So what's happening to shares?

A TOXIC cocktail of worries about higher interest rates, spiralling oil prices and escalating tensions in Iraq has smashed investor confidence and driven the FTSE 100 share index below the level at which it started the year. On Wall Street, all the gains made since January by the blue-chip Dow have drained away.

Only a month ago, it all looked so promising as the global economic recovery and improved corporate earnings propelled the Footsie to its highest since July 2002. But that optimism evaporated almost overnight. The words 'equity meltdown' have been bandied around the City in recent days.

The man responsible for much of the gloom is Albert Sharp, global equity strategist at Dresdner Kleinwort Wasserstein, who famously warned at the weekend that the worst stock market crash for 17 years could be days away.

It is a disaster scenario that most analysts do not recognise, but that is not to say the outlook is particularly rosy either.

Weakness in financial markets in recent weeks has been blamed on an unholy trinity of factors: interest rates, oil and Iraq. The all-important US employment gauge - non-farm payrolls - showed 288,000 new jobs were added in April on top of 337,000 created in March, leaving little doubt that the US economy is firing on all cylinders.

Two months ago, the big Wall Street banks were predicting US interest rates would remain at 1% for the rest of the year. After the non-farm payroll figures, an increase at the Federal Reserve's next policy meeting on 30 June looks a shoo-in.

False security

'THE market is trying to climb a wall of worry,' says Stephen Ford, at broker Brewin Dolphin. 'Having reacted with some aplomb to the terrible events in Madrid and the recent bombs in Greece, the focus remained on the prospect of a jobless recovery in the US.

'Now, after two months of strong job creation, the market is worried that the US appears to be creating too many jobs too soon.'

The problem is many investors have taken on too much speculative debt, lulled into a false sense of security by low interest rates and easy credit.

The payroll figures have pulled the rug from under them, forcing them to bail out of riskier assets such as equities and corporate bonds and scramble into safe-havens such as government bonds or gold.

However, many believe the market is fretting too much about higher rates. After all, Federal Reserve chairman Alan Greenspan has said the US central bank will raise them in a 'measured' fashion. Futures markets are pricing in 2% rates by the end of the year - hardly excessive for an economy expected to expand by between 5% and 6% this year.

The second major blot on the landscape is the oil price, which this week hit a record $41.85 a barrel. Concerns are twofold. In the short term, it can boost inflation through higher petrol and domestic heating prices. In the longer term, it can stifle growth because of rising interest rates and industry costs.

The Centre for Economics and Business Research has estimated that 0.4 percentage points will be shaved off world gross domestic product in 2004, and another 0.7 percentage points in 2005, if crude oil prices stay in the $38 to $43 range.

But the Iraq crisis and geopolitical unrest cast perhaps the biggest shadow. David Buik, at City bookie Cantor Index says: 'Markets cope brilliantly with good and bad news but they just have no answer at all to uncertainty and that's what the world has in spades.

Hairy moments

'TRADERS admit that the staggering oil price and its inflationary overtones, plus inevitably rising interest rates on both sides of the Pond, have a bearing on the performance of stocks and shares, but the level of influence pales into insignificance in comparison to the

disruption caused by the chasms of geopolitical turbulence.'

In the face of this, analysts believe investors are in for a bumpy ride for the rest of the year. Brewin Dolphin's Ford says: 'The next six months could be volatile as we move into the summer months. Low volumes, combined with the handover of power in Iraq, the Olympics - a possible terrorist target - and a Presidential election in the US could provide some hairy moments.

'Despite this, we believe that the indices will gyrate around a gradually improving market,' he adds, predicting that the FTSE 100 index will end the year in the 4700-4800 range, compared with 4400 now.

Tony Craze at broker Goy Harris Cartwright says investors should concentrate on picking specific stocks rather than worrying about the market as a whole. 'There are three things to focus on; a good balance sheet, good management team and a decent product and you can't go far wrong,' he says.

'My gut feeling is that the Footsie will end the year higher, at around 4600, but it wouldn't take a lot of bad news to tip it to 4000. If, God forbid, we had a terror attack in central London, you would see 200 points wiped off in five minutes - that's how fragile it is,' he adds.

Keep your heads down

Comment by Michael Clark

CITY investors greeted 2004 with enthusiasm and optimism. They had just accrued their first gains after three consecutive years of stock market losses and it looked as if the UK economy was set to piggyback on a strong US economic revival.

Almost five months later, the enthusiasm has waned and optimism turned to despair. The London stock market has been one of the worst performers among world financial centres. The FTSE 100 index is down 27 points, or 0.6%, on the year. The Dow is down 486 points, or almost 5%, in the same period.

But traders in London are taking claims of a stock market meltdown with a pinch of salt. They admit the outlook is bleak but they also believe the current level of corporate earnings and ratings will limit falls.

Share turnover is way down in recent months. Traders can still make money in volatile markets by jobbing in and out of stocks, but everyone suffers when the situation becomes illiquid. The big fear is that the soaring oil price and rising interest rates will push up costs and eat into profit margins - and mounting inflation will bring with it a drop in companies' competitiveness.

As I pointed out in January, 2004 was always going to be difficult for investors. Nothing has changed, so far, to alter that view. Keep your heads down, folks.