It's an irony that better economic performance heralds thinner pickings in the financial markets. And faster global growth lies ahead. That's why it's time investors reduced their equity holdings, got out of most bonds and built up cash.
There is a growth shock out there for all the OECD economies. I expect real GDP to grow at 3.4% next year. What's more, inflation will be over 3% in the OECD by mid-1997, compared with just over 2% this year.
This growth shock is the result of extraordinary monetary easing and the amazing purchasing power created not only for corporations through their increasing profit share but also for households. Money supply is growing much faster than GDP in the OECD and it also costs less than the average of the last 10 years in both nominal and real terms. And international liquidity is booming, too.
Labour income has soared in most places, despite rising unemployment in Europe and Japan. Most people have kept their jobs and got paid more in real terms, while in the US
8 million new jobs have been created in the last three years. Households have also got richer through their investments.
So the purchasing power of households and corporations (the two major economic players) has steadily increased, while that of governments has steadily declined. Corporations got richer because unit costs dropped (principally through new ways of working and making things) and so profits rose as a share of value added. Households got richer because workers who kept their jobs (as in Japan and Europe) or were recruited into new ones (as in the US), got paid more because their productivity rose. Also, the price of many goods and services fell, increasing households' purchasing power. This is not the stuff of recessions, particularly if money is cheap. Household savings rates are already at, or above, long-term averages, and it doesn't pay to save.
But don't be fooled. This burst of growth is an end-of-cycle affair, with all that that entails for productivity, interest rates and inflation. This has been a very long cycle. In the OECD it has been more than five years since the trough. This cycle now contains the seeds of its own undoing. The phenomena which caused its longevity - wage disinflation, rising profit shares, increasing productivity and pricing power to the people(PPP) - are unrepeatable.
The combination of PPP (which held down prices) and wage disinflation (which pushed profits up without destroying real incomes from work) created a happy history. Corporations got richer, their employees got wealthier, inflation and interest rates fell, and financial markets went up. To put icing on the cake, the three major world economies (the US, Germany and Japan) combined big budget deficits with loose money.
High growth kills the cycle
The cycle will end for three reasons. First, as at the end of every cycle, productivity growth is waning, particularly in the US and Europe. And in Japan the corporate welfare state keeps unemployment on companies' P&L rather than the government's accounts. That will keep productivity from rising much more. As productivity growth slows, increased demand will raise the cost of satisfying it.
Second, PPP is being transformed into CPP (corporate pricing power). So much has been done to streamline corporations that they are now in a position to recapture some of their lost pricing power.
Third, cyclical effects are made worse by tardy fiscal and monetary reactions to them. In this cycle, the central bankers will respond belatedly because each of them has a hot domestic reason not to tighten. US Federal Reserve chairman Alan Greenspan has a presidential election to contend with. Bundesbank president Hans Tietmeyer is pandering to chancellor Helmut Kohl's plans for European monetary union (EMU). And Yasuo Matsushita at the Bank of Japan has a bust financial sector to keep afloat. Lax money may lie at the root of the growth burst that's unfolding. But it also means it will be excessive. That's called a cycle!
Higher real growth will create demand for capital, which will in turn shove up interest rates. And higher inflation - or the fear of it - will cause interest rates to rise too. Either way, you don't want to be in bonds while this is happening. The exception is where something sound and structural is happening to the budget arithmetic, so that bond yields may actually fall or their spreads improve relative to their peers.
New Zealand fits that picture. So does Canada. And German Bunds look better than other bonds in Europe. I think the budget mess there will be brought under control long before it is in France. Yet French bonds are selling on yields below that of Bunds. This can't hold for long.
Until now, industrial commodity prices have lagged behind those for energy and wheat. But they will rise as growth in industrialized economies does. And that's before accounting for the shift in demand and supply caused by an acceleration of growth in China. That makes global resource stocks look attractive. I prefer Canada's to their Australian peers, and Scandinavian and Canadian forest-product companies to Indonesian ones.
