Wall Street's Dow Jones index fell by 96 points on Friday, reducing the value of US shares by around 2.5 per cent in the biggest fall for more than two years. Some analysts believe this could trigger a larger fall in London, perhaps taking the FT-SE index of 100 leading London shares below 3,350 from Friday's close of 3,475.4.
Analysts on Wall Street say that US share prices could plunge further if the fall frightens individual investors, who own around 45 per cent of US shares.
This could feed into European markets because many US investors have put money into internationally exposed mutual funds, equivalent to British unit trusts. But some analysts note that many individuals regard their mutual fund investments as long-term savings, akin to supplementary pension payments.
Paul Walton, equity strategist at James Capel, said that the FTSE- 100 could fall by 50-100 points, depending on reaction in the Far East, but that the correction would not turn into a crash and could last for just a couple of weeks. Mr Walton noted that since 1967 the London stock market had risen by an average of 15 per cent in the year following each trough in US interest rates.
But the London markets may also be unsettled by a warning from Incomes Data Services that pay settlements in Britain have increased since the turn of the year, suggesting the first stirrings of inflationary pressure in the labour market. The Bank of England is likely to warn tomorrow, when it publishes its quarterly Inflation Report, that a resurgence in pay increases could undermine hopes that non-inflationary growth will be sustained.
IDS said the first pay settlements of 1994 showed an upturn, with a growing number of private sector deals at 3 per cent. In January, four out of every 10 pay deals were at or above 3 per cent, compared to three out of 10 in the previous three months. 'Negotiations over pay in the next few months are likely to become tougher as inflation rises and the impact of the Budget tax rises starts to be felt,' warned IDS.
The rise in pay settlements may prompt Kenneth Clarke to follow the example of Alan Greenspan, the US Federal Reserve chairman, and raise interest rates pre-emptively to counter inflationary pressure. But most economists believe rates in Britain are still set to fall during the spring, to offset the depressing influence of April's tax increases and to boost Tory fortunes before the local and European elections in May and June.
The Bank of England will concede in the Inflation Report this week that prices have risen more slowly than it expected, but it will warn that non-inflationary growth could still be imperilled if pay settlements take off.
Bank officials are likely to argue that signs of an upturn in pay settlements in the public and private sectors are reasons for caution. City economists were worried that John Major's concession of 3 per cent pay increases to key public sector workers last week would set the private sector a bad example. It also cast doubt on the Government's ability to keep to spending targets.
The Bank will argue that interest rates should be set with regard to the likely rate of inflation in 18 months' to two years' time. By then pay settlements could reflect a higher headline rate of inflation and the desire of employees to compensate for the effect of tax increases on their take-home pay.
Eddie George, the Bank's Governor, told the annual banquet of the Bankers' Club last week that underlying inflation was at its lowest for a generation and that the prospects for steady but sustained growth in output, and gradually falling unemployment, were better than at any time in his career. But he warned that that outcome was not assured.