The markets bonkers? Don't you believe it, guv!

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The Independent Online
So who's calling whom bonkers? According to an unnamed "senior member of the Government" quoted in the Financial Times this week ahead of the Budget, the markets were "bonkers" to think Gordon Brown was not going to abolish tax credits on dividends.

For Peter Lilley, shadow Chancellor, this was tantamount to a Budget leak, and he said so just before Mr Brown got up to give his one-hour dissertation. He was right, of course. It was a leak, but with the real news just about to happen, the Government had no difficulty sidelining the issue.

The point about insanity in the markets, however, is a rather wider one. The word "bonkers" could just as easily be applied to the stock market's apparent tendency these days to view anything New Labour cares to throw at it in a sunny disposition. Certainly, the equity market seems to be behaving in a more than usually odd way right now.

Interest rates to rise; just luv it, Gordie. Whack the City for a pounds 500m anti-tax avoidance measure; outstanding, Chancellor! Abolish tax credits on dividends; well, we deserve it really, don't we. Sterling through the roof; excellent stuff. A windfall levy on the utilities; more, please, more. The stock market's ability to take punishment with no apparent ill effect knows no bounds. Since Labour came to power the FTSE 100 share index has risen by 11 per cent. What's it all about?

Actually, this is not an entirely perverse response either to Labour's performance at the polls or to what has happened since. Markets had been anticipating a Labour win for at least a year before it happened. Fear of what Labour might do once elected held London equities back, so that they did not share fully in the bull market enjoyed by Wall Street and the main European bourses.

Now Labour is in, and on the evidence of the first two months, it appears that Mr Blair is going to be as good as his word. There are no Jospin- type nasties up his sleeve, no reds under the bed, and there's to be no playing fast and loose with the economy. Labour has signalled its willingness to continue in broad terms with the same set of macro-economic policies as the last Government. The bells and whistles added to meet the party's social agenda are neither here nor there.

Indeed, Gordon Brown has, if anything, shown himself to made of even sterner stuff than his hush-puppied predecessor. He's given up control of monetary policy (though it ought to be said here that he's also loosened the inflation target a bit), and he's committed himself to a rigid long- term plan in fiscal policy and spending. He's tied himself up in a straitjacket and the City just loves him for it. Whew, is the response of markets. After a year of worrying about what might be in store for the corporate sector and the economy, it is like a pressure cooker being released.

The same is broadly true of the abolition of tax credits on dividends. Now if this had not happened, the stock market would have roared away like an express train. In fact, everyone has long believed it likely and it was already largely factored into stock valuations.

These are all good reasons for claiming that the stock market is not bonkers at all. Actually share prices are responding in an entirely rational and measured way to the events of the last two months, it can be argued. All the same, there have been some mighty strange happenings in share prices this week, some of which suggest the stock market should perhaps have been committed after all.

Up and down, up and down, the FTSE 100 share index went yesterday, like a fiddler's elbow. Nobody had much of an explanation for what was going on, other than the rather unhelpful one that equities do not yet know what to make of the new Chancellor's first Budget. The day before the Budget, the FTSE 100 share index went up by 123 points on the rumour that the Chancellor was not after all going to abolish tax credits on dividends, its biggest one-day climb since the crash of 1987.

Logically, then, share prices should have fallen back again by at least that amount when it turned out that he was indeed dispensing with this pounds 5bn-a-year tax perk. Not a bit of it. The FTSE celebrated with another 100-point surge. This at a time when gilts were falling and the pound surging in anticipation of higher interest rates. Surely some mistake?

As it happens much of the activity in the stock market since the Budget has been caused by technical factors. It would therefore probably be wrong to interpret the market's exuberance as the City giving Mr Brown the thumbs up. Actually what's been happening here is that some big providers of equity options have been forced to re-hedge their positions in response to the abolition of tax credits and moves by the Inland Revenue to close a lucrative tax loophole. It is hard to get to the bottom of this affair, which is arcane and complex, but observers believe market-makers have priced these tax breaks into the options, which as a consequence now face a shortfall that needs to be plugged. Suggestions that the whole thing will end up costing the City upwards of pounds 1bn refuse to go away.

Nobody is going to have much sympathy for the City over these losses. Tax scams like this are one of the reasons why City traders drive around in Porsches. But it does help to explain the FTSE's curious behaviour and it may be a harbinger of a rather less exuberant performance to come.

In any case, the FTSE 100 share index gives a rather misleading impression of what's happening to stock valuations more generally. The market surge has been led by financials, pharmaceuticals, and more recently, utility and retail stocks. The rest haven't done nearly as well and some, particularly manufacturers, have actually gone down. The FTSE 250 index, representing the next 250 biggest companies after the 100, is now lower than at the beginning of May.

Mr Brown made much in his Budget of his desire to create a fiscal and economic framework for long-term investment in British industry. Unfortunately, his first Budget does little to help that cause, rather the reverse. Actually what the Budget did was just pile on the bad news for Britain's industrial heartland. Already hit badly by the strength of sterling, it is companies such as ICI, British Steel, and British Aerospace, which are most profoundly affected by the abolition of tax credits on dividends. According to Richard Kersley, equity strategist at BZW, around half the FTSE 100 companies will become underfunded in their pension schemes as a result of the move. Furthermore, most of these are industrial companies. The situation is worse once outside the top 100 companies. Moreover, it is these companies that benefit least from the corresponding cuts in corporation tax.

So perhaps the markets are not that bonkers after all. The really bonkers one may be Mr Brown in believing he can reverse the long-term decline in British manufacturing and its replacement with a service-orientated economy.

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