My outlook on the economic cycle is bad for most equity markets in the short term. In the long term I expect an increasingly efficient use of capital generally, and the OECD corporate sector will capture the growth and returns of the emergent economies as they integrate into the global economy. That favours equities over bonds, since bonds are really the equity of the most risky, unstable and economically profligate users of capital - governments.
But in the short term, equity valuations will have to contend with rising interest rates and lower profit growth. And then will come tighter liquidity, when the central bankers get back in the driving seat. Equities will fall as cyclical growth rises (irrespective of whether the growth is real or nominal), because all that's missing for a real equity correction is rising short rates.
At first sight, stronger growth may seem bullish for EMU success and Europe - but maybe not. Rising interest rates in the core will increase yield gaps with the high deficit-and-debt southern comfort countries (SCC). Interest rates drive SCC budget arithmetic. Even in the core countries I don't see growth being strong enough to stop unemployment rising. That will lead to bigger budget deficits in France, but not in Germany, because Kohl's Dm70 billion spending-cuts programme will more than offset the impact of rising unemployment.
Emerging markets will not be immune from this deleterious fallout of the global cycle. I'd stay out of some of the big emerging democracies. Where democracies have carried through economic reform, they have won support - Poland and Argentina, for example. Where they have been half-hearted, it has led, or will lead to, rejection by the electorate. India is one of those. The others will be Brazil (high public deficits and debts); South Africa (inadequate savings, unemployment and separatism); Russia (bureaucracy and corruption). Failure to restructure will mean that these economies will become waterlogged, neither emerging nor submerging.
Latin America will suffer from rising US interest rates and a concomitant drop in portfolio inflows. But the equity markets of Chile, Argentina and Mexico - in that order - are reasonable value. Brazil's reforms are likely to fail and the market is expensive.
East Asia still causes delusions among strategists. The growth story is as old as the hills. Valuations often reflect that story. What is often left out of the picture is that East Asia is in the dollar bloc. Overheating hit East Asia before it affected the OECD because of excess money creation (be warned!).
Many of its more overheated economies will have to raise rates when the US does, and for as long as the dollar is strong. That's bad news in a region where what you invest in are Chinese family-owned companies in real-estate and its financing (with the exception of Korea and Taiwan, which are real industrial economies). So avoid Hong Kong (because of the impact of the Chinese takeover and the threat to the dollar peg of rising US rates). And Malaysia and Indonesia have hot economies and valuations.
The silver lining
But there is a positive story, too. You should buy into the equities - and the bonds, if you can get them - of those economies that are over the hump of overheating - Korea, Taiwan, Thailand and, believe it or not, the Philippines. And Singapore sits there like a sub-tropical Switzerland that you should never be out of.
In eastern Europe, I continue to love Poland, its people and all things Polish. It's the only eastern European economy that gets anywhere near being an Asian tiger. However, I am increasingly concerned about rising trade deficits throughout the region and the potential spillover effects of a Bulgarian debt default.
The German economic cycle is turning and will not be far behind Japan's. Indeed, I expect confidence in German recovery to be greater than in Japan's by mid-year. That's when Japan's fiscal stimulus package runs out and the private sector has to take up the running. So it's dangerous to be long the yen and short the Deutschmark on the expectation that the Bank of Japan will raise short-term interest rates before the Bundesbank does. I also think the Deutschmark could be a winner once the markets realize that chancellor Kohl means business about shrinking government.
The US is likely to recover faster than Japan and US interest rates will rise first. US trade won't tank as this happens. Rising exports to Canada and Mexico will help drive US recovery rather than tax it. And Japan's external surpluses will continue to be eroded by double-digit import growth. Also, the Federal Reserve will have to raise interest rates by the fourth quarter of 1996 and Japan won't. So the dollar will be strong up to the year-end and could reach ¥115. >
David Roche is president of Independent Strategy, a London-based research firm. |