View from City Road: A rest for equities before their next climb

Where are shares going now? After breaching the psychologically important 3,000 level on the FT-SE 100 index, it would be surprising if the market did not take a breather. But the forces that have pushed it up from its year's low at 2,737 have not yet been dislodged. The bears may have temporary triumphs - a market that does not climb a wall of worry should be sold in a hurry - but the market looks well supported. In the longer run, the bulls are likely to have the better of the argument.

The underlying forces driving up shares in London are precisely those that have driven Wall Street for the past few years. If you make alternative forms of investment less attractive, it is not surprising that people switch into equities and that share prices therefore rise. Short-term interest rates are the lowest since 1977, and look much more sustainable at these levels now than they did then. Indeed, they are likely to fall just a little further later in the year.

So money market deposits look correspondingly less attractive. The 6 per cent rate available on three- month money provides a real return for investors who do not pay tax (such as pension funds) of just over 3 per cent, exactly half what it was at the time of Black Wednesday last September. For 40 per cent taxpayers, the calculation is worse: a real rate of 2 per cent has plunged to just 0.4 per cent. Building society and bank deposits look even less attractive. No wonder money is hunting returns elsewhere.

One response to the decline of interest rates is the chase after higher yields over longer maturities. Despite the shadow of a pounds 50bn budget deficit, the gilts market has had a terrific run, with a typical long bond price jumping by 11 per cent since the start of the year. That in turn has driven long bond yields - the fixed interest rate as a percentage of the capital value - down from 8.7 per cent in January to just less than 7.4 per cent today. As bond prices rise and yields fall, shares also look more attractive.

A key question for equities is therefore whether there is more to come in the bond market, where the growing optimism that the Government may indeed meet its long-term 2 per cent inflation target (in which case yields should fall to 4-5 per cent) tussles with the well-grounded suspicion that British politicians are rascally debauchers of their currency (in which case yields are too low). But given the unexpectedly good news on inflation and earnings, and the likely impact on gilts prices of another cut in short-term rates, it would be surprising if the bond market reversed.

The other question for shares is whether the outlook for earnings is as good as the market hopes. The key test will be the September reporting season. While there will undoubtedly be more shocks, such as BOC's profits warning, which stopped the FT- SE 100 from breaching the 3,000 barrier on Tuesday, the run of results - including those from Commercial Union and General Accident this week - give some confidence that the City's demanding earnings targets will be met.

In the current year, investors should get a psychological boost from the absence of the pounds 15bn of exceptional restructuring charges that wiped more than 10 per cent off the profits of UK plc last year. That means that headline growth for industrial companies could be at least 25 per cent - and a still-healthy 15 per cent after stripping out the exceptionals. The need to rebuild cover means dividend growth will lag earnings for at least the next two years. But it should still be comfortably ahead of inflation at about 5 per cent a year.

That does not mean everyone will be a winner. As always, stock selection will be crucial. Regardless of the outcome of the US healthcare reforms, the pharmaceuticals sector looks set to be buffeted by a period of price pressure and investor dissatisfaction and is unlikely to recover from its recent underperformance. Food retailers, the other unfashionable defensive stocks, are likely to remain out of favour as they grapple with the discounters and food price deflation.

Instead, the focus will remain on the metal bashers, builders and other capital goods producers - and if they are heavily geared to the British recovery, so much the better. Far more of those are in the FT-SE 250 index - which is 25 per cent capital goods, compared with just 10 per cent for the FT-SE 100 - which explains why it is up 58 per cent since Black Wednesday compared to just 25 per cent for its bigger brother.

There will also be scope for bargain hunting - and it is unlikely that British Gas will remain on a yield of more than 5.5 per cent, or Allied-Lyons on more than 4.8 per cent for long.

Shares are on a multiple of more than 13 times 1994 earnings, so the market remains vulnerable to disappointment on earnings this autumn. With much of the good news on inflation and interest rates already taken into account, we may now be in for a period of consolidation until more solid evidence of company performance comes through.