North America

  • As if the, earlier, December employment report wasn’t bad enough, last week we got a number of releases pointing to significant economic weakness. The Beige Book painted a picture of the US economy mired in a "soft spot" - - a jingle originally uttered by Greenspan, who you may recall was careful not to mention how long it would last. Also confirming softness, was a fall in industrial production, accompanied by a rise in capacity use. But the real biggie, that rattled some analysts, was the gaping negative trade balance for November. It depicted a situation good for foreign and bad for US producers. Asian countries did particularly well, with China, Japan and South Korea chalking up hefty trade surpluses.
  • Hopes are still riding high that a nice mix of stimulatory fiscal/monetary policy will do the trick in boosting the economy. The Bush stimulus plan will, naturally, be subjected to much horse trading in Congress before a compromise is hammered out. But if the economy remains moribund we should expect a sizeable package to emerge. Right now, there is not much help coming from other sources of demand. Exports are weak, firms are reluctant to increase capital spending and consumers are at long last beginning to lose some of their ardour.
  • But, what about the tax breaks that households are projected to receive? Well, the amount isn’t too clear at this point in time and, besides, there is going to be some offset from higher taxes imposed by financially strapped state and local authorities. There is a good chance that households will save a high proportion of the sums received, if they reckon that the lofty government deficits created by give-aways will eventually have to be financed by higher taxes. As always, somebody, at some point in time, has to pay for big budget deficits and, in this case, it may not be the foreigners.
  • Of course, those same households have been happily increasing their spending by going into more debt. However, the state of household finances is none too rosy, and every now and then analysts note the heavy debt loads they carry. Corporations have made some headway in de-leveraging but not so the household sector. The day of reckoning has been delayed by historically low mortgage rates, zero-interest car financing and house price appreciation.
  • If fiscal and monetary measures don’t work, then another means of boosting the economy, as well as inflation, is currency depreciation. Are the authorities averse to a pickup in inflation? Not in the least! Politicians - - and Greenspan can be considered a political animal - - are motivated by pragmatism and expediency. What’s better than a good dose of moderate inflation and a fall in the dollar to help corporate profits? Provided inflation does not get out of hand, equities will outperform. Creditors, of course, will do badly and are likely to exact a higher risk premium to cover inflation.
  • The corporate earnings reports, released thus far, have been fairly lacklustre. There is the usual grumbling in certain quarters that firms are still reluctant to report GAAP rather than pro-forma earnings. This is because recalculating pro-forma numbers by accounting for pension adjustments, employee options and one-time charges usually produces a weaker result. In any case, it looks like earnings growth has been largely eked out of cost cutting rather than top-line expansion. One problem with interpreting the meaning of average earnings for the S&P 500 is that it may be biased upward by good results from a couple of big earners like Microsoft. Meanwhile, many of the big corporations have been cautious about the forward outlook, though Wall Street optimists say that this is a deliberate pessimistic ploy on the part of management.

Europe

  • Major Euro-zone countries are currently in a bit of a bind. Their economies have pretty much stalled and structural reform is on hold. Actually, some of the maligned structural rigidities act as stabilisers and prevent further declines in activity. But they also impose a measure of inflexibility that thwarts quick recovery. It is tough for governments to make any headway in carrying out structural reform until growth picks up. Meanwhile, the relative openness of the Euro-zone economy, compared with Japan or the United States, makes it more vulnerable to exchange rate changes and global developments.

Asia/Pacific

  • The Nikkei 225 took a hit in 2002 but is looking a bit more upbeat this year. Foreign investors have been net buyers of stocks for a long while, taking up the supply unloaded by the banks, who are busy unwinding cross-held shares. If the Bank of Japan does indeed implement an inflation-targeting policy, then the outlook for stocks is generally brighter. However, the banks will face problems as their large holdings of JGBs (government bonds) decline in value.

Bonds

  • The downbeat economic data led to a rush back into Treasuries, and while the outlook for the conflict concerning Iraq is uncertain it has, for now, helped a rally at the short end of the curve. There is speculation about another Fed rate cut, not at the upcoming FOMC meeting but in March. In reality, most of the easing is likely to come via a lower dollar.

Currencies

  • The appreciation of the yen may be nearing the pain threshold of Japanese authorities and they are likely to intervene if it shows further strength. Also, euro strength is hurting Euro-zone economies. If major economies remain weak, fears of competitive devaluation will increase. Meanwhile, macro hedge funds that some had given up for dead, a while back, are busy making profitable bets on currencies.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.