View from City Road: Fear takes charge in the markets

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The Independent Online
Are stock markets staring into the abyss or was yesterday's 51.8- point fall in the FT-SE 100 share index just a case of another day, another volatile session for share and bond prices - one that might easily be reversed over the next day or two? A movement, in other words, which signifies very little.

Investors and dealers have come to expect and live with big day-to-day swings in prices. The present bearish tack nevertheless begins to look worrying in the extreme. Chartists still tediously debate whether we are in a bear market or the mature phases of a bull one but for the rest of us there can be no doubt. Since its February peak the FT-SE 100 has fallen nearly 16 per cent and gilts by more.

The narrative for yesterday's renewed downward lurch runs something like this. Renewed weakness in the dollar on Friday night combined with a fresh round of US inflation worries - sparked by rising commodity and oil prices - drove down US Treasuries and Wall Street. European markets moved lower in sympathy. So far, so simple. But ask for an explanation of why markets should behave like this as the world recovery grows daily more secure, and there are a hundred different answers.

George Magnus, of Warburg Securities, and Glenn Davies, of Credit Lyonnais Securities, think the risk of rising inflation is not the primary cause. The markets have become destabilised by the coincidence of high budget deficits and economic recovery, they argue. As a result, demand for capital has soared. Mr Davies believes we are facing a liquidity crunch.

Clearly markets will eventually drop to a level where they become competitive once more with the alternatives. Neither analyst believes we have got there yet. Mr Magnus thinks that if governments don't tighten fiscal policy and reduce their demand for capital, the incessant rise in bond yields will eventually result in a stock market meltdown. Mr Davies, too, believes a final 'blowoff' in the stock market is inevitable.

Chris Dillow of Nomura Research Institute is equally bearish but he dismisses the competition for capital theory as so much nonsense. The real problem, he argues, is inflation. Worries about rising inflation are entirely justified even if you believe the Government is doing all the right things to counter the threat to prices. Rising oil and commodity prices, themselves partly a reflection of rising inflation expectations, will do enough damage on their own.

Whichever line you want to take, however, it does not make comforting bedtime reading; the weight of argument is strongly bearish. Though markets might respond to the rational, fundamentally they have always been driven by two basic instincts - greed and fear. Trends come and go, and so do theories about why stocks rise and fall, but these two most powerful of psychological forces remain the same. For the time being it is fear that has the upper hand. It's hard to see what's going to change that.