The worst is yet to come

THE period since the end of World War II has been littered with stock market collapses. But few have been as deep, prolonged and damaging to confidence as the one currently being experienced on both sides of the Atlantic.

Despite the ruinous fall in the markets, a majority of leading fund managers, who invest on our behalf, believe that there is a great deal more grief to come, much of it out of Wall Street.

We in Britain may feel a long way away from events in New York. But the City of London and Wall Street are connected by an umbilical cord. The same giant firms that call the shots in New York - Goldman Sachs, Merrill Lynch and Morgan Stanley - are the big powers in British finance.

However much we pride ourselves in Britain on operating to higher ethical standards in business and strong governance standards in our companies, it is all but impossible for us to decouple from the mother ship.

The big question many people here have been asking in recent days is when will this 30-month nightmare on the world's stock markets end? Not soon, if you believe the experts

A Merrill Lynch survey of the top fund managers, who control hundreds of billions of pounds of investments, has found that 57% believe that shares in the United States are still expensive, and the profits outlook of U.S. companies - many of which are our biggest inward investors - are poor.

Moreover, even after the slump in the American dollar in recent weeks which has seen it fall to parity against the sickly euro, there is a belief among market experts that the greenback has not yet experienced the worst, with a further devaluation to come.

This realignment of currencies (predicted among others by George Soros, the man who broke the Bank of England in 1992) is contributing to the extreme turbulence being seen across all the money markets.

There is an old Wall Street adage which pinpoints the dilemma of investors. It states that the right time to buy shares is when 'the last bull becomes a bear'. In other words, when all optimism about a stock market recovery has vanished.

That point has yet to be reached since there are large investment funds, including the big Scottish-based insurer Standard Life, who remain heavily invested in shares and have not seen the need to shift large sums of money into safer assets such as cash, government stocks and bonds.

But it has been a nasty fall. Since the London stock market peaked on the eve of the Millennium - on December 31, 1999 - the value of shares in Britain has plummeted more than 43%, or an astonishing 3,000 points on the FTSE, affecting the savings and pension hopes of almost every family in Britain.

The burgeoning fear must now be that this financial market shock, the greatest in a generation, will blow the whole economy off course, making a nonsense of Labour's promise to end the cycle of boom and bust.

Stock markets are considered by many economic thinkers to be a critical forward indicator of economic trends. If this is the case, then Britain and much of the rest of the world could face a torrid time.

Many people have likened the present stampede out of the stock market to that which took place in Japan at the end of the 1980s when Tokyo's bubble economy burst. More than a decade later, Japan is still suffering low growth and trying to fight its way out from a mountain of bad debts.

Gordon Brown believes he has put in place policies to maintain stability in Britain which will let us ride out the economic storms. He was proved right in 1997-98 during the financial meltdown in East Asia and Russia.

Moreover, although share prices shuddered and growth ground to a halt in the final months of last year, after the September 11 attacks, output is still rising and the nation effectively has full employment.

Nevertheless, most private economic forecasters across the Square Mile no longer agree with him. Chancellor Brown is currently sticking with his forecast that British output will rise by up to 2.5% this year and between 3% and 3.5% next year - despite the fact that it is currently expanding by only 1.2%.

Leading City forecasters believe he is way off the mark and growth of 1.5% is the best that can be expected this year, given the global markets turmoil.

What is curious about the present financial crisis is its origins. Most shocks to the international economy in recent decades have been caused by big global events such as the oil crises of 1973 after the Yom Kippur war, the Iranian revolution in 1979 and, most recently, September 11.

The present problem is more insidious. It has been a gradual process which began with the implosion of the telecoms market and dot.com bubble two years ago and has since crept across corporate America.

Corporate scandals have deepened the distrust of investors who have realised that the profits being reported by American companies are no longer honest.

In the wake of the seismic scandal surrounding the energy group Enron, the Securities & Exchange Commission, America's financial regulator, ordered 945 chief executives and finance directors to confess to any shortcomings in the way they present their profits and accounts by August 14.

Those who sign off on clean accounts, which are subsequently proven to be wrong, would face prosecution for fraud. This vast investigation has cast a pall over the whole of corporate America.

It also exposes a statistical weakness in the way America measures the size and speed at which its economy is growing. Profits are one of the key components of gross domestic product or national wealth.

If it is shown that these have been overstated, then it is also possible that America's glorious decade of growth in the 1990s, when President Clinton was at the controls, was not as shiny as was perceived.

Here in Britain a similar exercise has been going on behind closed doors. The independent directors of the biggest firms have asked the auditing firms to recheck the accounts for any possible flaws. Informal reports back so far suggest that there is nothing fundamentally wrong with the way in which British companies present their accounts, so investors have little to worry about.

Despite this, many of the biggest UK investors decided some time ago that share prices, linked to inflated valuations in the United States, had become too high and it was time to get quietly out of stock markets and invest in safer havens like cash and bonds.

The Boots pension fund blazed this trail, and last week it was revealed that even the London Stock Exchange's own pension fund was also abandoning shares in favour of more cautious investments.

The first bears escaped the market with nothing less than a few scratches. Now, however, the rush to the exit has become a mad stampede - which might yet shake the very foundations of Western capitalism.

Alex Brummer