Wednesday, April 20, 2005

The deflation blues are back

I’ve followed the markets for over ten years. Rarely have I seen a shift in sentiment as sudden and dramatic as the one that has taken place over the last two weeks. Let me elaborate a bit (a bit?!? Ok, this will take a while, so bear with me).

Last month, everyone was worried about high oil and raw material prices –the by-product of strong growth in the U.S. and China—and the impact they were having on inflation. As a result, interest rates rose significantly in the U.S.: the yield on 10 year T-bonds went from 4% to 4.6%. By itself, this didn’t do too much damage. Equity prices hardly budged, which proved that investors were mainly concerned with the growth prospects for profits. However, higher rates did have an impact on rate -sensitive sectors, such as emerging markets and financial stocks.

Also, the jump in interest rates finally put an end to the downward trend in debt risk premiums (a definite negative for stocks), a point emphasized by GM’s warning on its financial outlook.

In April, this scenario changed radically. A string of negative economic reports –led by lower than expected growth in U.S. payrolls and retail sales, as well as underachieving earnings numbers in some leading firms (IBM)—led investors to question the growth prospects for the U.S. economy. Consequently, stocks plunged and bond yields drifted lower, along with energy prices.

How could the economic picture change so suddenly? After all, short term economic indicators are notoriously noisy and it may well turn out to be an unfounded panic sell-off.

Yet…I don’t know. A good starting point is to go over some facts:
1) The U.S. consumer, literally the linchpin of the world economy, is tapped out. Personal savings have fallen to nearly zero. This means that from now on consumer spending can only grow in line with employment and earnings growth. These two variables in turn depend on the willingness of firms to hire workers.

2) Private investment picked up last year, but still seems sluggish. Firms will not invest much unless they expect consumer spending to grow, specially when many sectors are still burdened by excess capacity left over from the 90’s.

3) Rising labor fixed costs (mainly healthcare premiums) and strong productivity growth have limited payroll expansion.

This looks like a vicious circle. In the last two years, the U.S. economy managed to lift itself in large part due to massive fiscal and monetary stimulus. These options are not in the cards today.

What will happen? Richard Berner of Morgan Stanley argues that underinvestment and underhiring in the US over the 2001-2003 period has left firms with pent-up demand for real assets and workers. He has long argued that it’s just a matter of time before these needs are reflected in the relevant macro stats. If he’s right and hiring picks up, then consumer spending will grow at a moderate clip and investment will follow.

This is a sound and reasonable point of view. However, I have my doubts. The main issue, I believe, is that the U.S. economy needs a spark to get Berner’s virtuous circle going. That’s not going to be easy. For some time now, everyone has been bombarded with articles that talk about how the structural imbalances in the U.S. economy (fiscal/current account deficits) will have to be unwound sooner or later. If you were a CEO at a large firm, does this talk inspire confidence in the future?

Of course not. Not that the analysts in question are wrong: the imbalances are a very serious issue. Things are made much worse by the fact that the U.S. government doesn’t have a real strategy for dealing with these issues seriously. And let’s not forget that there are many other worrisome flash points in the world economy: Europe and Japan remain stagnant and unwilling to reform, the EU may be thrown into a crisis if French voters reject the proposed European constitution, China and Japan are screaming at each other, etc.

BOTTOM LINE: Unfortunately, I’m a pessimist by nature, so it’s hard for me to see the glass half-full. My guess is that U.S. growth will disappoint this year. Given that, will Asian money keep flowing to the U.S.? In the end, the world economy can only attain a more sustainable position if Asia saves less/consumes more. Lower U.S. growth will eventually force them to this, but frankly I don’t know how they’ll be able to pull it off.