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V. Anantha-Nageswaran

The coming year could turn out to be as challenging as the last few for global economies and financial markets. It is good to be prepared for the worst while carrying the hope that the world would be luckier, says V. Anantha-Nageswaran.

IT MAY be time for the next set of employment figures to be released in the US. However, it is important not to miss the significance of the figures for November. To a large extent, the employment picture and the consumer response to it, are going to shape the US, and the global economy next year.

US employment figures for November came close to painting the real picture of the labour market. Unemployment rate climbed back to 6 per cent. New jobs were not added but existing ones were shed. Hours worked in the final quarter remain flat and the number of industries adding new jobs is still less than thoseshedding jobs.

While employment is usually deemed a lagging indicator, in reality, it could also have useful information value about business prospects. Rising unemployment suggests that businesses do not view the chances of a rebound in business conditions as very high.The number of workers who have remained unemployed for more than six months has jumped dramatically over the last one year. In the US, workers who remain unemployed for more than six months lose their unemployment benefits (from 1.1 million in November 2001 to 1.7 million in November 2002). That this is turning out to be one of the weakest recoveries has obvious implications for consumer spending and the economic recovery in the US next year. Aggregate hours worked in the economy (one year after the recession) are actually lower now than they have been at this stage of an economic recovery in the past forty years (see chart).

Consumers turning markedly cautious

True enough, since Thanksgiving, mortgage-refinancing activity has tailed off sharply as have applications for new mortgages. Weekly chain store sales for the week ending December 10 (Bank of Tokyo-Mitsubishi Index) showed a drop of 2.3 per cent week on week. That is quite a substantial decline over such a short period. Consumers, on looking at their credit card statement and monthly debt servicing payments, appear to have decided to pull back from the abyss. This is also revealed in the ABC News Money Magazine Consumer Comfort Index that is at a historical low.

Given all of these, we are not willing to attach a much higher degree of importance to the November retail sales in the US. Excluding autos, sales were stronger especially boosted by sale of home furnishings and durables. November includes post-Thanksgiving sales and, hence, analysts might have underestimated the impact of aggressive discounting by retailers. Subsequently, these sales have tapered off. Indeed, we reckon that November sales might have sliced off December retail sales, possibly rendering it substantially weaker. In any case, the aggregate dollar value of retail sales in November came in below consensus expectations. That is, the larger decline for retail sales in September (-1.5 per cent versus -1.3 per cent earlier reported) means that November sales figures came off a much lower base. Therefore, retail sales in November are actually lower than expected.

If we are correct in our assessment that consumers are turning cautious, it has several implications.

Fed funds rate may head further lower

One, it means that the Federal Reserve may not be finished cutting rates. Indeed, it could very well be possible that the Federal funds rate drops to a level of 0.75 per cent in the first half of next year. This is not priced in. Federal funds rate futures discount a flat funds rate for the first half of next year. Two, it means that there is more life in the bond market than is priced into consensus in recent weeks. Indeed, we now see the 10-year bond yield re-testing its lows of early October. Three, it means that recent dollar weakness accelerates as net yield on money market assets turns negative. Four, it means that earnings expectations for S&P 500 for 2003 have to be revised lower further than is already happening. An economy with a clear lack of growth momentum will not be able to support the earnings expectation on Wall Street.

ECB pessimism on growth may push rates lower

We move on to Europe. In the last one week, views at the European Central Bank (ECB) have turned 180 degrees. The ECB has begun to focus on growth risks rather than inflation risks. The ECB, in its latest monthly report, brought down the range for Eurozone growth by a full percentage point to 1.1 per cent-2.1 per cent from 2.1 per cent-3.1 per cent. It also played down inflation risks. This is the clearest possible indication that the ECB is not finished lowering rates.

Euro poised to move to 1.05

That the euro managed to shrug off this big reduction in growth expectations coming from the ECB is a significant development. It appears that the market has welcomed the new realism in the ECB rather than reacting negatively to the prospect of lower euro yields. Further, the decision by the German Chancellor to extend shopping hours on Saturdays is a symbolic reform measure and suggests that all hopes for structural reforms in the Continent (that the ECB continues to insist on) are not lost. We reiterate now our new target for the euro at 1.05 against the dollar in the next few months.

