LOM Weekly Perspectives

Testing time for the economy

It is a difficult period right now, both for U.S. households and how economic growth is going to pan out in the near term. What we had been looking for, since the beginning of the year, was an eventual hand-over in growth leadership from the household sector to the corporate sector. In such a scenario, stronger business spending was forecast to replace weaker consumer spending and maintain reasonably healthy growth, though at a decidedly slower pace than in the first quarter. However, as we had said before, there is nothing smooth and automatic about the process, despite the best efforts of the Fed in providing plenty of liquidity. Firms need strong top-line growth and the expectation of higher profits to induce them to engage in more capital spending. So far, it appears that firms will be late at the rendezvous to take over from households.

On the evidence of the recent disappointing retail sales data and the poor reading on consumer sentiment, it looks like households may have stumbled a bit. This is consistent with a lower growth rate than in the first quarter but not a sufficient reason to project another dip in the economy as a whole. It does, however, merit a bit of concern. Household-sector finances aren’t rosy but they’re not dismal either -- partly because the housing market has done quite well. In addition, for large numbers of the employed population, real disposable income has held up well. But there are two important factors that could still crimp spending growth. First, the job market is not improving fast enough to boost employment, and to raise the confidence of jobholders. Corporations are still in a cost-cutting mood, trying to eke out profits from slow revenue growth. They have to be relentless in applying the squeeze to suppliers and employees, given that the consumer refuses to be squeezed via higher prices.

The second factor is the poor performance of the stock market. It is true that real estate holdings constitute the biggest part of most households’ total wealth. However, wider ownership of stocks, which formed part of the equity culture of the past decade, has also increased household sensitivity to the vagaries of the stock market. This means that there is a negative wealth effect emanating from the poorly-performing stock market. What's more, its impact on spending may arrive with a lag. Novice investors have been exercising patience for a long time now, and some of them are getting somewhat edgy about the lack of positive results. Irrational or not, many people refuse to accept "paper" losses as "real" losses and hope for an eventual turnaround that will restore their original positions. But at some point they may have to adjust to reality.

Others are becoming a little dizzy from all the volatility. They thought they had signed on for a scenic funicular train ride to the summit, but now find that they are on a big-dipper ride instead. It’s no wonder that they are reaching for a bit of safety and security. Cash, bonds and value stocks are in, but we would hasten to add that not every kind of bond or value stock is on the preferred list. Value investing, harking back to the principles of Graham and Dodd, is once again back in fashion. Mind you, it is a modified version of the original analysis, which was formulated for a different industrial structure and is barely applicable now.

There is growing suspicion among the more astute investors about complex business organisations, untested products and technologies, and fancy financial engineering. Proven business models and stable earnings records are preferred. The taste for venture capital funds has diminished considerably, as those who entered after 1999 have been handed punishing losses. Meanwhile, hedge funds are still the rage, partly because most investors are unfamiliar with their nature and strategies

The above dictum has been attributed to former president Reagan. It constitutes valuable advice. When applied to the current business environment in the United States, we note that there is now little trust in management and, moreover, given the distorted quality of the accounting data that some of them issue, it is difficult to verify their claims. So, inevitably, in pricing stocks people are going to apply a risk premium to make up for the greater uncertainty involved. The dodgier the stock the greater the premium required.

During better years, corporate management was quite keen to pass on risk to bondholders by issuing debt and buying back equity. Later, as corporate finances deteriorated, many corporations were shut out of the commercial paper market because their lower credit ratings prevented them from selling their paper to investors. Then the banks became very finicky about lending to firms. Now, bondholders are also demanding a higher risk premium for corporate debt of all grades and spreads have moved further out. In addition, the supply of junk bonds has increased as more and more firms have been downgraded. Leverage is great when the going is good but can really hurt when times are tough. In the last instance, bondholders may have the final say on corporate fortunes. All in all, this has resulted in a greater demand for safe-haven Treasuries, and government budget deficit concerns have been sidelined for now.