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V. Anantha-Nageswaran

If the Federal Reserve decides that deflation risks have got out of hand it may unleash the weapon of deflation destruction — the printing press — and target interest rates all along the yield curve and not just the Fed funds rate. It is deficits vs. deflation for US bond investors, says V. Anantha-Nageswaran.

GLOBAL equity markets began their war-related rally on March 13. At that time, only one of the many oversold indicators was flashing an `oversold' signal. That was investor sentiment. Volatility indices, insider interest in buying, the ratio of puts/calls on the market were either neutral or bullish. This mostly explains why we did not anticipate the move in equity markets.

With equities selling off this week on the news of the US-led troops facing stiffer resistance than expected, it does not mean that markets are now headed south in the short term. A week of more positive news for the US and allies would turn sentiment around again. Simply put, equities are bound to be volatile. We do not think that standard oversold or overbought indicators would work at this stage.

Short-term rally reinforces long-term bearishness

Nonetheless, we continue to hold our long-held view that equities in the US remain overvalued and the rally up to March 21 provided a good opportunity to further reduce equity positions.

There is no change in that view. Standard and Poor's reckons that nearly $12 have to be reduced from expectations for S&P 500 Earnings per share this year to account for under-funded pensions and expensing stock options. That would bring the consensus forecast of $40 for GAAP earnings down to $28 and the prospective P/E ratio of S&P 500 would be 30. This is not what one finds at the end of bear markets.

Pension under-funding issue is huge. Corporate pensions, having invested in equities during boom years, now face a cash shortfall, which companies have to make up. This problem is compounded by the fact that companies have actually used up unearned pension income to improve their income statements.

Due to accounting rules that permit companies to assume a return on their pension funds (aim: to smooth volatility in pension funds earnings), some thirteen companies on Wall Street were able to convert an actual loss of $30 billion into a gain of $8 billion and use it to shore up their profit and loss account last year. This problem could get worse if corporate profits do not recover soon. That is what some fear now.

The Merrill Lynch chief economist, Mr David Rosenberg, points out that the nominal GDP growth rate of 4.2 per cent last year does not support consensus Earnings per share growth rate forecast of 16 per cent for this year. He adds that while pre-tax profits in Q4 surprised with a 3.3 per cent sequential gain, almost 60 per cent of the increase came from one sector — wholesale trade — and the rest from energy and transport/utilities.

"In other words, all of the earning growth came in sectors that collectively account for 13 per cent of the profit pie — the remaining 87 per cent generated no earnings growth at all last quarter" (North America Morning Market Memo, Merrill Lynch, March 28, 2003). He also adds that the nominal GDP growth rate of 4.2 per cent does not necessarily cast the 30-year Treasury bond yield of 4.9 per cent as too low.

Further, as the Lex column in Financial Times (March 25, 2003 Asia Edition) points out, if equity investors expected a more normal cyclical recovery, they should have bid up steel and construction materials stocks. Instead, in the US, the most actively traded stocks in the rally were the technology majors — Microsoft, Intel and CISCO.

This merely confirms that investors remain steeply in denial. They do not remember that a new bull market has never begun with the leaders of the previous bull market in charge. That they gravitated to technology stocks, when they anticipated a swift end to the war betrays their yearning for a return to the more familiar and more profitable days of the late-1990s.

Indeed, the incredible rally in American and European equities before the onset of war revealed an extraordinary mindset in the market that moved to price in only one of the many possible outcomes to the war: A quick and victorious war for the US, regime change in Iraq, Iraqis living harmoniously ever after in a democracy and showering the US with cheaper oil in gratitude. The bull market in equities might have gone but the bull market mentality lives and is vigorous. As long as it is the case, the real bull market will not return for a long time.

War scenarios gradually getting complicated

As for the war itself, it is not a surprise that most Iraqis did not see the US-led troops as liberators to the extent Washington had hoped. The US had not positioned itself as such with its pre-war utterances and its decision to commence aggression without UN authorisation could not have won many converts within Iraq.

