money

INVESTMENTS

Sniff the air in the City these days and it doesn't take a genius to sense that the prospect of a Labour government is beginning to enter in earnest into investors' calculations. A week is an even longer time in the City than in politics, but with the next general election now a year at most away, the probability that Tony Blair will be the next occupant of Downing Street is for the first time clearly being discounted seriously.

The diminishing scope for tax cuts looks a critical final nail in the Major government's coffin. NatWest's leaked advice to its private clients to avoid the Railtrack privatisation issue is one interesting straw in the wind. The bank's warning that the regulatory and political risk is higher in this issue than in previous privatisations is, I suspect, no more than a roundabout way of saying that it expects Labour to win the next election.

Another sign of the changing climate is the widespread feeling in the boardrooms of Britain's big companies that the window for completing bids and deals before the election is rapidly drawing to a close, despite the corporate financiers' frantic efforts to sustain the momentum of bids. Indeed, the Government's seemingly political decision to block the power generators' bids for regional electricity connpanies suggests that the "anything goes" days of the last few years may already be over.

Already we are seeing the first fruits of the inevitable "What will a Labour government mean?" type of research emerging from brokers and tax advisers. And there is also a discernible shift in the City's attitude towards Labour policy. Polite but studied indifference is giving way to a recognition that now it really is time to start ploughing through the minutiae of policy documents for clues as to what may happen if - or, more probably, when - the Government changes.

This tide of gathering concern is consistent with the view that the stock market at least is likely to be relatively weak in the second half of the year. The trend will accelerate if the current downward trend on Wall Street - five straight down days in a row up to last Wednesday - is indeed the first sign of the significant market correction on the other side of the Atlantic that so many have been anticipating for so long.

What might a Labour victory mean for the markets? I have been chewing over the outlook in this new climate with Stephen Lewis, for many years a strategist with the brokers Phillips & Drew, and now the markets-watcher at the London Bond Broking Company, a boutique research firm he helped to set up after Big Bang. His feeling is that a Labour victory may well be more serious for the stock market than it is for gilts, although neither market clearly is likely to be affected as dramatically as they were the last time Labour took power, in the dark days of the 1970s. A Labour government of the traditional big-spending, inflationary sort would be expected to shy investors out of gilts and into equities. But that recipe looks too pat this time around. Rather, assuming that Labour pronouncements can be trusted, we have the prospect of a new government pursuing a tight fiscal policy to meet the Maastricht criteria and also pursuing a stable exchange rate policy of some sort. Companies meanwhile will be wrestling with the impact of the Social Chapter and a generally more restrained operating environment, which will serve to put a cap on potential profits and dividend growth.

Against a background of still-subdued inflationary pressures, that should guard against gilts again becoming the wealth-destruction machine they were last time round. (Anyone who bought gilts a year before the Labour victory in 1974 would have seen their investment fall by nearly 40 per cent in real terms over the next six years. Likewise, anyone who bought gilts the year before Labour's 1964 victory would have lost 20 per cent of their investment by 1970). In fact, Lewis concludes, with inflation at under 3 per cent and yields on medium-term issues above 8 per cent, gilts do not look bad value for the risk involved (though he reckons that Canadian and German bonds, with real yields of 6 per cent and 5 per cent respecively, look better bets still. He also likes US bonds).

And that, anyway, is how it may well appear to US investors, who - Lewis predicts - will be the first out of their traps to buy gilts if a Blair victory is confirmed in the election. From a US perspective, a Labour victory will seem to fit the pattern visible elsewhere in Europe of centre and centre-left governments trying to achieve modest social objectives within a framework of restrictive fiscal policies.

It is, says Lewis, one of the paradoxes of the modern international investment arena that foreign investors are often the ones who see the dynamics of a market more clearly than their domestic counterparts. It is American investors who tend to get cleaned out in the Treasuries market and who get carried away with the excitement of a strong run on Wall Street. Even the Germans are often blinded by their faith in the strength of the mark.So it may prove to be with the election.

Politics inevitably involves emotions, and there is no doubt that there is still a residual fear in many quarters of the City about what a Labour government might mean. But this time around, there are genuine grounds for thinking that the transition will be less painful for investors than it has been in the past, even if it will take time for the Labour Party's intentions towards Railtrack to become clear.