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Wednesday, Aug 21, 2002

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US economy and markets: Improving prospects

S. Balakrishnan

ON Monday, the Dow came roaring back to within striking distance of 9,000. This happened despite the big fall in the index of leading indicators on the US economy released the same day.

Markets are, of course, not anything, if not forward-looking. Thus, the pallid GDP report, drop in consumer confidence, and deceleration in industrial production have not dampened the "animal spirits", as much better times are seen ahead.

The combination of record low interest rates, near-zero inflation and rising productivity that we have now is unique in the last few decades. True, the US has just gone through an asset bubble. The shares of Internet and telecommunication companies rose beyond all reasonable canons of valuation. Yet, the technological fact is that we now have a "borderless" world. The implications of this for expansion and integration of markets at ever-lower costs are obvious and only now beginning to be realised.

Thus, plenty of winners are set to emerge out of the ashes of the stock market collapse in the last two years. The "smart" money has, in fact, already started to move in.

But pessimism still abounds. There is the theory that recoveries from asset bubbles take more time than from normal economic and business cycles. Even cyclical recoveries were interrupted by double dip recessions on five of the last occasions.

Two new factors have come into play this time — accounting frauds and the continuous pressure on profit margins in business. Mr Alan Greenspan has referred to the risks to confidence and recovery posed by them. While the first has hopefully been rectified given the stiff penalties and punishments for corporate executives if they falsify accounts, the second is a more enduring matter. Practically all businesses have lost their leverage on pricing because of intense competition and overcapacity. If corporate profits sag, stock prices will follow.

But falling prices also increase market size. A good bit of what is lost on margins should be made good on volumes. Add to this productivity gains and there is a recipe for increased profits.

Interest rate talk has also become cheap. Seven of the US Federal Reserves' primary dealers are leaning towards at least one more interest rate cut this year although it is difficult to see the rationale for that unless there is a meltdown in markets.

The economy-market feedback loop should start working positively soon. The pessimists' fears are exaggerated. Looking back, the present time will seem (regrettably for those who missed it) a historic buying opportunity.

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