Hamish McRae: A bull may be on its way, but it won't save Labour's economic reputation

Economic View

It is easy to have a great leap forward if you start from far enough back. The world's stock markets have had their best month for several years, six years in the case of the FTSE 100, which is up 20 per cent on its low at the beginning of March. But it is still not up to the level it was in January. Back in September the index was above 5500. Other markets have made even greater gains. In the US, the S&P500 is up 30 per cent, the DAX in Germany 27 per cent, the CAC 40 in France 24 per cent and so on.

What should we make of all this? Anthony Bolton, the legendary fund manager at Fidelity has declared the start of a bull market and if there is indeed a world economic recovery towards the end of this year that would figure. In the past, shares have turned up somewhere between three and nine months ahead of the turn in the economy. Were the start of the recovery to be delayed well into 2010, or were it to pick up then fall back, then this bounce might turn out to be a bull phase in a still-intact bear market. In the short-term, there are reasons for caution – and not just because of the "sell in May and walk away" market adage. From being unbelievably over-pessimistic a couple of months ago, sentiment has recovered, but it may have "over-recovered" and be ready for a set-back.

That is the view of Chris Watling at Longview Economics. He expects a month or so of unwinding this appetite for risk, so the short-term outlook is bad. But he thinks that we are starting another bull market that will last for the next two or three years, though that may not take us back to the highs of the last cycle.

That raises a further issue: whether a slower-growing world economy, burdened by public-sector deficits, can sustain the solid rise in company profits needed to underpin higher share prices. Put round the other way: will a below-average economic recovery lead to a below-average stock market recovery?

If so, that would emphasise just how badly shares have performed over the past decade, particularly in Britain. If you want to see this in political terms – and in a week where our Prime Minister has become a figure of contempt a lot of people will – the Centre for Policy Studies has come up with some ammunition. In a new paper, The Stock Market under Labour, it compares what has happened over the past 12 years to the British market both with what happened under previous Conservative and Labour governments, and how the UK market compares with those in other major economies.

The lessons are pretty stark. One is that markets under Labour end down and markets under the Tories, with the exception of the Heath government, end up. The other is that, over the past 12 years, the British market has done worse than that of the other major economies, with the exception of Japan.

You could simply conclude that Labour governments always mismanage the economy. That was, after all, the record that Gordon Brown desperately wanted to break: to prove Labour could be trusted with the nation's finances. That led to the stress on the end to boom and bust and the fiscal rules. Unfortunately – and you can debate how the blame should be ascribed – he has been proved wrong.

But to be fair to Labour's record, it is true that for the two of its four periods of office, international conditions were difficult. From 1945 to 1951 it was burdened by the catastrophic borrowings to pay for the war. During the 1970s, the country experienced the first oil shock and its associated inflation. We coped rather worse than others but it was difficult. The legitimate criticism seems to me to be that during its other two periods, Labour has been very disappointing. Hardly anyone would defend the performance during the 1960s, for there was indeed serious mismanagement of the economy. As for the present period, we are perhaps too close to make a considered judgement, but already the chancellorship of Gordon Brown is looking much weaker than it appeared when he moved next door. Calculations by the Institute for Fiscal Studies show that fiscal policy was far too expansionary from about 2002 onwards, leading to the mess we are in now.

One could equally criticise the performance of Tory chancellors, in particular during the Barber and Lawson booms, but the basic point that the government will hand over a much more serious fiscal position than it inherited is beyond dispute.

British share prices have performed about the same as those in the US and better than Japan over the past 12 years. But they have done a low worse than European share prices. That must be a criticism of economic management. The UK seemed to be growing faster than all the other G7 economies with the possible exception of the US. You would expect this to result in a better market performance. Why not? There are several possible explanations. One is that the British index is heavily weighted towards the financial services sector and that has been hard hit. Another is that the "raid" on pension funds by Brown in his first Budget has cut the money available to invest in shares, resulting in lower valuations. Still another is that the continental bourses and pension funds were quite underdeveloped relative to the UK (and US) in the mid-1990s and accordingly had more potential for growth.

All those points have some merit. However, another possible explanation is that continental European countries in general tightened their fiscal policy from the mid-1990s onwards, partly under the Maastricht conditions, whereas Britain and America were not under similar discipline and loosened policy. It is a bit crude, but you could say that more money going into financing the state meant less available for financing companies. At any rate, the relationship is striking, for the country that ran the highest fiscal deficits through this period, Japan, also had the worst market performance.

What should we conclude about this looking forward? Since the UK stock market has gone nowhere in the past 12 years you might reckon that it will be able to make up some ground once a government more favourable to enterprise is installed. Unfortunately, it won't be as easy as that, for the next British government will have to confront the worst fiscal position since the late 1940s and, unlike then, we cannot inflate away the real value of the debt. True, the FTSE100 index reflects the world economy more than Britain's but other economies will be hobbled by debt too.

On the other hand, the value of shares is back below its long-term trend line, having been well above it during the late 1990s and 2004-07 booms. So prices are "normal" again. If that is right, there is scope for several years of steady, unremarkable advances. Unexciting? Sure, but after the recent madness a bit of a relief.

Don't expect the housing market to recover anytime soon

Shares may have turned up but don't expect house prices to do so, either here or in the US, anytime soon. A friend who sells property in New York was telling me that there is a huge gap in perceptions of what apartments are worth. Potential sellers are still in denial, not appreciating that every month they wait the further the values of their flats will fall. They never cut by quite enough. And would-be buyers keep holding off, frightened that they will make a bad deal. So property is simply not moving.

The situation is made worse by the social stresses of recession. The husband loses his job, the marriage breaks up and the apartment cannot be sold – the result is the poor chap ends up sleeping on friends' sofas because he cannot afford to rent anywhere else.

New York, or at least Manhattan, does, however, differ from the rest of the US in that there is limited space. There are not whole housing estates left unfinished or becoming deserted. It is financial rather than physical blight, and at some price everything in New York will clear. But from a financial point of view, this is small comfort, for until the US housing market hits bottom, it is hard to put a valuation on "toxic assets" held by banks and other institutions. The global crisis began in the US and that is where it will end. Once we know what the assets are worth the world can draw a line under the whole affair. This week sees US banks facing the official "stress test" and the suggestion is that several will fail and have to raise more capital. But we have no way of knowing if the test is too severe or too lax.

Here in the UK, we have a better template than they do in the US because we had a more serious housing crash in the early 1990s than they did. The positive aspect of that experience is that the economy re-established decent growth a clear three years ahead of the housing recovery. The negative aspect is that were this cycle to follow our early-1990s pattern, US house prices will not recover until 2012 or 2013, and ours about a year later. That is a long time to be sleeping on a sofa.