The bulls are far from finished

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The Independent Online
This is the expected correction in the US secular bull market, but it is not necessarily the end of the bull market. Although the bull market phase is mature, and so vulnerable to shocks such as this, there may still be a way to travel.

For months now it has been clear that the upturn in the US interest rate cycle, when it came, would deliver a shock to share prices.

It was also clear that a sharp reaction on Wall Street would affect other markets, although there has been much debate over the impact.

Thinking through the implications for UK investors is therefore a two-stage business: first a sketch of the outlook for US markets, and then some thoughts on the way we will react here.

Wall Street will continue to be fragile until it becomes more evident how aggressively the Federal Reserve intends to tighten policy. But while US short-term interest rates can be expected to rise a full percentage point over the next 12 months, the fact that the Fed has so far moved pretty much as the market expected will comfort long-term investors.

A greater danger than higher short-term rates would be a hesitation by the Fed to increase interest rates in the face of rising inflation. To do that would have been to risk losing credibility with the bond market, and a sharp sell-off there would have had an even more dramatic impact on equities.

As for timing, moving in line with market expectations is not necessarily the best policy for the Fed - central banks need periodically to surprise the markets just to show their teeth - but at this sensitive point of the interest rate cycle it has been wise to behave as convention would dictate.

Looking ahead, US investors can be assured that the economic recovery is fully bedded-in, and that will underpin earnings growth. There ought to be several more years of solidly rising profits from USA Inc. Besides, though share prices are fully valued on the conventional price/earnings measures, they are not absurdly valued: the underlying tone to the market has certainly felt bullish in recent weeks, but it has not been truly euphoric.

Plateau likely

So while no one with any historical feel for market cycles would want to be fully invested in US equities at the moment, it does not necessarily follow that the secular bull market is over, or that a crash is around the corner. The decisive end would come with a surge in inflation or a threatened return to recession. Since neither is likely in the next couple of years, a plateau in share prices is perhaps more probable than a crash.

Let's assume for the sake of argument that US share prices plateau for the rest of this year, and that they will not resume their climb. What would be the implications here?

The economic recovery in Britain is not only less well rooted than in the US: it suffers from the fact that the main export markets in Continental Europe will remain muted for at least another year. It is about 20 months into its growth phase and has been proceeding at a gradually accelerating pace. It will not continue to accelerate. At some stage this year there will be a pause, perhaps triggered by tax rises or something else.

At that point everyone will clamour for a cut in interest rates and, if the pause looks serious, they will get it.

But the next reduction will be the last or the second-last of the cycle. While we can still look forward to further cuts in interest rates we can feel, as American investors did through last year, that there is more jam ahead. The market might run ahead of itself, but each correction ought, on their analysis, to be a buying opportunity. While that situation prevails, London should be protected against an excess of Wall Street- driven caution.

Serious test

This is a test for the market, but unless things go really wrong in the US over the next few weeks, it will not be a serious test. That will come some time after the autumn when, for the first time, British interest rates start to nudge up. A plateau in US share prices could still be consistent with a further modest rise in British ones. But for the market to continue to climb in the face of rising British interest rates would be a demanding task.

Fortunately, British investors can look at the US for a rule-of- thumb guide. British markets - bonds as well as shares - have tracked US markets in much the same way that the UK economy has tracked the US. We had a somewhat deeper recession, but have had, like America, a liquidity-driven recovery. Money has been pumped into the economy, but instead of resulting in higher inflation it has resulted in higher prices of financial assets.

Anyone wanting to guess what would happen to the British economy should have looked at the US recovery and superimposed a graph of it on the British chart, but with Britain lagging by about a year. Anyone wanting to guess what might happen to UK interest rates might assume, too, that the first rise will come in about a year.

All this is rather unscientific, but it is at least reasonably plausible in a rough and ready way. What about the final piece of the argument - that one should go on to assume London share prices will broadly track New York, but lag by about a year?

It is difficult to feel comfortable with that; if the world's financial markets were so simple it would be too easy to make money out of them. What is surely more likely is that if US share prices do plateau this year those in the UK may advance a little but not much. If US shares have a final surge, a blow-off that signals the end of the bull market, we will have a similar surge here. And if US prices slither back through the second half of this year British share prices will be pushed to hold their own.