Cyclical prospects grim in Japan

The Bank of Japan released the survey of business conditions for December known as the Tankan survey. Superficially, business conditions for large manufacturers remained weak but did not deteriorate. However, the survey does not give many reasons to anticipate a cyclical recovery in Japan. Businesses of all hues and sizes continue to project a decline in investment spending next year. Excess capacity is expected to persist and both overseas and local demand conditions are expected to remain weak. Pricing power is not expected to return soon.

Therefore, prospects for an economic recovery in Japan continue to depend on eye-catching structural reforms matched/supplemented by aggressive monetary expansion by the Bank of Japan. The exit of Mr Hayami as the Governor of the Bank of Japan in March could pave the way for aggressive monetary policy action and we expect yen exchange rates to begin to reflect that.

Gold breaks important psychological barrier

Gold has broken many technical barriers in the last two weeks. It is now poised to move higher. Much of the recent resilience shown by gold has to do with rising war risks. However, importantly, it reflects a subtle but clear shift in the rhetoric emanating from the Federal Reserve. Fed officials have clearly signalled their intention to avoid deflation and if that would involve debasing their currency by buying up all sorts of assets (corporate bonds across the yield curve, stocks and real-estate), so be it. They would do it. They would flood the economy thus with liquidity which would mean a weaker dollar. It is the first law of economics that any increase in the supply of a commodity, other things held constant, would erode its value.

We are not passing any moral judgment on the Fed stance. We simply have no means of running counterfactual scenarios to determine which of the two dangers — deflation or a drastically a weaker dollar and possibly higher bond yields (despite the Fed efforts to target bond yields across the curve) — imposes higher economic costs on the US and on the globe. Somehow, we reckon that financial assets will thus inevitably be marked down in any scenario that is likely to unfold in the US. Hence, we continue to stress the importance of gold (or, gold related stocks and funds) for any portfolio.

Easier central banks not positive for equities

The scenarios that we have painted above do not necessarily translate into a bullish stance for equities. Inflated earnings expectations across the globe, particularly in the US and in Europe, do not provide much room for a bullish stance on equities. As the well-known Asian equity strategist of CLSA, Mr. Christopher Woods, told the author once, low (and falling) interest rates are not a cause for celebration (as Wall Street is used to and still interpreting) but a symptom of a disease of weak and falling nominal demand. A bubble-stricken economy simply needs time and balance-sheet repair to re-emerge healthier. To the extent low interest rates prevent such repair work, it, perhaps, does a disservice by the economy.

A sobering reminder on equity valuations

Sanford Bernstein — an independent research firm in Wall Street whose (ex) chief Sally Krawcheck has been head-hunted by Mr. Sandy Weill of Citigroup to head Solomon Smith Barney research — had these observations to make on the equity market valuations while analysing the chances of losing money next year (a fourth year in a row) through a value-at-risk analysis:

"With the equity markets approaching their third successive year of negative returns, it might be reasonable to assume that a brighter period is around the corner. We analysed this likelihood by using traditional value-at-risk tools that quantify the probability of exceeding a stated level of return based on a given return expectation and a measure of volatility. We found that the expected return of each regional equity market has risen since the peak, but not as much as one might think, given the decline in interest rates. In addition, the probability of having negative returns in the following year has not eroded significantly, because the modest increase in expected returns has been offset by continued high volatility... These results are consistent with our analysis of market valuations (based on normalised earnings power), which suggests that current levels are close to their long-term averages; thus, without a cushion for valuation, the risk of negative returns is still elevated" (Source: Global Equity Portfolio Strategy, November 2002, page 26, Bernstein Research).

With the war on Iraq increasingly looking inevitable and with the Palestinian crisis in West Asia remaining unresolved, the world has to gear up for continued and possibly, intensified terrorist backlash next year. Hence, geopolitical risks impose their additional hefty risk premium on financial assets. At the minimum, 2003 could turn out to be as challenging as the last few years have been, for global economies and financial markets. It is good to be prepared for the worst while carrying the hope that the world would be luckier.

(The author is Director in charge of global economics and asset allocation in Credit Suisse, Asia-Pacific. The views are personal. Address feedback to nageswar@singnet.com.sg)

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