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History key to markets' future

By Neville Bennett

Friday 7th March 2003

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The markets are caught in the thralls of history. Several trends have contributed to a dreadful year, with losses on the main indices of 20-45%.

Looking on the bright side, the depreciation of global markets reduced risks of a collapse when the bubble deflated. The fall has been gradual and there have been no bankruptcies in major financial players. There is some hope that the market has fallen sufficiently to form a bottom, which could be a launching pad for a modest recovery.

But optimism must be tempered by the realisation that an 18-year bull market in the US came to an end in 2000 and many experts believe the present market is still too highly valued. Even if there were no war-induced uncertainty, few people believe this is the time to go overweight on stocks. There do not seem to be many bargains out there.

The bear market has utterly discredited those brokers who pumped up shares on some vague notion that they would eventually become profitable. But "value" investing will always be a recommended practice.

The guru here is Warren Buffet and in his annual report to shareholders he expressed only mild interest in equities: "That dismal fact is testimony to the insanity of valuations reached during The Great Bubble."

He proposes to sit out until he can get 10% pre-tax earnings. He also regards derivatives as "time bombs." His fund has invested profits and new money into junk bonds as sometimes "successful investing requires inactivity."

There is some uncertainty over monetary conditions. A year ago, it could be said there had been a 20-year war against inflation. New Zealand played an honourable part in this world by setting a trend that interest rates would be controlled by the Reserve Bank, rather than the minister of finance.

The battle seemed to be won and the balance of risk swung towards deflation. Deflation is the reality in many economies, especially the formerly vibrant Japanese and German.

Yet the US authorities have taken measures against recession, which have greatly inflated their economy and have created significant liquidity. Interest rates have fallen to record lows, in addition to a Budget blowout.

The administration is also introducing tax cuts and the US consumer has maintained a high level of spending, at the cost of doubling household debt in the medium term.

While the monetary tone of the global market appears to be deflationary, inflationary counter-tones are emerging from the US in monetary and fiscal policy ­ and this is increasing with burgeoning war expenditure. Even if the war is short, expenditure on it will slow world growth by 1% for several years.

The events of September 11 set in motion another defining trend: an unrelenting war on terror, which has influenced business profoundly, especially travel, and has set in motion the present Iraq situation. This in turn has promoted considerable inflationary pressures.

These are easily gauged by the price of gold, which has appreciated rapidly. More importantly, it has greatly increased the price of oil, although other factors are apparent in the increasing oil price.

It must be remembered oil price rises by Opec were the basic reason for the huge inflation of the 1970s. It is too early to be certain of the effect of the present oil price rising to double what it was a year ago.

Sustained high prices may bring about another bout of stagflation: the bewildering situation where output is stagnant but prices rise sharply. There is already cause for alarm at the slowing of the global economy, and a prolonged oil-price spike would induce a global recession.

But the oil price hike may be temporary. Perhaps the Iraq situation will be quickly resolved. My impression is a halt in Venezuelan supply, remarkably cold weather and record low inventory, have caused pressure in the US market.

But an expert I contacted in London believes there is enough oil embarked on tankers to supply the US market. Saudi Arabia is also committed to raising production as necessary. The futures market also seems to indicate the oil problem will last for only three months.

Nevertheless, a recovery is hardly likely until uncertainty lifts. And the inelastic spending on oil is reducing consumer expenditure on other goods and services. This slows growth and will slow orders for New Zealand's exports.

Equity markets may be boosted if war breaks out. Shares normally lift in the third year of the presidential term, and Standard & Poor's has predicted the possible rise would be accentuated by the outbreak of war.

Markets gained 18% in the 1951 Korean War, the 1967 Vietnamese War, and the 1991 Gulf War. I expect a large rise in the Dow Jones on the outbreak of war simply because of relief that some uncertainty has been resolved, but it is less certain that a rise could be sustained in the shorter term.

Some stocks perform better in war. Some experts believe that the outbreak of war will be good for defence, oil and retailing stocks. An alternative "peace basket" would accumulate financial and technology stocks, according to Lehman Brothers.

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