Sunny shares defy the gloom

GIVEN the grim mood on global stock markets for much of this year, one might have expected a further lurch downwards this week.

This 'nervous breakdown,' as Sir Eddie George described it on Tuesday, has its roots as much in national security worries as in economics.

A new pall has been cast over the world by the suspected Al Qaeda bombings in Bali, which if anything have brought closer a confrontation with Iraq and all that implies for Gulf oil supplies.

In Latin America, the Brazilians are struggling to prevent an economic implosion, raising interest rates from 18% to 21% in an effort to halt the slide in the currency ahead of the run-off elections for president. The radical Workers' Party leader, Luiz Inacio Lula da Silva, is still favoured to win.

In the US the relentless drive against corporate corruption gathers pace, with former ImClone chief executive Sam Waksal pleading guilty on insider trading charges. This move could drag his close friend, the home making icon Martha Stewart, into the web. Citigroup, the world's biggest bank, has new difficulties with allegations that its Travelers insurance offshoot made 'secret loans' of £438m ($679m) to Bernie Ebbers, disgraced former chief executive of WorldCom.

Despite all this and some disappointing inflation figures in Britain, stock markets in London and New York are powering upwards.

The turning point for global markets came at the end of last week, when two bellwethers of American capitalism, General Electric and IBM, turned in sparkling earnings figures. With around half of the Dow Jones companies reporting results over the next week, there is a growing expectation that the worst may be over for equities.

In Britain, the FTSE is comfortably back at 4100 having touched 3609.9 three weeks ago. In the US, the Dow surged back through 8200 last night.

Most encouragingly this is a self-generated rally without the assistance of the interest rate cut which many in the financial markets have been looking for. A UK rate cut looks less likely with the latest prices figures. These show that the underlying rate of inflation climbed 2.1% in the year to September.

This data brilliantly illustrates Britain's two-track economy. Goods prices continue to tumble, falling 0.9%, whereas the service sector remains as strong as ever, with prices climbing by 4.8%. Even with the latest increase, the Monetary Policy Committee is well within the target of 2.5% inflation set by the government.

So this should not be a bar to rate cuts. But the hawks led by Bank of England deputy governor Mervyn King have been in the ascendency for a long time now on the MPC.

Despite pressure from manufacturers and exporters, it seems unlikely that the anti-inflation resolve is going to vanish.

Bank Governor George is plainly worried that if rates were cut now, to offset the downturn in the global economy, the build-up in household debt and the acceleration in house prices might reach bubble proportions, which would take years to clear through the system. Moreover, George is less than confident that a rate cut would lower the value of the pound and assist exporting industries. As he told an audience in England's industrial North West, it could have a 'perverse effect'.

Still, the warnings of former MPC member DeAnne Julius, who fears Japanese style deflation, should be taken seriously. She was consistently right during her days on the MPC. As for US rates, they will be very dependent on what happens to the Dow. With two Federal Reserve directors showing dissent at the last gathering, it had been assumed that there might be another cut in rates to come, from 1.75% to 1.5%. But that may be less likely now.

The real test for markets is their ability to cope with bad news. This continues to flow. In Europe, there is the endemic weakness of financial institutions from Commerzbank to the Swiss insurers. In the US, Wall Street has been put to the ethical test by New York attorney-general Eliot Spitzer and been found wanting.

Nevertheless, analysts and investors have started to focus on fundamentals. The average price-earnings ratio for American shares has returned to around 15 - which is close to the long term average. So a great deal of froth has come out of share prices.

This may be the start of the fourth quarter rally, on both sides of the Atlantic, which only the greatest optimists had expected.