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>Subject: [CrashList] One week after the big blip
>
>Editorial comment:
>Published: April 21 2000 19:45GMT | Last Updated: April 21 2000
>19:50GMT
>
>
>
>How will April 2000 be remembered in the financial history books? It
>may go down as the month when the allure of dotcom stocks was
>seriously tested for the first time. The bigger question is whether
>it will also be remembered as a turning point for equity markets as a
>whole.
>
>The stock market dive a week ago was led by steep declines in high-
>technology shares. Investors decided that their expectations of the
>earnings potential of many of these companies had become much too
>optimistic.
>
>By contrast, the recovery in equity prices over the past week has
>been supported by very good results from blue-chip companies. Strong
>growth in the global economy has allowed many such businesses to
>record large increases in profitability.
>
>There has been a spate of US companies reporting first-quarter
>earnings well above expectations. Examples include Coca-Cola, Johnson
>& Johnson and Ford. With evidence of double-digit earnings growth in
>many sectors, stock valuations in the old economy did not seem
>unreasonable.
>
>Still, last week's setback is prompting some investors to ask whether
>this happy state of affairs can go on forever. However strong the
>global economy may look now, there is evidence that the world
>economic cycle is turning in a way that will be less favourable for
>equities.
>
>In the aftermath of the Asian financial crisis, it became possible to
>argue that global inflation had come to an end. But it turns out that
>the old rules of economics still apply. Higher growth is leading to
>worries about inflation across much of the developed world, meaning
>that global monetary policy is set for a further phase of tightening.
>
>Concerns are centred on the US economy. It was the release of an
>unexpectedly high consumer price index that triggered the big
>declines a week ago. Labour market tightness is also a worry. The Fed
>was waiting for evidence of inflation before taking strong action to
>slow the economy. But the momentum that has built up in the meantime
>means that quite substantial rate rises could be needed to bring
>growth back to sustainable levels.
>
>Euro-zone anxiety
>
>There are also worries about inflation in the euro-zone, although
>these are perhaps exaggerated. Prices are rising rapidly in some
>peripheral economies, and the combination of a weak currency and
>higher oil prices helped the headline rate of inflation in March to
>jump above 2 per cent for the first time since the launch of the
>euro. Core inflation remains low. All the same, the European Central
>Bank is preparing the ground for a further interest rate rise.
>
>In the UK, high earnings growth and strong domestic demand led three
>monetary policy committee members to call for higher interest rates
>at the committee's last meeting. Next time, they are likely to get
>their way. And even in Japan there have been hints that the zero
>interest rate will not continue past the end of the year.
>
>Market momentum
>
>Tighter global monetary policy need not crush growth. There is a
>great deal of momentum in the world economy, particularly as the
>emerging markets of Asia and Latin America are looking stronger.
>
>But the impact of higher interest rates on the cost of capital,
>together with the prospect of slower economic expansion, will make
>the current rate of earnings growth of many US companies hard to
>sustain. If investors begin to fear this, then equity valuations will
>be undermined.
>
>Research by investment bank Goldman Sachs backs up this argument. The
>bank picks out five phases of global monetary tightening over the
>past three decades. Average real equity returns during these phases,
>it finds, are 0.5 per cent per month in the big industrial economies,
>compared to returns of 1.2 per cent per month during periods when
>monetary policy is being eased worldwide.
>
>The bond market may not have fully priced in the monetary tightening
>to come later this year. Long bond prices in the US have been
>supported by an expected contraction in supply. It is true that they
>hold some attraction as a safe haven when equities are falling, but
>they are vulnerable to further evidence of inflation.
>
>Equity valuations can be as much a product of investor sentiment as
>fundamentals. Optimism about long-term growth prospects in the US
>could allow valuations to ride out a temporary slowdown.
>
>The uncertainty over the extent of the slowdown, however, combined
>with the difficulties in valuing high-technology stocks could mean
>that the extreme volatility in asset markets that has recently been
>experienced could continue for months to come - making it even harder
>to pick out the trends in asset prices. Perhaps that will be the most
>significant legacy of this month's remarkable events.
>
>FT.com 22.04.00
>
>
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