LOM Weekly Perspectives

Markets digest nasty dose of reality

Disagreeable U.S. payroll data, last week, spooked equity markets that were already feeling jittery due to concerns about earnings prospects.  Some cheery folk on Wall Street tried to look past the data, saying that it is normally a lagging indicator.  They forgot to mention that in the new, more flexible economy with just-in-time labour, employment conditions do not lag to the extent that they did previously.  In other words, it is becoming more a coincident than a lagging indicator.  The more sober observers considered the dismal job market figures as further indication that after the largely inventory-related boost to growth in the first quarter, economic performance for the rest of the year is not going to be as rosy.  This means that forward earnings expectations have to be revised in a more realistic direction, and given that there is no further lift to come from declining interest rates, equity valuations are going to be questioned.  Mind you, there could still be further attempts at rallies, which are likely to fizzle unless momentum-seeking money tries to back the surge.  Meanwhile, insider selling among the Dow companies -- remembering that this is the best performing of the big-cap indices -- has increased.

Creeping disenchantment with U.S. model

In the eyes of international investors, the prospect of a quick rebound in the U.S. economy is beginning to diminish and their gaze is turning towards other, potentially attractive, places.  The American model was the darling of investors for many years and even as it became tarnished they were willing to give it the benefit of the doubt.  Increasingly, they are becoming less forgiving of any blemishes and unwilling to pay top dollars until the imbalances have been corrected and the shine is restored.  The U.S. model has evident strengths, in terms of technological know-how, flexibility and innovative capability.  But it has also developed some imbalances and excesses that have not been properly expunged from the system, yet.  In addition, the odour of management indiscretions and creative accounting has not dissipated.  To those who expected a "normal" rebound in U.S. equity markets in this recovery, based on past experience, we can only say that it was not a "normal" recession.  The policy decision to soften the recessionary blow via substantial fiscal and monetary easing lengthened the adjustment period and distorted the re-pricing of assets.

Productivity growth

We have seen that U.S. productivity growth has held up remarkably well during the slowdown in activity, and this has been due in large part to the determination by corporations to implement cost-cutting and efficiency measures.  Not all the gains helped the bottom line, because some of it was shared with labour, through higher incomes, and some with consumers, through lower prices.  At best, corporations only managed to lower losses or eke out meagre profits, in a difficult environment.  At the same time, they have kept a pretty tight lid on capital spending.  All of which looks sensible from the viewpoint of the individual firm but has nefarious effects in aggregate terms.  Cost cutting includes a large dose of layoffs, which reduces spending power among households, and saps their confidence.  Meanwhile, lower capital spending diminishes the sales prospects and profitability of firms in the capital-goods sector, and has additional downside multiplier effects.  High rates of spending on investment goods would introduce a virtuous circle of sales growth and profitability.  However, to kick-start the process individual firms would have to feel comfortable that there are prospective profits down the line from the extra investment spending, and take the plunge.  That confidence is still lacking, but will return is due course as capacity is used up and competition to keep up with rivals looms larger.

Monetary policy

The meeting of the FOMC, this week, is generating a lot of yawns among observers.  Most analysts have recognised that the Fed will sit on its hands for a good while until it can see better signs of balanced growth -- namely, more capital spending to replace flagging consumption expenditure.  However, timing monetary policy to achieve this is not as easy as it looks.  It is essentially an exercise in fine-tuning that has not worked particularly well in the past.  Moreover, the world isn’t going to stand still for the Fed to act as it pleases, when it chooses.  If U.S. asset prices are considered too high, in the eyes of foreign investors, then one way of cheapening them is through a lower dollar.  A modest currency slide would generally be good for growth and a little bad for inflation.  But if the dollar starts to fall rapidly, then matters could become considerably more complicated.  This could force interest rates up fairly quickly and hit the household sector, jeopardising the recovery.

Policy measures are often overdone and must subsequently be reversed in the opposite direction.  A reading of recent history appears to confirm this contention.  Witness the easing cycle after the Russian and LTCM crises in 1998 and the further boost to liquidity to address Y2K concerns in 1999, which fed the stock market bubble.  And, all the while, beneficiaries on Wall Street were full of praise for Greenspan's wisdom and the achievement of a Goldilocks economy.  In fact, this sort of policymaking introduces distortions in asset prices and results in overshooting, which can cause a lot of damage when there is a correction.