 10 per cent on UK bonds with maturities longer than 10 years to 5.3 per cent on Dutch bonds.

Contrast that with total returns on Germany's DAX index of 51.04 per cent, measured in marks, just about neck and neck with the Amsterdam Exchanges Index in the Netherlands, with a total return of 51.25 per cent in guilder terms. The CAC 40 index in France has returned 29.02 per cent this year in francs. The FT-SE 100 offers a total return of 22.87 per cent in sterling terms.

Stocks are surging in all four countries even though their economic performances differ widely. Germany's gross domestic product growth reached an annual rate of 2.8 per cent in the first quarter. That's from from a low base, though: in the first quarter last year Germany was in recession, its growth declining to 0.4 per cent from 0.8 per cent the quarter before. The jobless rate was 11.4 per cent last month, close to a post-war record.

In the Netherlands, by contrast, GDP grew 2.1 per cent in the first quarter and unemployment dropped to 5.90 per cent. In the UK - Europe's fastest- growing economy - GDP climbed an annual 3.4 per cent in the first quarter. Last month, Britain's jobless rate was just 5.7 per cent, the lowest of Europe's major economies. In France, GDP barely grew at all in the first quarter, expanding just 0.9 per cent from the year before, and unemployment last month reached 12.6 per cent, a post-war record.

France and Germany, however, gain, something else besides low inflation - weak currencies. The franc and mark are both down about 21 per cent against the dollar this year. The cheap franc and mark are boosting their stock markets, since shares of exporters are soaring.

The UK has much to be proud of on inflation, although that owes much to its terrible track record. The 3 per cent annual pace is half its six- year average, and down from 9.5 per cent at the beginning of the decade.

After four interest-rate rises in as many months, the Bank of England signalled last week that it is more comfortable with the inflation outlook. Charged with keeping price rises, excluding mortgage payments, within one percentage point of 2.5 per cent, it said last week: "Monetary policy has now reached a position at which it should be possible to pause in order to assess the direction in which the risks are likely to materialise."

Investors are rewarding the UK with cheaper long-term borrowing. Benchmark 10-year yields are about 6 basis points lower than those of the longest- dated conventional gilt, showing investor confidence that the UK has inflation licked. "The view of the world reflected in the long end is that, ultimately, monetary policy will deliver 2.5 per cent inflation," says Kevin Adams, gilt strategist at BZW.

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