Hamish McRae: Next year could be a good year for the world economy but a bad one for shares

The distant rumble of thunder from the world economy is now loud enough to be heard by the share markets, which in the UK and US at least have given up all the gains of the year and some. I don't think that there has been any material deterioration in the world economy or its prospects over this period, at least not enough to lead to the pretty dreadful performance of the main exchanges this month. But perceptions matter as much as reality, more perhaps, and they are now a bit dire.

Several perceptions have shifted. One is the likely growth of the US economy next year; a second, the ability of the Fed to cut rates to counter this. The Federal Reserve has just cut its forecast of growth for next year, with the mid-point of the range now below 2 per cent: but the issue is not whether growth is, say, 1.8 per cent or 2.2 per cent. It is whether there will be a recession. Private-sector forecasters now put that possibility as up to 40 per cent.

But would any slowdown be met by lower US rates? That assumption, widespread in the US, was slightly undermined this week by the Fed revealing that the last cut in rates was a close call, but I think more so by an awareness that the ability of the Fed to cut rates is limited, given the inflation outlook. That outlook is in turn undermined by the weakness of the dollar, which is helping to push the oil price back towards $100 a barrel. Add in the growing awareness of the scale of the error made by the Fed under Alan Greenspan, when rates were set so low that they stroked up both the property and the derivatives bubbles, and you can see how faith in the power of the Fed has evaporated. Actually quite a lot of us always felt the ability of the Fed to cut rates was limited, but now that awareness seems to be spreading.

The next shift of perceptions is about the ability of the rest of the world to "decouple" from the US. In other words, as the US economy does slow, will Europe and China be able to keep growing?

Until recently the view that the rest of the world could ride through a US downturn, maybe even a recession, was the dominant one. I have pointed out in these columns that this year will be the first when China adds more demand to the world economy than the US. Further, while US imports from China might slacken, the rest of Asia is a faster-growing market for China anyway.

That line of argument still holds water as far as China is concerned, or at least it will do for the next year or so, but there are some doubts about Europe.

The very latest data from German industry is a bit troubling, and since Germany is the best-performing large economy in Europe, if companies there are worried then the rest of Europe should be even more so. Obviously the high euro does not help, inflation is worrying, and it is not at all sure that there will be any cuts in interest rates. Indeed, a rise in rates is possible. Some countries, particularly Spain, would be very vulnerable to falls in property prices coupled with a decline in construction.

The decoupling argument has been bought by the markets up to now, witness the way the DAX index for Germany shares has shot ahead of US and UK indices (see first graph). Will it go on being accepted? Well, we will have to see, but I have been intrigued by some comments by Jim O'Neill, head of economics at Goldman Sachs, that de-coupling might be the next big theme in the world economy. My own instinct remains that next year will see some slowing rather than anything worse and that 2009 remains the danger year. But maybe next year will be more difficult than I have thought. That seems to be the message of the markets.

Yet shares are cheap – or at least British shares are cheap by historical standards (see next graph). The price/earnings ratio for the UK is 11 and the dividend yield is 3.3 per cent. That compares with a 30-year average P/E of 14 and adividend yield of 4.1 per cent for that period. The yield on some shares is amazingly high: Royal Bank of Scotland is yielding 8 per cent, raising the question as to why anyone should deposit money with them at half that rate: much better to buy the shares. The answer to that question must surely be that the dividend is suspect, that some cut is expected, or at least that some sort of rights issueis in the offing. As you can see from the graph, the market has become farbetter value since 2004,despite rising by some50 per cent. The simple point here is that profitability has risen even faster.

A further element of support comes from the deterioration in the yield on commercial property, as you can see from the third graph. Taking the earnings yield on shares (as opposed to the dividend yield), this is now around 9 per cent, allowing for the latest fall in the market. That compares with property at under 6 per cent and 20-year bonds at about 5 per cent. On the very long view it is always right to be in equities.

That does not mean that it is right in the short term. Capital Economics, which produced these graphs, warns that though valuations look attractive, "there remains a very clear risk of further falls in the UK equity market". Of course that is right. But are UK shares more exposed than, say, German ones? There is one reason to suppose that they might be, and one reason why they should not.

The reason why they might is that the British economy shows some of the characteristics of the US one. It has a high current account deficit, albeit not as high as the US. It has heavy dependence on the financial sector, arguably higher than the US. And its consumers are heavily indebted. The reason why we may be better placed is that more than half the profits of the FTSE 100 companies are derived outside the UK, maybe as high as 70 per cent in fact. So British shares are a bet on the world economy, not the domestic one.

We have to recognise that this is a very mature bull market. That does not mean that there is nothing further to go, but the financial market disruption of recent weeks may be bringing the bull-run to a premature close. It is quite possible that next year will be quite a decent one for the world economy, yet be a poor one for share prices. The job of markets is to look into the future.

I suppose what is most disturbing is the present volatility. Individual share prices are unusually volatile, with, I am afraid, quite a lot of malicious rumour-mongering going on. But more worrying still is the overall market volatility: the world economy does not change from month to month, even if investors seem to think so.