Financial Daily from THE HINDU group of publications
Monday, Mar 04, 2002
Columns - Global Finance & Overview
Beyond the big bull market
IT HAS been an eventful week in the US. The Federal Reserve Chairman, Mr Alan Greenspan, made a subdued testimony to the Congress on the outlook for the US economy this year. He virtually signalled that the monetary policy was on hold for the rest of the year. This testimony was closely followed by fourth quarter GDP growth estimate that was substantially higher than the first advance estimate. Thus, the US had actually experienced only one quarter of negative GDP growth and that was in Q3, 2001.
The final icing on the cake came in the form of a strong ISM reading (formerly known as National Association of Purchasing Managers or NAPM Index) on March 1. The index surged well above 50 signalling that the manufacturing sector was in expansion, after a long period of contraction. Stocks closed the week on a very upbeat note. Is this sustainable? A hat trick of double-digit returns unlikely.
Much as one understands the relief in the stock market over the decisive end to the US recession, it is hard to share in their exuberance. If any, these instant relief-rallies only delay or even deny the possibility of a long-term expansion of the US stock market. For this reason, it is almost impossible to see the US stock market repeating its stellar performance of the previous two decades. There will not be a hat-trick.
The Table shows the performance of the S&P 500 stocks over the last seven decades, with and without dividends. It is obvious that the last two decades had contributed substantially to the belief that buying and holding stocks is a rewarding habit. Returns over the last two decades were seen only once in 1950-59.The Economist (February 16, 2002) reported that in late 2001, Boots, a British retail chain that sells prescription drugs, cosmetics and other personal-care products, astonished the world of pension investment by announcing that it had shifted its entire pension fund into high-quality bonds. Why did they do so?
That question is answered easily by answering why we would not have a third decade of double-digit returns in the US this decade similar to the last two decades.
As the dollar is bloated
Two main reasons for this are that the US dollar is overvalued and, second, the US fiscal surplus of the last decade is about to disappear, because of the external circumstances and the ill-advised tax cuts (favouring predominantly the rich) of the Bush administration. We will examine these factors in some depth.
The dollar is now at a level not matched even by the high overvaluation of the German mark and the Japanese yen in the mid-1990s. The yen was as strong as 79 to a dollar and the German mark was at 1.38 at the peak. In terms of real effective exchange rates, the dollar today is at a much higher level of over-valuation than these two currencies.This overvaluation of the dollar would eventually correct itself as the current account deficit rises to unsustainable proportions. An interesting study from the Federal Reserve Board published in December 2000, makes the following observations:
This paper has attempted to provide a brief characterisation of the process of current account adjustment in industrialised countries. A typical adjustment occurs after the current account deficit has grown for about four years and reaches about 5 per cent of GDP. The results from previous episodes suggest that reversals involve a real depreciation of 10-20 per cent and slow real income growth for a period of about three years.
Foreign interest in US assets diminish
Foreign investors who have poured money into the US in the last several years are already beginning to show signs of fatigue. Mergers and acquisitions flows involving American corporations have dried up. In contrast, in the aggregate, foreign portfolio investment into US long-term securities (Treasury and Government agency bonds and notes, and US corporate bonds and stocks) did not slacken in 2001. Foreigners bought a net of $500-billion worth of securities in the US compared to $419 billion in 2001.
Further investigation reveals two interesting trends. Europeans cooled off noticeably while the UK and ex-Japan Asia showed increased fervour for dollar assets. Further, in the second half of the year, the purchases were concentrated in Agency and Treasury securities. Now, as Asia begins to recover, Asian fervour might not be sustained.
The unending controversies surrounding the collapse of Enron and the spell of scepticism it has cast over the entire US accounting system will have a lasting impact on the appetite for US equities.
What would exactly trigger a dollar correction is difficult to pinpoint. What exactly triggered the Nasdaq collapse from around 5000? No single factor was the immediate trigger. One can only say that anything can do it. The timing is uncertain but it is likely to happen sooner rather than later. If the Federal Reserve Board research paper is anything to go by, as US current account deficits heads towards 5 per cent this year, the dollar correction might occur in the second half of the year.
Pillar of fiscal rectitude has already collapsed
Early in his term, the former US President, Mr Bill Clinton, passed an unpopular budget in 1993 that involved spending cuts and tax increases. It was widely denounced by conservatives at that time, for its tax increases. Nonetheless, it laid the foundation for a long period of fiscal austerity that was fortified by economic expansion and the bounty in tax receipts. Fiscal surpluses allowed long-term interest rates to come down and thus supported investment activity. All that is now history.
Partly propelled by external circumstances and by flawed ideology, the Republican administration, in the name of economic stimulus to counter a recession that never arrived, has announced tax cuts that mostly favour the rich. Independent projection of budget surplus by the non-partisan Congressional Budget Office (CBO) has dropped by around 71 per cent for this decade, compared to the projection made a year ago (see bar chart). That is one reason why the long-term interest rate (US 10-year Treasury yield) remained virtually unchanged throughout last year, despite a record 475 basis point reduction in the Federal funds rate.
This has tilted the risk-reward ratio away from equities. Historically too, the Price-Earnings Ratio of the S&P 500 stocks is at an elevated level and the index is not cheap. The broader US indices, unlike the ones in Asia, do not have the support of cheap valuation behind them. Therefore, they will have their good and bad days but a sustainable rally over a longer period is unlikely. If the broader indices go nowhere and give rise to only trading opportunities over shorter intervals of time, how to profit from such a market, if one wishes to stay invested in that market, in the first place? That will be the subject of the next column.
(The author is the Regional Head of Investment Consulting in Credit Suisse, Asia-Pacific. The views are personal. Feedback can be sent to email@example.com)
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