Lex: A question of confidence

This is an FT archive article, originally published on 20 October 1987

The market’s natural instinct yesterday was to conceal its shock by claiming the whole collapse had been predictable. But in truth, for London it came from an almost clear sky. Rising US and German interest rates were not supposed to affect UK equities because Mr Lawson had cleverly anticipated all that back in August. And although markets have been known to overreact when a bear trend has been established, who could conceive of a ruinous plunge of more than 10 per cent in a market perched near its all-time high?

The sheer extent to which records were broken brought out a rash of explanations, not all of them good. The two obvious differences between now and 1974 are the new dealing system and the rash of derivative instruments such as index futures. Both will have played a part but new dealing systems had nothing to do with the astonishing collapse on Wall Street. At least as important was the bizarre circumstance of London being out of action on Friday, when the rot really set in, producing a whiplash effect yesterday morning - proof, if it were needed, that suspending trading in these conditions would do more harm than good.

The scale apart, yesterday came as less of a shock to bond traders. Yields in all the world’s bond markets have risen sharply since the summer as concern over inflation and consequent rises in interest rates have increased. Indeed the widening yield gap had suggested for a while, to those who still looked at it, that shares were overvalued.

It took two events to bring home to equities that bonds had been worrying about something serious - the small rise in West German interest rates two weeks ago and last week’s poor US trade figures. The two together suggest that just when the dollar faces another bout of downward pressure the Bundesbank will be unwilling to intervene in its support because of domestic monetary considerations. Hence the repeated attacks on German policy by US Treasury Secretary Baker which knocked the dollar yesterday. In spite of remarks by the German Finance Minister that the Louvre accord would continue, the previous confidence that G7 could handle the dollar’s decline without unleashing inflation or putting up interest rates has shattered.

The main concern now is how US handles its monetary policy and currency while batting to reduce the trade and budget deficits. The US must find buyers for $28bn of Treasury bonds when the refunding comes next month and as debt-or-nations have frequently found, it is the creditors who set the terms. US Treasury yields are already discounting a further rise in discount rate. Too small an increase would raise concern that Mr Greenspan, who is still a new boy at the Federal Reserve, is insufficiently tough. Too large a rise might threaten the US economy, in election year too, with knock-on effects on other countries’ economies.

With the benefit of hindsight it is easy to argue that by the early autumn most of the world’s major stock markets were more than fully valued by historical standards and were waiting for an excuse to fall. The Tokyo stockmarket peaked only last week, having risen by more than 40 per cent since the start of the year, and other markets ranging from Hong Kong and Australia to Spain, Sweden and Switzerland had all reached new highs in the past three weeks. By the start of this month Goldman Sachs had estimated that, even if they heady Japanese stock-market valuations were excluded, the world stock markets were selling on a multiple of 16.2 times prospective earnings, or nearly a third above the average multiple between 1982 and 1984.

Some sort of correction looked overdue, particularly in the US where, even after the latest savage corrections, the earnings multiple on the S & P 500 remains high by historical standards. The dramatic rise of Wall Street has been fuelled by two rather unstable elements. Since 1984 close to $300bn of equity has been taken out of the market by corporate takeovers, share buybacks and leveraged buyouts, with the result that the supply of equities has been shrinking at an annual rate of about 3 per cent. At the same time foreign investors, led by the Japanese, have been piling into US equities. Traditionally, net foreign investment in US equities has never topped the $5bn mark. However, last year more than $18bn net flowed into the market and in the first half of the current year foreign investment in US equities has been running at an annual rate of close to $40bn. Remove these two props and it is far more difficult to make out a continued bullish case for Wall Street.

The real question is how far the rest of the world has cause to worry about this, or for that matter about the fact that Tokyo - about the same size as Wall Street - has not yet shown serious signs of cracking at all. By any standard, Japan is surely overvalued. If the plunge in world equities has been triggered by bonds, how long can Japan hold out against the recent doubling in domestic bond yields?

What has upset markets as much as anything else is the fact that markets have shown themselves capable of this kind of unthinkable one-day movement. Many fund-managers simply refused to deal yesterday, on the grounds that objective decisions in these conditions impossible. In rational terms the threat outside the US consists of the potentially deadly combination of a falling dollar, rising world interest rates and a US recession. Compared with just a month ago, everything suddenly looks much more fragile.

In falling markets, the trick is to find the least-bad performer. Almost by elimination this points to Europe and a strong candidate could be the UK. Barring disastrous official statistics this week there is no domestic justification for a rise in interest rates. The corporate sector, too, is financially much more robust in the UK than in the US. But even in London it would take a brave investor to start buying today.