Be afraid. The bears haven't gone away, they're just hiding

The dollar is weak. If the Japanese begin to repatriate their funds, Wall Street will collapse

AS STOCKMARKET prices dashed up to record levels again last week - and the bulls were proved right - I began to feel nervous about what I had written here in early October. Financial markets around the world had been gripped with a panic more intense than I had ever experienced before. The cause was the Russian default coming soon after the collapse of the east Asian economies.

Had I fallen again into the common journalistic error of supposing that the most recent events are the new reality and that of ignoring long-term trends?

I know that it didn't occur to me that there could be a swift recovery in share values.

Looking back, I find that I argued that - after what I described as a an unprecedented bone breaking, dislocating shock - the result would be that the amount of credit available to us all - whether by way of mortgages or overdrafts or hire purchase arrangements, or whether in the form of the loans which most companies need to supplement their capital - was going to be significantly reduced. Economic activity would be scaled back, some individuals would get into difficulties and some companies would go bust. There would, undoubtedly, be a recession.

I over-estimated the shock. Since October, I haven't seen much evidence that companies and individuals have in fact found it harder to obtain financial facilities.

The main reason is that central banks acted more swiftly than I supposed they would do, to cut interest rates. They were led by the US Federal Reserve. The Bank of England followed suit: the quarter point reduction to 6% it announced last week was the fourth since October, when the Bank's operational interest rate stood at 7.5%.

The two central banks had different concerns. The Fed was troubled by the spectacular crash of one of the largest and most respectable hedge funds on Wall Street: it feared the domino effect. The Bank of England, on the other hand, could see that the British economy, unlike America's, was beginning to lose momentum.

However, I was correct about the imminence of recession in the United Kingdom: the technical definition is two consecutive quarters of declining economic activity.

It now looks as if the final three months of 1998 will show a downturn when the figures are published shortly. And judging by recent evidence, the first quarter of 1999 will also register a drop. We know that manufacturing is in decline, but a recent survey showed that one in four service sector companies also reported a fall in their December workload and the sector is beginning to shed jobs.

All in all, I admit to a feeling of relief when I re-read my October piece. I had at least learnt something from 35 years of following financial markets - caution. I wrote that the tempest in financial markets was like a storm well out to sea. It was heading our way. But nobody could say whether it would largely blow itself out before it touched our lives, or whether it would still be raging fiercely. The main precaution one could take was to prepare one's mind for what may come.

In the event, it did blow itself out. Calm returned. The sun is again shining on investors. Nonetheless I still feel uneasy as I pace the shore line. Immediately before the Great Crash of 1929, life appeared normal, untroubled: few had an inkling of what was to come.

In relation to the stockmarket, my mind is in the same state as those seismologists who study the risk of earthquakes in great urban centres such as California or around Tokyo. All the precedents, the instrument readings and the minor tremors suggest that something big and disagreeable is about to happen, but for years, thank goodness, nothing does.

I have three concerns. The first is the American economy. It has now been expanding continually for 93 months. It's the longest peace time run ever recorded. Only one factor appears to keep it going - the stockmarket itself.

The effect works like this. A much higher proportion of Americans are invested in the stockmarket, directly or indirectly, than is the case anywhere else. As a result, when the stockmarket goes up, consumers feel richer and they borrow more and they spend more. Activity increases, and this in turn has a good impact upon investor sentiment.

Wall Street rises again, and so the cycle repeats itself.

This was perfectly illustrated on Friday: Wall Street prices hit a new, all-time peak on the same day that remarkably good economic figures were released. These showed that the unemployment rate fell to its lowest level for 28 years as a proportion of the workforce. In December alone, the US economy created 378,000 new jobs. The result of Wall Street's further rise is that American stocks, in terms of earnings and dividends per share, have become extremely expensive by the standards of the past.

So my question is this: if Wall Street breaks again, for whatever reason, will the Federal Reserve once more be able to cut interest rates sufficiently to restore confidence so that investors hold their nerves, or is this a manoeuvre which is less effective second time round? We can be fairly sure that if Wall Street turns down sharply and stays down, then American consumers will quickly reduce their spending and a significant US recession will follow, with negative consequences for all.

Americans are, collectively, borrowers rather than savers and this is the cause of my second concern. For many years Japanese savers have made good American deficits by buying huge amounts of US Treasury Securities. By doing so, they have obtained a good return, and they have also benefited from the strength of the dollar.

But recently this equation has changed its terms. Yields on US Treasury securities have fallen and the dollar is weak. If the Japanese begin to repatriate their funds, Wall Street would collapse.

And my third concern is what readers might recognise as my pet nightmare - that deflation returns for the first time since the 1930s. This is not yet mainstream thinking. But, in a sense, it is already happening. It was announced last week that prices charged by British manufacturers for finished goods fell over the 12 months to November by 0.5 per cent, the sharpest slide since records began in 1958.

Yes, I will have to admit it. I remain pessimistic about stockmarkets and the economic outlook. The Great Bear growled and paced around last October, and then went away. I think the animal will return.