No 'normal' cycle

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The Independent Online
Kenneth Clarke made the twin points yesterday that the recession was a global one and that Britain was leaving it earlier than our Continental partners. Nothing wrong with that, except perhaps the implicit qualification that what he was saying ought to be made explicit: that though growth in Britain looks good at the moment by comparison with that of other European Community countries, this is very largely a cyclical phenomenon. Put less agreeably, it is easy to have a great leap forward provided you start from far enough back.

That much of Britain's current outperformance is simply cyclical, though, has a significance beyond party politics, for there are important investment implications. The cyclical recovery of the economy has been matched of course by the boom in equities. This must in part be a cyclical phenomenon too, and, in as far as it is, it raises questions about the nature of the turning point, and how far off it might be.

As far as the economy is concerned, the cyclical position can be summed up in two sentences. The recovery is becoming increasingly broad-based and is now quite secure. But it is still immature and there are no signs at all that growth will start to hit barriers in the next 18 months or two years. The cyclical indicators published yesterday confirm this, though these should always be taken with a pinch of salt for the measure they provide is a rather crude one. They say nothing about the quality of recovery; they merely measure its quantity and its timing.

The length of economic cycles varies, but the growth phase ought to last at least four years and, if growth is muted, maybe five or six. On past form, then, the UK should expect another three or four years of reasonable growth; there may be more, but the safe assumption is that there are at least three years. The US, which is moving nine months to a year ahead of us in the cycle, ought to expect at least another two years of acceptable growth. Continental Europe and Japan have yet to establish a recovery so it is hard (and actually a bit ridiculous) to start talking about the end of the growth phase. From an investment point of view a more substantial worry is that the recovery might be delayed for another six months to a year, rather than the possibility that it might peter out in 1997.

Yet the markets will try to signal the end of the growth phase. There is absolutely no sign of that either, but, again on past form, one would expect equity markets to start to show concern some 18 months, maybe two years, ahead of the top of the economic cycle. How mature - in purely cyclical terms - is this bull market in equities?

It is best to look first at the US, partly because it is the dominant market, partly because the US economy is first in the cycle. The most thorough analysis comes from the Bank Credit Analyst team in Montreal. The view there runs as follows. We are in the mature phase of the bull market in both bonds and equities. It has been a powerful and long-running bull market and it still has some momentum behind it. But there are early signs that a cyclical turning point is not too far off. Very cheap money has created a false sense of optimism, and the very high valuations do not allow adequately for the risks ahead. Its conclusion is that conservative investors should take advantage of any strength in the market to lighten their holdings of shares.

The BCA team is not so negative about the UK, where it feels that there is still good value in bonds and equities. In any case, thanks to the different position in the cycle, the turning point should be some months further off. But of course were the US market to move sharply backwards, it would be hard to see this not hitting British markets too. The British share market reflects the international economy as much as it does the British, for at least half the profits of the companies in the FT-SE 100 are generated abroad.

It would be wonderful if UK investors could ride the boom in share prices, secure in the knowledge that when Wall Street turned down they would have several months to lighten their load. But the world is not like that: a fall on Wall Street would trigger falls elsewhere.

It would even damage Continental markets. Look at Germany. While the economy has yet to show any recovery at all and may even be heading into a double dip, share prices are behaving as though the economy has had a couple of years of good growth behind it. The economic cycle worldwide is far from synchronised, but the investment cycle is in danger of becoming so.

This is always the problem with cyclical analysis: each cycle of the economy and of investments is slightly different from past ones. There is no such thing as a 'normal' cycle. The many investment advisers still making the bull case are relying on the argument that the current cycle is particularly abnormal. Essentially because growth is so muted and inflation so low, short and long-term interest rates are likely to remain low for longer than in previous cycles. Accordingly the boom in equities can be sustained longer than in previous cycles.

And so, for example, Goldman Sachs uses its value indicators to argue that equities on most of the main markets (though not Germany) are cheap. Nomura remains a strong bull of UK shares. James Capel's technical analysis team is suggesting that the next surge in the FT-SE 100 could bring it to 3,300, and is looking at 3,500 for the first quarter of next year. Indeed the James Capel team thinks that 'the market is on its way again and it would require an unforecastable exogenous shock to stop it now'.

That may well be right. Even instinctive equity bears like BCA accept that there is considerable momentum behind the market. But they would also argue that the risk/reward ratio has become unattractive. Cyclical analysis gives only a vague indicator of when to accept a turning point. As far as the world investment scene is concerned, the message seems to be 'soon, but probably not quite yet'.

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