Capital isn't working Larry Elliott Tuesday June 25, 2002 The Guardian
The stock market euphoria of March 2000 seemed a long time ago yesterday as shares in London and New York resumed their downward slide. Back then, Kevin Keegan was England's manager, Bill Clinton was president of the United States and the long bull market in share prices was about to end. For anyone with money invested in a pension plan or an endowment mortgage, Lastminute.com's debut on the stock market seems like a relic from a different age. Did the Nasdaq really hit 5,000 as investors loaded up with shares in hi-tech companies that had never made a cent's profit and were never likely to? They did. Were investors seduced by the patter of snake-oil salesmen who said the good times would last for ever? They were. There has been time to repent at leisure. The bear market has been under way for more than two years and shows little sign of ending. Rallies on stock markets in the autumn of last year proved to be false dawns, a sad reprise of the irrational exuberance that had propelled them to such ridiculous heights either side of the millennium. The Nasdaq is trading at less than one third of its peak and the S&P 500 in New York and the FTSE 100 in London are within a whisker of the lows they reached last autumn. Six months ago, it was assumed that September 11, terrible as it was, had been cathartic for the markets, generating one last wave of panic selling but clearing the decks for recovery. Expansionary policies - cheaper money, lower taxes, higher public spending - would reverse the global economy's drift into recession by boosting growth. Higher growth would mean higher corporate profits. Higher profits would mean higher share prices. Anticipating the return of the good times, the markets went up, only to slide all the way back down again during 2002, even as optimism grew that the full-scale global recession prophesied in the aftermath of September 11 had been averted. Policymakers - especially in the US and Britain - responded quickly and aggressively late last year to cut the cost of borrowing and flood financial markets with liquidity. At first, markets rose sharply in anticipation of stronger growth, but now there are signs of a pick-up in activity they have given back nearly all the gains they made. Growth picked up markedly in the US in the first quarter of the year and there are hopes that the rise in unemployment may have been capped at 6%. Britain's economy, according to the official data, stagnated in both the fourth quarter of 2001 and the first quarter of 2002, but there is justifiable scepticism about whether the figures paint an accurate picture. Upward revisions to the growth estimates are likely; in any case, the strength of the housing market and a rebound in manufacturing suggests that the second quarter will be much stronger. So what is going on in the stock markets? Is there any rational explanation for their behaviour, or are they exhibiting the personality traits of a manic depressive, veering between excessive optimism and deepest gloom? One theory is that we are in the darkest hour before the dawn. Not only is global recovery now well under way, but all the bad news - the spread of Enronitis, the possibility of further terrorist attacks on the US, war against Saddam Hussein - is already discounted by the markets. In historical terms, the recession of 2001 was the merest of blips that was choked off by the coordinated actions of the world's central banks. The fact that the Federal Reserve, the Bank of England and the European Central Bank may all raise interest rates over the coming months is clear evidence that the worst is over, and that once the markets recognise this a durable rally will start. A second argument is that markets are still overvalued, particularly since the ferocity of global competition means that companies are finding it increasingly hard to push up prices. The 1990s saw the longest period of uninterrupted profits growth in the US in the post-war period, aided by the weakness of the dollar in the first half of the decade, favourable tax treatment of the corporate sector, a weakening of labour's bargaining power and the pioneering role of America in the development of the new technololgies. Markets were right when they said something significant had happened to the US economy. But they were wrong to think that earnings could continue to rise inexorably for ever, justifying higher and higher share prices. A stronger dollar since the mid-1990s, a tighter labour market and wasteful investment that led to overcapacity all contributed to the pricking of the equity bubble. Profits always go up and down with the economic cycle but since 2000, the annualised decline in profits for the S&P 500 companies has been the sharpest in the post-war period. 'Unsually modest' With large amounts of spare capacity, prices have been slashed. Ford and General Motors have been offering fantastically generous car deals, computer manufacturers such as Dell have been accused of predatory pricing - all of which is good news for consumers, bad news for corporate earnings. And, as a result, bad news for share prices - and investment plans such as pensions linked to stock market performance. Peter Oppenheimer, a global strategist at HSBC said: "The rebound in world stock markets following two years of decline has, so far, been unusually modest by the standards of history. "From the September 20 lows, world stock markets have risen around 10%, compared with an average rise of around 20% six months after previous bear market lows. There has been a range of factors that have no doubt contributed to the continued weakness, from accounting issues to valuations. But underlying all of these are structural factors that will lead to low returns in stock markets for a long time. Interest rates cannot continue to decline as they have done over the past 20 years, the risk premium may be rising and profit prospects are deteriorating." Mr Oppenheimer says the scope for sustained rises in equity prices is limited. "Indeed, while it is commonly thought that September 20 marked the end of the bear market, if one excludes the sharp fall in the immediate aftermath of September 11, and then the sharp rebound that followed, the trend in the equity markets is still downwards." Even assuming this is the case, it may have little impact on the real economy in Britain. Traditionally, there have been long periods in the 1950s and 1960s when full employment and low inflation coincided with modestly performing share prices. Michael Saunders, UK economist at Citibank, says: "The economy probably has more than enough support from low interest rates to overcome the drag from modest weakness in equity markets. Despite equity weakness, surging house prices have probably lifted household wealth slightly over the past year." Mr Saunders also believes that the plunge in profits among UK quoted companies seems to greatly overstate the weakness of profits for the overall UK business sector. He says the stock market indices give too little weight to the domestic market-oriented service sector and construction firms - which have benefited from the consumer boom - and too much to companies that rely heavily on overseas earnings. Doomsday scenario For the FT 350 companies, 58% of profits come from outside the UK. By contrast, the government's accounts show that for the corporate sector as a whole, only 22% of profits come from outside the UK. The real danger for the UK is not a fall in the stock market to more realistic levels, but the threat of a double-dip recession in the US. Some analysts see the recovery so far this year as merely the first leg of a double-dip recession. Robert Brenner, author of the recently published The Boom and the Bubble, is the best exponent of the doomsday scenario. "The deflation of the stock market bubble is propelling a US economy, heavily burdened by manufacturing overcapacity, toward a serious recession, and in the process detonating further recession all across an advanced capitalist world that is similarly held down by superfluous productive power. "The resulting downturn is weighing particularly heavily on the triangle of interlinked economies in East Asia, Japan and the US itself, so that a mutually reinforcing downturn seems in prospect." Mr Brenner says there might be a mass exodus from US financial markets, prompting a full-scale run on the dollar. The Federal Reserve would then be in the nearly impossible situation of having to cut interest rates to keep the economy afloat and of needing higher interest rates to attract a flow of funds from overseas to fund the US current account deficit. This remains a minority view. Officially, the US economy is on the way back, and dragging the rest of the world along in its slipstream. But concern is growing that the recovery may stall, and there is no possible way in which the Federal Reserve will raise rates tomorrow. Indeed, there are some who think the severity of the bear market will require the next move to be down. It's not only investors who are getting nervous.
