We investors are nightwalkers in a dream world, where success is not predicting what economies will do next, but what the markets will dream they will do. So in trying to predict where markets will be by the end of 1998, a realistic starting-point would be to say: we don't know. But, at least, we can outline the critical variables that will make you richer or poorer over the next year or two.
The biggest variable is world growth. What's good for people is bad for the capitalist running dogs. The stronger growth is, the weaker will be financial assets. So the last thing financial markets need is a synchronized, strong world economy. But this year and much of 1998 will deliver just that.
Implicit in this is that I don't think inflation is dead. Stronger growth will bring it out. Global productivity is already falling. Capacity utilization is tightening. And so are labour markets, with US and Japanese labour costs on the up. Service sector inflation is already becoming a problem in some economies.
Sure, inbuilt consumer pricing power will limit price rises. I expect only an extra 1% on consumer inflation over the next year or so. That's mild by most precedents. But it's quite enough to boost short-term interest rates by more than markets are pricing in.
Money is now super-cheap and super-abundant and markets expect this to change little. But central bankers are bound to revert to their conservative mean. So short-term interest rates in the OECD will rise towards their long-term (10-year) average over the next two years. That will be the peak of the cycle - well below the peak of previous cycles, but still above what the market expects.
The US is an unstoppable wealth-creating machine. America's expansion is driven by income gains for corporations and people. The consumer's balance sheet is very strong. Rising financial asset prices have added $3 trillion since the beginning of 1995, boosting personal consumption by 2%. Not only are households rich in net assets, but savings rates are relatively high. And the cost of servicing consumer debt is only average. Short-term interest rates would have to go to 7% to raise the burden of short-term debt to the level where consumption normally slows.
Financial markets think a rise in short-term rates of 50bp to 60bp will do the trick and slow the US economy to steady growth without serious inflation. But I think it will take at least 150bp. A small interest-rate rise may help to slow the US economy, but income gains will win over monetary tightening. In Europe, super-easy monetary policy in the core will triumph over tighter fiscal policies (an average contraction of 0.7% of GDP) and poor income from labour gains (no growth in real terms) as corporations rationalize. So, on a global scale, 1998 will offer stronger, more synchronized growth than in 1997. And that will be big (bad) news for financial markets, because central banks will have to tighten monetary policy further.
Underpriced equity
Current equity valuations give off mixed signals. They are expensive when compared with bonds on a one-year view. But that ignores the fact that historical risk premia don't mirror a world where globalization is improving the efficient use of capital, and the death of Marxism has empowered corporate governance to manage for shareholder wealth. Much the same reason has forced governments to shrink everywhere, leaving room for profits to grow.
The price that investors pay for profit growth encapsulates much of this. And it is not outrageous. Because the world is a better place for equity investors and likely to remain so, I don't think the next big equity market correction will break the back of the secular bull market. But the strength of the next correction will still surprise because it will stem from twin causes: the rising tide of global interest rates and a fall-off in capital exports from Japan as the Bank of Japan raises interest rates and the yen rises.
As Japan recovers and monetary policy is tightened, less capital will flow out of Japan into world financial markets. Nothing has changed to the US requirement for foreign capital to plug the country's current account gap. The US Congress' balanced budget amendment is a peak-of-cycle political charade that means little. And US Inc makes less and invests less in the US of what it consumes than do "national" economies like Japan. This means the US always saves less than it needs and always runs big external deficits. So its corporate excellence means a weak Colbertian economy. And the US current account shows this. It remains in whopping deficit.
When this deficit is plugged by unwilling foreign central banks, the dollar is weak. When it is financed voluntarily by the foreign private sector buying and holding US financial assets, the dollar is strong. The latter has been happening - driven by two factors. The spread between US and Japanese interest rates attracts the Japanese, who need high yields to hold US bonds. And Europeans, in fear of a potentially weak euro, are buying buckets of US treasuries too.
But the inexorable build-up in US foreign liabilities and the fact that foreigners now own 30% of US bonds means that, when Japanese monetary policy tightens, Japan will cause all global markets to fall. As recovery puts up Japanese interest rates, big hedge fund long positions in other markets will have to be sold. Japan's short-term money market is where hedge funds borrow, to go long everything else in the world. That means tightening monetary policy in Japan will hurt the virtuous and the venal alike.
So I would sell equities and take profits now, before the end of this seemingly unending stock market boom.
David Roche is president of Independent Strategy, a London-based research firm.