A rat among the bulls

Making money in financial markets is a lot more difficult than is commonly understood. Except, according to current wisdom, in Continental Europe. Here it is easy. Everybody knows that the French and German economies in particular are in trouble so it is obvious that short-term interest rates, artificially held up by the Bundesbank's lagging paranoia about inflation, have much further to fall with beneficial consequences for bond and equity markets alike. Having massively under-estimated the magnitude and duration of their own interest-rate-driven bull market, the Americans in particular are determined to bet the ranch on Europe.

We smell a rat. 'Obvious' is a very dangerous word in the context of financial markets. Our objection to the bullish hype surrounding these markets is that they are coming round later in the world business cycle than the United States and Britain. Investors now know how to play the game and are determined to apply their newly acquired knowledge almost at any price.

The extent to which any future interest rate decline has already been discounted by the markets is irrelevant. Pay any price today to participate in the earnings recovery tomorrow.

With the extra impetus imparted by declining interest rates, this is, if anything, an even more potent version of the theory that there will always be a greater fool in the market prepared to buy at still higher prices - the theory more normally seen at the extrapolation of the top of the cycle. Liquidity and momentum are meant to be an adjunct to actual and prospective fundamentals, not an antidote.

Such is the mood of compulsion on these occasions that the bull is easily capable of rewriting the script to circumvent the nasty intrusion of reality. Just six months ago, the French economy was thought to be some paragon of high growth/low inflation virtue that deserved lower interest rates, which would in any case be delivered as German rates came down.

The reality has been a total collapse in expectations with regard to the real economy. The consensus expectation for gross domestic product growth this year is now minus 0.9 per cent, compared with plus 1.3 per cent as recently as January this year. The bull story for the French equity market has thus shifted to the fact that the French economy is so weak as to require dramatically lower interest rates immediately. The franc will be forced into cutting the link with the mark.

This outcome is unlikely. The reality is that German interest rates will decline rapidly enough to save the franc, but not rapidly enough to save the French economy, and more particularly the French stock market.

Current valuations thus carry unduly optimistic assumptions about current and future earnings and the profile of declining interest rates - they expect too much too soon. Equity market bulls will, to say the least, be disappointed.

Much the same can be said about the German stock market. If the outlook for the real economy is as bad as the interest rate bulls would have us believe, then corporate earnings expectations are almost certainly too high, especially perhaps for 1994.

Forward rates, moreover, are already calling for short-term interest rates to be below 6 per cent by December compared with 7.2 per cent now. Not much has to go right with the domestic economy for this expectation not to be met, let alone exceeded.

Recent developments have simply been a reaction to the unsustainable surge in the economy following reunification and none of the conditions for a prolonged slump would seem to be in place - no asset price bubble, no high level of consumer indebtedness, no credit crunch induced by a weakened banking system.

With the equity market already trading on the basis of sharply lower interest rates, it is difficult to see where the upside is expected to come from. American investors may be buyers on the 'greater fool' theory but they should be concerned to identify who that fool actually is - not a European, we suspect.

Nicholas Knight is head of strategy at Nomura Research Institute Europe.

Jim Slater is on holiday.