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V. Anantha-Nageswaran

ON WEDNESDAY, the US Federal Reserve left the funds rate unchanged after lowering it from 6.5 per cent to 1.75 per cent in the course of 2001. The decision was widely expected and hence the market reacted favourably. The Fed is tentative about the economic situation and feels conditions are weighted more towards weakness than inflation.

Absence of nominal demand, pricing power

The Fed was correct in its judgment. GDP growth figures for the fourth quarter released the same day confirmed the deflationary conditions in the US. Real GDP grew by 0.2 per cent in Q4, 2001 whereas expectation was for a contraction of 1.1 per cent. However, the deflator was negative (that is, instead of prices rising, they contracted) and therefore, nominal GDP growth was a negative 0.1 per cent compared to expectation of 0.6 per cent. As elsewhere, the US economy lacks pricing power and, hence, analysts' expectations of margin improvement in 2002 might be somewhat excessive.

Capital expenditure no growth driver

The economic slowdown the US went through in 2001 was related more to the crash in investment spending after an unprecedented expansion in such spending from 1996 to 2000. That collapse is now nearing the bottom but would take considerable time before it begins to contribute vigorously to growth. Even in Q4, business equipment and software spending contracted 12.8 per cent on an annualised basis.

Capacity utilisation in the technology sector is showing signs of stabilising after sharp declines through 2001 but it is far from being closer to levels that would signal pricing power for producers and suppliers.

Spending got fast-forwarded into 2001

On consumer spending side, this recession was quite exceptional. Consumer spending held up quite remarkably. Buoyed by low interest rates and exceptional offers, consumers bought more houses and automobiles. As such conditions withdraw, consumers could phase out their spending in 2002. It is reasonable to infer that much of the spending that took place in 2001 was 'borrowed' from 2002.

At a macro-economic level, the consumer debt-servicing burden has not improved as it usually does during economic slowdowns. Normally, households take a hard and closer look at their personal balance-sheets during economic contractions and increase savings, as the decline in income reminds them of the dangers of overspending. During 2001, wage growth held up quite remarkably at around 4 per cent — unusual for a recession year — and lower interest rates supported further borrowing. This is not clearly sustainable for an economy. Here is why.

Private sector cannot continue to dissave

The US Government ran huge fiscal surpluses through the 1990s and, hence, the private sector could merrily borrow. The nation as a whole, for sure, imported capital, to meet this appetite for borrowing. However, such borrowing was lower than it would have been, had the Federal Government too been a net spender and not saver.

That may not be the case in the future. The Congressional Budget Office (CBO) had sharply lowered the budget surplus projections for the next 10 years from $5.6 trillion to around $1.6 trillion. Even this surplus is contingent on the growth projections they have assumed for the economy of around 4 per cent real GDP growth in 2003 and around 3 per cent until 2011 after that.

Hence, if the private sector does not mend its ways, the US current account deficit would continue to mount and at some stage, would lead to a major correction in the US dollar that is already cresting the overvalued levels of the yen and the German mark seen in 1995, against the US dollar. Then, many commentators found justifications for the excessive dollar weakness just as they do now, for US dollar strength.

While the economic news out of Japan continues to show deterioration — threat of a further downgrade by Standard and Poors, absence of bank reforms and record-high bankruptcies — such is not the case either in the UK or in Europe. The unemployment rate did not rise in continental Europe and in the UK as much as they did during past slowdowns and indeed, the UK could claim to have avoided the slowdown altogether. While the European structural problems are well-known, at the margin the US fundamentals are the ones that have shown the most serious deterioration in the last one year, as discussed above. I have not talked about Enron and the credibility issues with the US corporate sector! Hence, dollar strength against the European currencies, especially the recent rally, begs a reasonable explanation.

Hence, we would change our emphasis on shorting the yen against the USD, to shorting the yen against European currencies — the euro and the sterling.

Writing off bonds this year could be a folly

Bonds began to sell off when the first signs of recovery began to emerge in the US. Federal funds futures now discount a 75 basis point increase in the Federal funds rate by September of this year. That sounds rather steep. There is absence of pricing power globally. With both the unemployment rising and capacity utilisation rates low, isolated pockets of inflation do not mean acceleration in inflation. Furthermore, a tepid global economic recovery would keep oil prices firmly bottled, notwithstanding OPEC attempts to cut production. Indeed, one could argue that central bankers have to start thinking of abandoning their 'inflation targeting' framework. That is a topic for another occasion.

While dollar bonds could be examined only carefully due to currency risk, bonds in Australian dollar and New Zealand dollar, at the short-end, offer a much higher yield than dollar corporates. Many investors have been disappointed by the inability of these two currencies to rally at all. That was especially the case in 2000. As long as the US sucks in global capital, other capital importing nations will have to contend with weaker currencies. However, the downside risk for these currencies is rather limited at this stage. The logic applies with equal force, if not greater force, in the case of the sterling.

Outlook for equities

In the first month of the year, Asian equities dominated the world (see chart). Beyond a point, without support from American equities or from domestic demand, this recovery would stall in Asia. However, this is not imminent and quite some time away. For now, the recovery is boosted by abundant domestic liquidity, possible capital outflows out of Japan, an end to the bottoming process in the US and low valuations. These sets of factors would continue to support Asian equities. One should be clearly positioned in Asian equities.

Once the positive impact unleashed by these favourable factors begins to weaken, investors would look for structural reforms in genuine disposal of non-performing loans and sustainable economic growth, fuelled by domestic demand and not just demand for electronic goods from the US.

Korea is moving in that direction clearly and it is not clear that others are consciously embarked on such a path.

Japan remains a risk. But then, it is a risk for global markets and not just Asia.

The US, having experienced a strong recovery post-September 21, is struggling to maintain the momentum and justifiably so. Short-run indicators show that the market is still slightly above fair values and that investor sentiment is not weak enough to recommend aggressive buying.

In the short-term, one should look out for opportunities to sell and remain patient to buy. Long-term, there is worrying deterioration in fundamentals as discussed above. We have to rely on specific stocks that rely on their individual corporate strength, market leadership and other unique fundamentals. They might emerge from the technology sector or elsewhere.

One needs to balance these considerations with valuation parameters — low beta, low price-earnings ratio, high dividend yield. Stock-picking in a directionless market is more challenging than in a rising market, which exaggerates the acumen of those who pick stocks.

This might not sound very original but it is a frustrating fact we have to face up to. There are no overarching or dominating themes that stand out and scream for our attention in the world of financial market investing, right now.

(The author is the Regional Head of Investment Consulting in Credit Suisse, Asia-Pacific. The views are personal. Feedback can be sent to nageswar@singnet.com.sg)

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