View from City Road: No port in a storm for equities

THE SPECTACLE of another round of ineffective central bank intervention to stem a seemingly unstoppable decline in the dollar and the rumblings of Hurricane Andrew combined to remind nervous dealers yesterday of the late summer of 1987 and the subsequent autumn meltdown in equity markets.

There seem to be fewer similarities than differences between then and now. UK average dividend yields five years ago were driven down to 3 per cent and an overbought Wall Street was plagued by worries about the impact on the bond market of a swelling US fiscal deficit.

But the current situation is a good reminder that traditional methods of valuing the equity market appear to have been temporarily suspended, leaving dealers and investors with little to hold on to for comfort.

Market analysts had thought that an average dividend yield of 5 per cent - a rough average for the past 50 years - would be enough to stabilise UK markets. Now it looks as if 5.5 per cent has not done the trick.

Another blunted tool seems to be the yield ratio between gilt-edged bonds and equities. Historically anything above 3 - as was the case in 1987 - spelt doom for equities and anything less than 2 was a buy.

But the ratio has moved effortlessly below 2, did not stop at 1.9 and has found no firm floor at below 1.75.

This must partly reflect the fact that in the short term, a low-growth, low-inflation environment requires the return on equities to rise in relation to bonds.

This is because companies will not be able to generate unsustainable dividend growth out of cyclical, inflationary upturns. Average dividend growth will indeed be modest for the next couple of years.

Further along, the relentless pursuit of responsible fiscal and monetary policies within the exchange rate mechanism, which has benefited some but not all long-term ERM members, may well reduce the risk premium on equities. This would make the current yield ratio look like a buy signal.

But back in the real world the reluctance of Germany to cut short-term interest rates rather than intervene in the currency market to support the dollar has traumatised virtually all European financial markets, with the exception of its own bond market and those linked to it. Until the French referendum spells out whether we are in for a devaluation, even higher interest rates or both, keep your cash in the bank.