City shares a lost confidence: Gloom about the recovery has made raising money from the stock market a nerve-racking business, writes Richard Thomson

THE question marks hanging over the pounds 3.3bn flotation of Wellcome, the drug company, and other planned share issues grew larger by the day last week. Despite an upward blip on Friday, after rumours of an interest-rate cut, the stock market is yet again close to despairing of an economic recovery.

'It has not reached the panic stage yet,' said Bob Sempel, investment analyst at County NatWest, 'but people are distinctly worried.'

Compared with the heady days of mid-May when the FT-SE 100 index hit a peak of more than 2,730, the stock market is now a gloomy, even frightened, place. Last week confirmed beyond doubt that the post-election bubble in the market has burst. The FT-SE 100 ended June at 2,515.8, about 200 points below most analysts'expectations.

Merchant bankers, stockbrokers and company executives trying to launch share issues all feel as if they are shouting in the wilderness: the institutional investors seem resolutely determined not to listen.

Many stockbrokers are now quietly downgrading their forecasts of where the FT-SE will be by the end of the year. Among the most optimistic, James Capel has cut its forecast of 3,000 to 2,875. Goldman Sachs has chopped its 2,950 forecast to 2,500 in three months, rising slightly towards December.

'There can be no doubt that in the last six to eight weeks the world has become a much more fragile place,' said Sushil Wadhwani, investment strategist at Goldman.

The immediate problem in the stock market is not heavy selling by investors but rather a lack of institutional buying. Turnover has been relatively low, at around pounds 800m worth of customer share trades a day over the past few weeks. 'What we need to see is turnover of more than pounds 1bn,' Mr Sempel said. With no real investor demand for equities, share prices have fallen.

Despite the decline, the market still has its optimists. 'It's the usual summer time torpor,' Hugh Jenkins, head of the Prudential's investment arm, said. 'You won't detect any panic in me.'

He argues that with yields averaging 5 per cent, UK equities offer the highest return in the world, while the ratio of price to company earnings is among the lowest. In comparison with US stocks in particular, the UK looks cheaper than it has done for years, which may simply signify that London has fallen too far.

On this showing, irrespective of economic fundamentals, UK share prices are hardly likely to fall much further. 'On a 12 month view I don't see any downside,' Mr Jenkins said.

While the market will be reassured by such confidence from its largest investor, few share his point of view. For more than a month a creeping pessimism about the timing of economic recovery and industrial growth has infected the market. The decline was not triggered by a single event. Instead, it has been a steady erosion of confidence that has so far stopped just short of panic.

The day after the market hit its peak in May, Olympia & York - the world's biggest property developer - went into receivership. At the same time there was a spate of discouraging news about company performance and wage inflation in the UK.

Norman Lamont, the Chancellor, continued to sound chirpy about economic recovery but the evidence was not convincing. Investors paused from their post-election buying spree, looked around and started to lose heart. The long-expected recovery was still not visible. The disappointment of this discovery was all the more intense after the previous optimism.

The downward pressure continued in June. Canary Wharf went into administration, but more traumatic was the pulling of the dollars 800m ( pounds 421m) GPA flotation in mid-month. What shocked the market most was not the lack of demand for a company as complex as GPA so much as the way institutional interest in the UK and the US seemed to evaporate almost overnight. The same lack of interest showed through from private investors during the Daily Telegraph flotation last week when only 3 million out of 13 million shares were taken up.

Optimists like Mr Jenkins believe these issues were special cases. Yet the MFI share issue price had to be set on Thursday at 115p, well below original expectations, reinforcing the case for pessimism.

The arch-pessimist is Nick Knight, investment analyst at Nomura, who accurately predicted the current 2,500 FT-SE level. 'We felt for a long time that economic recovery was factored into the market. So there was no reason to think share prices would rise further. But then you have to wonder, What recovery?'

In Mr Knight's view, there will not be a pick-up in economic activity this year that will change the track of corporate earnings. The constraints of operating inside the European exchange rate mechanism mean that interest rates will remain high. There will be no currency depreciation or high inflation to help companies out, so there will be no earnings growth - and therefore no dividend growth.

On top of that, institutions are already 60 to 70 per cent invested in UK equities so they have a very limited appetite for more. Since they can get a better yield in cash or gilt-edged stock, that is where they are going.

Gilts are not only more attractive, there is a plentiful supply of them. The Government is issuing around pounds 3bn a month which is soaking up much of the liquidity that might otherwise have flowed into equities.

Few disagree with this as a short- term analysis. The worry over dividend growth is at the root of the pessimism. The day Bob Horton resigned as chairman of BP, partly over his insistence on maintaining the dividend, the company's shares plunged 14 per cent and took much of the market down with it.

Although there are healthy areas with steady dividend growth, such as pharmaceuticals and utilities, sentiment in most of the market has suffered badly.

The bank interim reporting season later this month, moreover, will show a high level of bad debts and many companies - particularly in the construction sector - will also report dire results. The weakening dollar, which hit dollars 1.9235 last week, will reduce the sterling value of corporate earnings in dollars - a fifth of the total.

'There will be a small fall in real dividend flows this year,' George Hodgeson, UK investment strategist at Warburg Securities, predicted.

Whether through optimism or wishful thinking, however, most analysts and fund managers claim to believe that matters are not as bad as they look. Despite calling the end of the recession wrong for more than two years, they still insist that an upturn will be visible by the last quarter of this year.

Both corporate and personal indebtedness are falling, as is inflation. At some point, higher savings among individuals must lead to higher spending and a pick-up in economic activity. 'The building blocks are in place for recovery, but the missing factor is confidence,' Andrew Bell of BZW said.

Confidence is what investors clearly lack. Having misread the economy so often before, they are unwilling to commit themselves until the indications of recovery are unmistakable. The market remains fearful that the economy may be slipping backwards but optimistic that it is not.

Investors and brokers are deeply confused. 'Intellectually, we are perfectly happy with the level of value in the market,' Patrick Gifford of Robert Fleming's investment management arm said. 'But we do not feel much pressure to buy.'

And that is the last thing that anyone about to launch a share offering on to the stock market wants to hear.

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