London Briefing: A massive rally in US and European equities has taken UK equities up 15 per cent, at the time of writing at least, from their lows reached in the middle of last week. During the last Gulf War, stocks rallied as soon as the shooting started. This time around, markets seem to be trying to anticipate a successful conclusion to the war, rather than to wait for it to start.
Of course, we will probably find out rather quickly whether this assumption is correct. All sorts of unintended consequence can flow from war and markets are likely to prove extremely reactive to events as they unfold.
Stock markets tend to focus on three things and unpredictable mood changes often dictate which of the three is in vogue.
Valuations, growth prospects and risk are the drivers of stock prices. So long as stocks, on some measure, are not too expensive, growth prospects are reasonable and risk is generally thought to be low, markets generally do well.
The past three years in global equities have mostly been about the first factor. Stock prices got so high during the bubble years of the late 1990s that no plausible combination of growth and risk prospects could possibly justify the resulting valuations.
It has taken three years but most of us reckon that UK equities now offer good value (but there are still a lot of questions asked about US equities, which are certainly not cheap).
So now it comes down to growth and risk. The first couple of months of 2003 saw equities fall, largely because of the risks associated with Iraq. But growth also played a part with forecasts of company profits for this year coming down fast. This was in part linked to war risk, as it has been painfully obvious on both sides of the Atlantic that spending decisions have been affected. Consumer confidence is falling, hitting retail sales, and businesses are postponing capital spending decisions. No good news for equities in any of that.
The recent rally has mostly therefore been about falling risk, as markets once again bet on a short and successful war, or some other equally benign outcome. If this line of reasoning is correct, this process must be close to running its course. Once a successful outcome is priced in, it cannot do so again. Should the market's attention return to growth prospects, it will find little to cheer about, unless more interest rate cuts from the world's central banks encourage investors to believe that the economic slowdown that is currently under way will be very short lived.
Of course, markets can overshoot and do entirely unpredictable things. Many of us thought that stocks were expensive in the late 1990s but they simply kept on getting expensive for much longer than any of us thought remotely possible.
In the immediate aftermath of September 11th there was a huge rally in stocks, despite a marked deterioration in the economic indicators, as investors chose to look through the slowdown and bet that growth would improve sufficiently to justify higher stock prices.
They were wrong. If stocks continue to rally from here in any significant way, they will need to see a quick bounce in the global economy to justify valuations.
The law of unintended consequences may have wider effects other than on growth. Last week, all the talk in London was about whether Tony Blair's term of office was coming to an end. Now, some people are drawing the comparison with Margaret Thatcher around the time of the Falklands conflict. Mrs Thatcher went into that war in a relatively weak position. She emerged much stronger, purged the cabinet of her enemies and embarked on a decade-long period of structural reform of the UK economy.
It is just possible to imagine something similar happening this time around. Tony Blair's position could be strengthened in a similar way and he might just be tempted to get rid of those unreconstructed socialists who stand in the way of his modernisation programme.
Once the Iraqi crisis subsides, and provided Mr Blair survives, he will have to turn his attention to the domestic agenda and the economic reforms that he has promised. Gordon Brown - widely blamed for hitting the stock market with bad tax reforms - has been very quiet recently, but he is now widely regarded as the most unreconstructed socialist in the cabinet and the biggest obstacle to market-led reforms of, in particular, the National Health Service (NHS). It is hard to see him being booted out of the cabinet but the thoughts of a more friendly Chancellor must be tempting Tony Blair.
Chris Johns is chief strategist with ABN Amro Securities, London.
All opinions expressed are entirely personal.
cjohns@eircom.net
