A turning point in interest rates is always important, especially when it is announced by the Federal Reserve Bank in the United States. Last week's rise of one quarter point to 1.25 per cent, still an exceptionally low level, was the first increase for four years. Before that it had come down to 1 per cent from 6.5 per cent at the start of 2001, a period that encompassed a stock market plunge, recession, terrorist attacks and fears of deflation.
A sudden hike is like the unexpected striking of a bell; the sound is arresting even if one isn't quite sure why it is being rung. The official reason is not so much that inflation has become a problem again after a lengthy period of subdued prices, but that it conceivably could be. The Federal Reserve believes that inflation risks remain balanced, which means, strictly speaking, that the rate of change in consumer prices is as likely to accelerate as to slow down. The American central bank has moved on, then, from worrying exclusively about deflation.
Does this mean that the widespread fears of two or three years ago that the world economy was going to revisit falling prices for the first time since the 1930s were misconceived? Not necessarily. The developments that generated fears of deflation are still present. For instance, the forces of globalisation, which intensify competition, are undiminished. More and more goods and services are traded online, where pricing is keen. Outsourcing back-office tasks to third world countries, so as to keep a lid on costs in advanced economies, goes on apace.
In the United States, at least, productivity is rising quickly. And wage increases remain subdued across the western economies, in spite of the surge in oil prices with its knock-on effect on energy markets. In other words, when the current upswing in economic activity peters out, it is perfectly possible that deflationary pressures will reassert themselves once more. That is why, in ranking the major risks faced by investors, I continue to have deflation on my list.
In reflecting on things that could go wrong, however, I am not leading towards a recommendation that stock markets should be shunned at current levels. There is always a tension between finding individual opportunities and paying attention to what could affect the whole market.
I have three major risks on my list of what to worry about. After deflation comes the possibility of a collapse in house prices. This danger has been commented upon many times during the past three years. And still residential values have continued to rise. No one dare be dogmatic about what will happen next. The Governor of the Bank of England, Mervyn King, admitted the other day that he had been surprised for several months by the rate at which house prices had been rising.
But could we at least agree on one thing: the market in owner-occupied homes behaves differently from the way in which many goods usually trade. For the market in homes cannot become overheated in the classic manner where greed is the driving force. Most transactions between home owners are driven primarily by personal or family circumstances rather than by the level of prices at a given moment. There isn't much speculation, except in buy-to-let.
What is reasonably clear, however, is that a downturn in house prices would have disagreeable consequences. More serious than the direct effects on the building trade, on suppliers of household goods, on publishers reliant upon property advertising and on banks heavily committed to the mortgage markets, there would be the indirect effects on consumer confidence. Home-owners and their families would feel less financially confident, and would rein back their spending on everything, from holidays to buying a new car to eating out.
The third danger that investors should bear in mind springs from the Middle East, not so much from Iraq as from its close neighbour, Saudi Arabia. The threat is that the Saudi royal family is replaced by a leadership hostile to the United States and the West. We know this is Osama bin Laden's aim. I don't have to spell out what this would mean for the oil price and for the health of the world economy, except to say that it would be dire.
For stock market investors, watching out for risks is a necessary but rather fruitless business. Dangers loom, precautions are taken, and then they disappear again. Deflation has been in this category. Other risks seem almost part of the scenery. The dangers from the US budget and trade deficits are regularly analysed, but life goes on. The dollar weakens a bit, but not much. Forebodings about UK property prices are also beginning to seem like a permanent fixture. And then when something terrible really did occur, such as the attack on the Twin Towers, nobody foresaw it. Thinking about risks, then is the unglamorous part of investment management.
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