Outlook: Markets enter danger zone

IT'S BEEN long in incubation, but Asian flu is finally beginning to strike home, both here in the UK, and more potently, on the other side of the Atlantic in the United States. US exports are down, growth in corporate earnings is slowing to a snail's pace, and the US economy is showing signs of faltering for the first time in eight years.

More worrying still for America's army of small investors, the stock market is heading south at a pace of knots. Since rather more than a half of all people in the US invest in the stock market, either directly or through mutual funds, that's going to make consumers feel less well off, they'll stop spending as much, and the economy will slow even further. Certainly the US stock market boom, by making people richer, has helped sustain the US economy in a way that might now be dramatically reversed.

None of this should come as a surprise to anyone. It's what we and others said might happen when the Asian meltdown led to a one day fall of 550 points in the Dow last Autumn. Yet most US investors chose to ignore the warnings and carried on pouring money into the stock market in the misguided belief that the Asian crisis was just an isolated problem in a far off region.

It is testimony to the mood of blinkered optimism that coloured perceptions at that time that many came to see Asia as a positive boon to the US economy. By dampening growth, it would take the heat out of the economy and reduce the need for interest rate increases. Between the beginning of this year and its peak on 17 July, the Dow rose a further 18 per cent.

Reality is now pressing home with avengence. Asia's difficulties look like getting worse before they get better. Much hope has been invested by the international financial community in Keizo Obuchi, Japan's new Prime Minister, but the more we see of him, the more he seems like a carbon copy of his predecessor Ryutaro Hashimoto. Certainly he doesn't look like the miracle worker necessary to pull the Japanese economy out of the doldrums.

So finally irrational exuberance in US markets is giving way to rational caution. Even small, retail investors, for the past year the backbone of the US stock market, are showing unnerving signs of losing confidence and bailing out. Enriched by the great bull market of the 1990s, many of them have no experience of a bear market. Yet we are half way to the 20 per cent fall that marks the official definition of a bear market already.

Futhermore, the gains of the first half of the year were largely confined to Dow constituents and other leading US corporations. Most US stocks are down on the year as a whole. Even if the bear is not yet fully visible, the bull has long since vanished.

Whether the bear comes out of the woods will depend a lot on what small investors do in the US over the next few weeks. If they lose their nerve and panic, we are all in trouble. Whatever happens, they are going to have to learn that the spectacular stock market returns of recent years won't go on for ever.

Here in the UK we have our own special problems. The economy looks a good deal shakier than the US. We are in that stage of the cycle where inflationary pressures are still strong, demanding tough monetary medicine, yet growth is plummeting with some areas of the economy in outright recession. For stock market investors, it's all beginning to look very worrying, very worrying indeed.