Outlook: Another grim day. No wonder everyone's avoiding equities

Woolworths/Bhs Ê

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Alarm as £33bn is wiped off shares

Collapse in US consumer confidence sends global stock markets reeling

Low unemployment and higher pay add to rate rise pressure

Bhs's Philip Green refuses to rule out hostile Woolworths bid after talks fail

Unemployment is at a 26 year low, the housing market is booming, average earnings are rising, inflation is in abeyance and retail spending is romping ahead. It's hard to recall a more benign set of economic circumstances. We seem to be living through a golden age of prosperity and opportunity. So how come the stock market is continuing to plummet, and what does it say about the future?

The second of these questions is the easier to answer. The bear market in equities that has been raging since the turn of the century can no longer be seen as merely a necessary correction to the excesses of the late 1990s. It's moved beyond that. Instead it is starting to point to severe problems ahead in the domestic and international economy.

Just a few statistics first. After yesterday's fall, the FTSE 100 index is not so far off the lows it fell to in the immediate aftermath of 11 September, when everyone thought the end of the world was nigh, and before that, the collapse of Long-Term Capital Management in October 1998, when blind panic gripped financial markets. Put another way, the stock market is back to where it was at the end of 1997. All the gains of the boom have been wiped out, with the effect that for four and a half years now, there has been no net return on equities. Since the turn of the century, the FTSE 100 has fallen more than a third, a position which almost exactly mirrors that of the S&P 500, the most representative index in the US.

There seem few reasons to be cheerful. On present earnings forecasts, shares continue to look expensive by historic standards, for the more the earnings outlook deteriorates, the more valuations have to fall to look cheap again. In the UK, economic growth has ground to a halt, and although there are now signs of business confidence and investment starting to pick up once more, the Bank of England has become so concerned about the runaway consumer and housing boom that it is now publicly warning of the need for higher interest rates.

Look at the sectors which have lately been driving the FTSE 100 lower (see charts on page 23), and you can see that the damage is largely confined to three sectors. The nuclear winter that has engulfed the telecommunications industry is familiar enough, so no surprises there. Likewise pharmaceuticals, which is losing some of its traditional defensive qualities amid a welter of patent challenges from generic rivals. But the real surprise is banking, which has hitherto been one of the strongest sectors in the stock market.

The resilience of the banking sector was always a curiosity since banks are usually one of the biggest victims of any business downturn. Up until this week, however, bad debt provisions have been limited. Better management and heavy cost cutting has more than compensated for any increase there has been. The stock market came to believe that the big retail banks, through better risk management, had finally managed to abolish the banking cycle. That presumption has been rudely interrupted this week by news of substantial extra provisioning at Abbey National. It remains to be seen how far the big clearers are forced to follow Abbey National's lead.

The wholesale banking problems suffered by Abbey National are one thing. More experienced commercial lenders may have avoided the worst of them, or at least laid off the risk more effectively in a manner that makes them less exposed. But there is another worry too, which is the huge expansion there has been in unsecured personal credit. With the Bank of England threatening to raise interest rates, this begins to look much higher risk than it did, particularly if higher interest rates are accompanied by rising unemployment.

So the situation begins to look grimmer still. One of the few reliable bankers in the stock market, the banks themselves, no longer look so reliable.

Such specific concerns are underpinned by growing alarm over the outlook for the US economy. The possibility of a double dip, so much talked about in the aftermath of 11 September, but then largely dismissed, is beginning to look all too possible again. For years American consumption and growth was fed by an apparently inexhaustive supply of foreign capital. Everyone seemed to want a part of the American dream. Her companies were superior, her technology was superior, her economy was superior. It was the place where capital wanted to be.

Not any longer by the look of it. The US stock market has gone to hell in a handcart, along with everyone else, Enron has exploded the myth of corporate superiority, consumer confidence is on the wane again, and to cap it all the dollar is heading for parity with the euro. The US is no longer the magnet for foreign capital it was, and if that's the case, then US consumption and growth must slow too.

A further negative ought to be added to the general picture of economic gloom. The fact of the matter is that since the turn of the century investors have become overwhelmingly disillusioned with equities. The hope is that the boycott will be a temporary phenomenon that will go away once the bottom of the cycle has been unambiguously reached. But there is reason to worry this might not be the case. Last time there was a prolonged period of poor rates of return from equities, in the 1970s, there was also very high inflation. So against the alternatives of bonds and cash, equities actually held their value relatively well.

That's not true this time around. Very low inflation makes cash, bonds and property look good value against equities. At least you don't lose your capital when it sits in a bank. Nor, apparently, do you lose it when you stick it into the housing market. But it also does the productive part of the economy no good whatsoever. Low inflation makes corporate profit harder to achieve, further undermining the case for equities. Conventional wisdom is still that the deflationary paralysis that has gripped Japan these past 12 years couldn't possibly happen in the West and, true enough, there are lots of differences to add comfort to this point of view. Unwise to bet on it though.

Woolworths/Bhs

Philip Green says the talks broke down because Woolworths wouldn't give him the financial information he needed. "I'm not sure why they ever phoned us up", he says. Woolworths says the talks broke down because there was nothing in it for its shareholders. He invited us to lunch, the company says indignantly, not the other way round. In any case, it is plain that a merger with Mr Green's Bhs is never going to happen, however much he threatens to go hostile, for it is hard to quarrel with the Woolies analysis.

The idea was that Mr Green would reverse Bhs into Woolies for shares, giving Mr Green something north of 60 per cent of the equity. He would then flog off around half the shares for cash. Mr Green would have got the quote he craves, he'd have got a cash exit for half his Bhs investment, and he would have gained exposure to another recovery story – Woolworths. In return Woolworths would have got ... well, it's hard to see what other than the toga partying Mr Green himself. No wonder Gerald Corbett, the Woolies chief executive, thought this was a deal he could resist.

jeremy.warner@independent.co.uk