Look at the performance of the FTSE over the last few weeks and you'd think that there was no such thing as bad news. When the bombs went off on the London Underground on July 7th the index fell for a bit but changed its mind almost instantly, recovering most of its losses by the end of the day and the rest the day after. And since then it has done practically nothing but rise. Every time we get new evidence that the housing market is continuing to weaken stocks rise. Every time we hear that the retail sector is suffering stocks rise. Note that when M&S announced last week that it had managed its 7th quarter in a row of falling sales, its shares instantly rose. And last Wednesday when we heard that unemployment in the UK (measured by the number of benefit claimants) had risen for the 5th month in a row, the worst run since 1992, what happened? The FTSE ended the day nearly half a percent up. The market seems to be actively welcoming misery be it bombs or collapsing consumption, it is all fuel to the FTSE's fire. It is now up 9% so far this year and 20% from a year ago.
So what's going on? Most market commentators would have you believe that, when it comes to the terrorist attacks (which, by the way, analysts are saying will cost our economy a good £3bn once you've added in their effects on tourism), the market is showing stoicism' and defiance.' And that when it comes to the economy investors are simply confident.'
This is complete nonsense. For starters, markets don't do defiance' and nor do investors. They do trying to make money' and if they thought shorting the market would make them more money than going long the market, they'd be shorting it. And, as for confidence, no one in their right mind would be confident about the UK economy at the moment. Numbers out from the Office of National Statistics last month showed that UK GDP grew by a mere 0.4% in the first quarter of this year and few analysts expect full year growth to come in at much more than 2% this year (some even think it will be less than 2%), making Gordon Brown's pipe dreamy forecast of 3-3.5% look even sillier than it used to. House prices for years now the main driver of our feel good economy - are falling (down 0.2% in June according to the Nationwide numbers) and the manufacturing sector is clearly contracting. Finally note that the budget deficit is on the rise and given that slowing growth means slowing tax revenues that's a trend that is likely to reverse direction any time soon. Not long now and Gordon Brown will have to spend less, borrow more or put your taxes up. I wonder which it will be?
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The fact is that the FTSE's rise isn't about defiance and it most certainly isn't about having confidence in UK Plc. It is about interest rates. As far as the traders are concerned every depressing bit of data we see simply increases their hope that rates will soon be cut. This is good news for them as markets look to the future not the past. The lower a yield they expect from gilts in the future (i.e. the lower they expect the Bank of England to set interest rates in the future) the higher a valuation they will put on the potential returns from equities. So when interest rates are expected to fall and indeed when they do fall - equities often do pretty well.
But here's a thought. What if the economy stays just as rubbish as it is now but interest rates don't fall, or don't fall as much as the market expects them too? Let's not forget that the Monetary Policy Committee's main stated aim is not to keep traders happy but to keep inflation under control and that interest rates are their policy instrument for doing so. Right now inflation as measured by the CPI is bang on target but it may well not stay that way. Input prices for UK producers were running at an annualised rate of 12% last month. In May wages in the public sector rose at an annualised rate of 7.6% (no wonder the budget deficit is on the up) and even in the private sector they're rising at about 4%. At the same time oil prices remain stubbornly high and the pound is falling, something that means the prices of all our imported goods are rising. None of this has really fed through into the retail inflation numbers yet, but it soon will and that is going to make it very hard for the Bank of England to cut rates as aggressively as some would like.
If I were a trader I'd stop pinning my hopes on rate cuts and start treating misery for what it really is bad news.
By Merryn Somerset Webb, MoneyWeek editor-in-chief, as published in The Sunday Times
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