Are equities entering Great Crash territory?

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The present toxic mix of inflationary and recessionary pressures makes for the most challenging economic conditions we have seen in more than a decade.

Should central bankers be putting interest rates up to choke off nascent inflation, or cutting them to stimulate growth? So far, they've chosen to fudge it in a wait-and-see approach.

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Second-round inflationary effects – where workers attempt to recoup their loss of purchasing power with higher wages – have so far been muted, though there are some worrying straws in the wind. Inflationary expectations have risen strongly, and there's plenty of evidence of companies from transport to chemicals and consumer products trying to push through price increases to offset rising energy costs.

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The key question for stock markets is whether the cycle is ending in an inflationary or a deflationary nemesis. Though much has been written and said about the possibility of a return to the stagflation of the 1970s, the bigger long-term threat to share prices would be the deflationary outcome. Experience from the 1930s and Japan from 1990 onwards shows that deflationary influences are profoundly more destructive of equity values than inflationary ones.

Conventional wisdom is that in the long term, shares always outperform bonds, whose value and income tend to be destroyed by inflation. Shares are inherently more risky, but they compensate by delivering higher returns.

In fact this may not even be true in the long term, as statistical analysis tends to focus on stock markets that survive economic implosions and ignores those completely wiped out by them. Yet on shorter time frames it is very definitely not the case.

In the past 10 years (which takes in the boom, the bust, the partial recovery and now potentially the bust again in share prices), equities have returned no more than government bonds. You would, frankly, have done better by sticking your money in a high interest rate bearing deposit account, assuming you could find a safe one.

Certainly you would have done better by investing in housing, as many did, thus replacing the previous bubble in equities with a new bubble in house prices.

That bubble, too, has now gone pop, and with its deflation have come some early signs of the onset of a wider deflationary environment, in particular a growing lack of both supply and demand for credit. The present dash for cash among investors if it takes hold must logically result in some perverse outcomes, with interest rates eventually falling because of the paucity of demand for credit or capital for business expansion.

One equity strategist who is firmly in the deflationary, ultra-bearish camp is James Montier of Société Générale. "Debubbling" is the word he has coined for the present unwinding of bubbles in the credit, property and equity markets.

In support of his thesis that we are in for a long and very serious bear market, he cites some worrying parallels with 1929. Then, as now, conventional analysis initially regarded the crisis that engulfed financial markets as a temporary phenomenon that was unlikely to have any prolonged effect on the wider economy. There was a generalised refusal to believe that the golden era of prosperity which had characterised the previous decade had drawn to a close. Policymakers were in a state of denial, and so too were many investors, resulting in a series of sharp rallies – or sucker's rallies – as the stock market descended into the abyss.

Is history about to repeat itself? We've already seen it happen with the Japanese stock market. Though I wouldn't place myself in the Montier camp, the possibility of it happening in America and Europe, with investment in productive assets plunging to levels synonymous with a depression, shouldn't be discounted.

A worrying aversion to equity investment is fast asserting itself. Even so, it still doesn't look to me like the way to bet. The world is a very different place from the way it looked in the interwar years. Political instability and protectionism were arguably more important causes of the Great Depression than the "debubbling" that took place in financial markets.

Undoubtedly the developed world is in for a very difficult couple of years. Living standards will get squeezed, unemployment will rise and equity markets must logically suffer along with all other asset classes.

At the bottom of the last bear market five years ago, Edward Bonham Carter, chief executive of Jupiter Asset Management, said that it would take until 2010 for the stock market to return to its turn of the century peak. At the time, this seemed unduly pessimistic. If anything, it now looks on the optimistic side. But in the round it seems about right.

A similar period of sideways trading took place from the mid-1960s. In that case it was 17 years before the Dow broke free of the rut it was in. A prolonged period of adjustment, rather than an outright crash, still seems to me the most likely outcome.

But who knows. Mr Montier may be right. As things stand, the newsflow certainly seems to support his doom-laden prognosis. The latest consumer confidence and house price data from the US are among the worst on record.

http://www.independent.co.uk/news/business...ory-854373.html