Outlook: Markets/rates

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The Independent Online
COULD LONDON be the surprise outperformer in Western stock markets this year? This column has not been an unmitigated bull of UK equities for some while now, but assuming there is no general crash in Western stock markets, London seems to offer surprisingly good value relative to others.

One of the reasons for this is that there is still significant scope for reduction in British short-term interest rates. Even after yesterday's quarter-point cut, taking the four-month fall to 1.5 basis points, they are still double the level that rules in Euroland and significantly above the US Fed funds rate. Neither of these two economic regions can realistically cut interest rates by much more. In Britain, by contrast, there is still plenty of leeway for cheaper money.

Obviously this is one of the reasons why British equities are generally more poorly valued than their US and European counterparts - interest rates are much higher and as a consequence, the pound is still painfully high too. But by the same token, this also provides potential for catch- up as rates fall.

Another is that the British economy is almost certainly not in as bad a shape as many of the headlines would suggest. Even the most bearish of forecasters are predicting only a shallow recession - perhaps three quarters of marginally declining growth. By the third quarter of this year, by which time interest rates should be down to 5 per cent or less, we could be pulling out of it. If the Government takes the plunge, and makes the policy adjustments necessary to take Britain into the single currency, then there will be even more of a following wind for UK equities.

The big proviso is how Wall Street behaves. If America crashes, then all bets are off, and there are still plenty of people around who believe it might. To the traditional reason for thinking this - that US stock markets have become an overvalued speculative bubble - was last year added the possibility that the Far East would plunge the world, including the US, into economic recession. So far, this hasn't happened. Now there's another potential bogey on the horizon - that the world, and particularly Japan, is about to stop financing the US current account deficit.

There is already some evidence of capital withdrawal from the US in the sudden about-turn of the dollar against the yen. Given the extent to which the US has begun to live on borrowed money, as well as the wealth effect of the booming stock market, this is obviously a very real threat to the general health of the US economy.

Even so, the idea that the US is about to become the latest victim of the "wrecking ball" tendencies of global capital markets, rather in the same way as the Pacific Rim economies, is not a very plausible one. The US economic miracle may seem a little more fragile right now than it has done, but the alternatives - sluggish Europe and recessionary Japan - hardly look any better.

Bear markets and crashes generally need a cause, and while the near collapse of Long-Term Capital Management came perilously close to providing one, the pin capable of pricking the bubble just doesn't seem to be there right now. So maybe London equities can expect another good year after all.