The massive missile attacks in Baghdad might have left many with mixed feelings towards US-led troops as they saw symbols of their country being reduced to dust heaps in minutes.

Thus, the lack of positive reaction from the Iraqi civilians to the American-led troops reinforces our apprehension that the post-war transition to a more normal regime in Iraq, overseen by the US, would be fraught with difficulties. Consequently, there is no change in our view that we expect geo-politics to complicate economic healing globally, particularly in the US.

For bonds, it is deflation vs deficits

Even without geopolitical complications, we continue to believe that the process of balance sheet adjustment in American households and corporations and stabilising pension fund assets would lead to weak consumer and capital spending and thus continue the pattern of below-potential economic growth in 2003, extending into 2004. This would push inflation rate even lower. Core consumer prices (excluding food and energy) have risen at an annual rate of 1.8 per cent in February, down from a recent peak of 2.8 per cent in November 2001. This is a 37-year low. We expect the core inflation rate to continue to drop. The reduction in core consumer prices in recent months confirms the absence of pass-through effects from higher input costs, particularly energy and steel.

Further, this confirms that higher input costs are crushing margins rather than inflating end-user prices. Thus, we see tremendous pressure building up on profit margins in the manufacturing sector and elsewhere. Therefore, we expect the first quarter earnings announcement season that starts in two weeks to be a disappointing one. Outlook for second quarter too would be uncertain and cautious, at best. In such an environment, we continue to expect the US treasury bond yield to resume its downtrend after a sell-off that saw the 10-year Treasury note yield to jump by 55 basis points. We expect the US 10-year Treasury yield to re-test 3.5 per cent in the course of this year. However, we are aware that, over the long-term (in 2004 and beyond), the fiscal deficit issue looms large. With every passing day, the issue of fiscal deficit assumes dangerous proportions. It is deficits vs. deflation for US bond investors.

Goldman Sachs has just increased its forecast for US budget deficit for the fiscal year ending October 2003 to around $425 billion (from $375 billion) and to $450 billion for the fiscal year ending October 2004 (from $425 billion). The official estimate of the Congressional Budget Office is $246 billion and $200 billion respectively. For now, we expect the deflation angle to exert more influence on bond yields. However, we will have to keep our eyes open for a shift in the bond market concerns from deflation to deficits. As deflation persists, the printing press will come into play. This could very well occur when (note, not if) the US Federal Reserve decides that deflation risks had gotten out of hand and unleashes its weapon of deflation destruction, that is, the printing press and targets interest rates all along the yield curve and not just the Federal funds rate.

The methodology has been well flagged by the Federal Reserve Governor, Mr Ben Bernanke, in a November speech titled, "Deflation: making sure that it does not happen here". The Federal funds rate would become less important and quantity of money in circulation would be the key.

Such an increase in money supply would tend to depress interest rates to start with but soon, bond markets would be frightened by the spectre of a Federal Reserve trying to incite inflation and a Federal government living well beyond its means. It is a combination that would prove deadly to the bond market. Further, when such expansion of money supply begins, asset market rise. Equities, globally and particularly in the US, and real assets (commodities, gold and real estate) would rise in value. Thus, the emphasis that we place now on bonds and commodities would shift briefly to equities and commodities.

By the time this monetary expansion induced rally in equities runs out of steam (make no mistake, it could be a big one before it exhausts itself), equities would have become far too expensive compared to bonds, setting the stage for a real and climatic finale to the bear market, perhaps in 2004. It would be back to bonds and commodities.

Admittedly, these are early days to look too far down the road on this scenario and end up selling bonds and buying equities. The Federal Reserve would not take such an extreme step lightly and indeed, for the probability of such a drastic action to rise, the war may have to be dragged out, well into May. That would be too much for the fragile US economy to take, prompting the Fed to contemplate extreme measures as above. Watch the war closely now while praying for less casualties on either side.

(The author is Director, Global Economics and Asset Allocation in Credit Suisse, Asia-Pacific. The views are personal. Send feedback to anantha@nageswaran.com)

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