Misreadings that cause midsummer madness

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The Independent Online
Let's say it, at the risk that this will be one of those columns I shall subsequently regret: the gloom of the markets is midsummer madness.

The whole business of the markets is to strike a balance between risks and rewards, between fear and greed. As information about the world economy and the monetary and fiscal policy of the main countries flows into investors' minds, the markets should and will adjust. The markets will not make this adjustment perfectly.

The economies will move in unexpected ways, and the markets will misread the information as they do. They will also misread policy. That is what is happening now.

But first the explanation for what happened yesterday. It was a further twist of the more general fallout in the markets, which has been happening for much of this year, with falling bond prices everywhere leading equities down.

Most recently the falls in US bond prices have also been associated with a fall in the dollar. This is a global phenomenon, with the bond collapse starting in the US and then spreading to other markets. But because we live in Britain it is probably more helpful to discuss it in British terms. A worm's-eye view first, then a bird's-eye one.

As far as the UK is concerned, there were three elements to the market pressure yesterday. One was sterling. The weakness of the dollar was pulling the pound down with it. For whatever reason, the markets feel that the pound should not rise above about dollars 1.54 against the dollar, so if the dollar goes on falling sterling may be pushed below its current resistance level against the mark of around DM2.46. If that happens, the market chartists say, expect another sharp fall.

Now the second element of market pressure, gilts. There has been rumbling concern about the danger of inflation here, but this has been increased by suggestions that sterling might weaken sharply.

The suggestion above, that sterling might simply be dragged down by the dollar, may seem rather irrational, but coming on top of other political worries - in particular the willingness of politicians of both parties to stick to anti-inflationary policies - it is enough of an excuse to help push down bond prices.

This leads to the third element of the meltdown, equities. Higher bond yields would suggest higher yields (lower prices) on equities, but add the possibility of a rise in base rates to counter sterling weakness and there is a perfectly proper reason to be cautious about share prices.

One could extend the worm's-eye view further by adding that UK institutions are rather short of cash, having faced a string of new issues, and are feeling none too brave following the recent falls in the market. No one wants to buy, and so even a few sellers meet no resistance.

The trouble with this view is that while its constituent parts may make sense the overall picture is nuts. A bird's-eye view shows why.

British bonds now yield nearly 9 per cent. Let us assume that inflation averages 4 per cent over the next 10 years. That leaves a real return of nearly 5 per cent.

This would not only be higher than the real yield on gilts for any sustained period since the Second World War, but would be very much the top end of the range of yields for any sustained period from the 1840s to 1913.

In fact, given the growing independence of central banks around the world, including Britain, that 4 per cent figure is surely too high. An average of 2 per cent is more plausible, and if the secular trend of inflation continues downwards even 2 per cent could be too high.

Nor is the outlook deteriorating. House prices did recover slightly earlier this year, but the rise in long-term interest rates seems to have checked that.

For what it is worth, the economists' consensus forecast for the two-to-three-year inflation outlook has improved over the past three months. Of course, there are always risks, but on any reasonably long-term view these are in the price. Gilts must be very cheap.

The other elements of market gloom appear equally unwarranted. The dollar is very cheap on the purchasing power parity measure, which will pull in the end.

The pound is correctly valued on this measure, too. As for equities, British companies are still in the early stages of the economic recovery and should be able to sustain a sharp rise in profits and dividends over the next three or four years. They may not be particularly good value now, but they are not such bad value as they were in February.

British markets at least are beginning to offer investors real value. A few more days like yesterday (which, as View from City Road argues on the opposite page, is extremely likely), and the value will get better still.

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