Old fears haunt the markets again

There is a clearly discernible feeling that inflation is edging back into investor awareness

Life, said the philosopher Kierkegaard, is lived forwards but understood backwards. This has always seemed to me to be one of the two definitive statements about the perils of stock market forecasting. (The second being the economist JK Galbraith's observation that forecasters make forecasts not because they know but because they are always being asked).

The point is that while it is often easy to see the direction in which a market must in due course go, it is next to impossible to determine at exactly what point any decisive change in direction will be triggered. Understanding the turning points in what drives bull and bear markets is a luxury available only with hindsight.

Those who have been arguing over the last few days that we are seeing an important turning point in market expectations on both sides of the Atlantic are therefore more likely to be wrong than right. What is not in doubt, however, is that the run-up to the Budget next week and the latest bout of jitters about Wall Street is beginning to focus minds yet again on what is the appropriate level for the stock market.

It is not every month that the London stock market falls six days in a row, as it did up to and including last Monday. While the main factor behind the market's nervousness is (as I said last week) concern about what Gordon Brown will do to present taxation, there is also a clearly discernible feeling that inflation fears are beginning to edge back into investors' consciousness.

Tim Congdon, a leading UK monetary economist, this week raised again the possibility that inflation is about to rear its head again, not just here but in the United States as well. His view is that while the markets are still convinced the US is enjoying a rare and sustainable period of falling unemployment and low inflation, the growth of the US monetary aggregates strongly points to a period of higher inflation ahead. He paints a similar picture for the UK.

His conclusion is that financial markets are "blissfully complacent about inflation". The differential between index-linked gilts and conventional gilt yields in the UK, for example, has fallen to under 3.5 per cent, pretty much the lowest it has been since index-linked gilts were first issued in 1981. Wall Street also looks more highly valued than ever, he argues.

As my chart shows, Professor Congdon is worried that the ratio between gilt yields and stock market dividend yields is in danger of going off the top of the scale. The yield on US government bonds is more than four times that on the S&P 500 share index. This compares with an average over the past 15 years of 2.5-2.75, and the previous peak - briefly above 3.5 times - seen in the summer of 1987, weeks before the crash in the autumn.

The evidence of this ratio points at some point soon therefore to either a sharp fall in the level of the stock market, or to a further decline in bond yields. The market bulls will hope for the latter: the inflation bears will fear the former. Since he thinks inflation is poised to start rising soon, Mr Congdon is in the second camp. He points out that if the bond/dividend yield ratio is to revert to its former level, it implies a correction on Wall Street of the order of 30 per cent.

The position is not quite the same in the UK, where the comparable gilt/market yield ratio is well within its normal historical trading ratio. But with the money supply growing quite fast, and consumer spending buoyant, the inflation outlook is also less promising, in Professor Congdon's view, than the markets currently expect.

This brings us back to Mr Brown and his Budget. He is still basking in the success of his decision last month to grant control of interest rate decisions to the Bank of England. The combination of that important decision and the continued strength of sterling - which puts downward pressure on inflation - are behind investors' feelings here that the traditional threat of inflation under Labour is receding.

If you look at the break-even rate of inflation implied by the differential between ordinary and index-linked gilts, it has fallen recently - and, significantly, by more at the long end of the market than at the short. In other words, the feeling has been that there has been a change for the better in Britain's long-term inflation prospects.

So far that seems to remain the dominant view among investors, but the doubters are beginning to come out of the woodwork again, for the kind of reasons that Professor Congdon has articulated. The Budget will be the next test of Mr Brown's intentions, with all attention focused on how far he feels the need to raise new taxes.

That he will feel the need to do something is not in question.That he will do something about the tax treatment of dividends, at least for tax- exempt institutions, also seems pretty inevitable to me.

The interesting thing for ordinary investors will be (a) whether he decides to extend any changes so that they affects PEPs; and (b) how far he wraps up any changes in the wider context of an overhaul in the whole tax treatment of savings and investments. Labour is known to be interested in the idea of scrapping the whole panoply of Tessas, PEPs and so on in favour of a single, consistent taxation formula for savings, perhaps linked to the introduction of individual savings accounts for retirement.

Since, strictly speaking, the Budget is only an interim one designed to introduce the windfall tax on privatised utilities and clear a path for the promised unemployment reduction measures, there is no need for Mr Brown to do anything about this until his first full Budget, in either the autumn or next spring.

As a footnote, it is only fair to say that not everyone shares Professor Congdon's view that the stock market here and in the United States may be getting carried away. This week Wayne Angell, a former governor of the Federal Reserve, gave his view that there is no reason why Wall Street could not continue its current bull run for another two years at least.

He says the Dow Jones index could well rise from its current level (in the low 7,000s) to hit 10,000 by 1999. Mr Angell is now the head of Bear Stearns, one of the biggest US broking firms, and presumably has a vested interest in seeing the market go on rising, but as I said at the beginning there is no reason to suggest that he, any more than anyone else, can call the turns in the market with anything like certainty. But watch that bond/dividend yield ratio with interest.