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September 11th and the gathering storm of the conflict in the Middle East continues to have major repercussions on the world economy. Tony Hawkins analyses the current and future situation in the world financial markets, looking to see if there is an end to the bear market

That markets hate uncertainty
 is a given, but when those uncertainties extend beyond economics to the future of the status quo in Europe and of transatlantic relationships, it is hardly surprising that many, possibly most, investors are staying liquid.

Even before the Iraqi crisis split NATO and the EU, fears over the immediate future of the global economy were engendering market panic on a scale not seen since the 9/11 terror attacks in the US. It is not just concern that the world economy is entering the much-dreaded “double-dip” recession mode, but that since 2000, the scales have fallen from investors’ eyes. They – and especially their pension funds and institutional savings – have taken such punishment that a US technical analyst, Robert Prechter, is now predicting that the Dow will fall below 1000 (from 8050 at present) as investors experience the greatest bear market since 1929-32.

These fears were underlined by a study showing that between 1987 and 2002 the J P Morgan Global Bond index outperformed world equities, returning 448 per cent over the period while equities gave a return of 387 per cent. One result of this experience – which runs counter to modern financial theory that equities always return more than bonds – has been to drive pension funds out of the equity market, thereby further depressing share prices. In the UK, a typical pension fund now has 55 per cent to 60 per cent equity market exposure, down from 80 per cent in 2000.ar.”

 

Resilience – so far
In an effort to reassure investors, the IMF’s Global Financial Stability Report (December 2002) insists that the international financial system has remained resilient "so far."

 

 

But, even this organization, with its track record of complacency and understatement, has warned that the “cumulative impact of market declines in recent years” has weakened the balance sheets of companies, banks and households. Indeed, the relationship between stock markets and national economies is a two-way affair. Buoyant economies boost corporate earnings and thereby stock market prices and returns. But a fall in equity prices increases borrowing costs for households and firms, whose collateral is eroded, increases the cost of new capital for businesses and reduces household wealth and thereby consumption.

 

Late last year, the US and European markets slumped to seven-year lows, while the Japanese market hit levels not seen since 1984. In New York, the S&P 500 was 39 per cent below its peak of March 2000, while the fall in Europe (FTSE Eurotop 300) was 43.6 per cent. The subsequent recovery was shortlived, and by mid-February the drums of war had wiped out most of the post-October gains.