They're shark-infested investment waters out there. Nasdaq, the US tech sector index, continues to plunge and most indices worldwide are now well down for the year. The US March inflation figures started the rot, even though April's appeared more benign. Real GDP and employment cost data for the first quarter of 2000 show a red-hot economy with rising labour costs. It would have been difficult to invent a more bearish set of macro numbers. So it was no surprise that last month the US Federal Reserve hiked the interest rate by 50 basis points and indicated that it was ready to raise it again unless there were signs of a slowdown. There won't be, so expect another 50bp before the summer is over.
For the tech sector, in particular, the squeeze on corporate margins as interest rates rise will mean downgraded long-term profit expectations. At the very least, companies with the highest cash-burn rates will find it more difficult to source cheap capital. That's why Nasdaq continues to dive, down over 30% from its peak.
If Fed chairman Alan Greenspan has made anything clear this year, it's that he wants to slow the runaway US economy "before it's too late". But bearing down on growth will almost certainly pull the rug from under the tech market. That's because short-term fluctuations in productivity are closely associated with shifts in output. So the implication of Greenspan's intent to slow domestic demand to a sustainable pace is that productivity growth will also slow.
And it wouldn't be the first time. For all the talk of a technology-driven efficiency boom in the US, there is nothing particularly unusual about the latest upswing. Each time US labour productivity has risen above 3% year- on-year - and there have been five separate occasions since 1960 when this has happened - it's subsequently fallen back to below 1% year-on-year within a couple of years.
Maybe this expansion is different. Its duration and the low level of accompanying inflation certainly give it some unique characteristics. And the combination of globalization, corporate restructuring and the cyber revolution suggests that price pressure won't get badly out of control. So the slowdown in productivity growth may actually be fairly gradual (as it was in the 1960s).
Nevertheless, if it is heading south from now on, it's highly likely that inflation will become more of an issue than it has been. Till now, there's been more evidence of a revival in demand-pull inflation than in the cost-push variety. But given the tightest labour market since the early 1970s, an acceleration in wages was always on the cards. So there seems every chance that price pressures will continue to intensify. If that's the case, the Fed will almost certainly have to keep on raising interest rates.
The US equity market has always corrected as the growth cycle turned. But its behaviour has been pretty inconsistent. When growth peaked in both 1984 and 1994, the S&P500 fell gradually and quite mildly. But in 1987 it took a much harder fall, mitigated only by the Fed's decision briefly to lower interest rates in early 1988 (before resuming its tightening policy).
Stretched valuations, as well as the concentration of capital in hi-tech and new economy plays, would suggest that the current environment is more like 1987 than 1984 or 1994. And Greenspan has less room for manoeuvre than in 1987. That's why I expect another 15% to 20% fall in share prices. However, it's a correction focused mainly in the tech sector - traditional stocks should weather the storm better.
The cyber dream is not dead. But the name of the game is changing. The dot com stocks were subject to a reality check even before US inflation expectations got hoisted. Capital was already being rationally reallocated towards traditional economy corporations that stand to reward shareholders by applying the cyber economy to their businesses. Hence the Dow has stayed stable while internet stocks dived.
Dot com valuations remain highly vulnerable to an upward shift in the discount factor. I remain bullish about traditional economy stocks, particularly the beneficiaries of the new cyber exchanges that reduce business costs so substantially. But even these stocks will now have to cope with the higher cost of capital.
Disinflationary potential is much greater in Europe and Japan under the increasingly competitive conditions of the new economy. The economic cycle is also younger than in the US - so inflation is a more distant threat. What's more, further ECB tightening is already priced into European financial asset markets. So I'd favour Europe over the US for equities.
What would really spook the markets would be if falling asset prices were to cause capital to leave the US for Europe and Japan. The dollar would weaken as a result, causing US import prices to rise, and so fuelling more domestic inflation. There are more loops in this nightmare than in Greenspan's specs. The chairman would finally be in a bind. If he cut interest rates to save financial markets, he would be abandoning his prime duty - fighting inflation. But if he continued to fight the good fight against inflation, financial markets would fall sharply.
But I reckon this nightmare won't happen. There is sufficient force in the e-commerce economy to keep disinflation alive globally. I don't expect a US recession, or a bear market, once the correction is over. There will be further downside in markets. After that, I'd buy back into the cyber dream through both traditional and selected dot com stocks.
And don't ignore the impact of a sharp drop in equity prices on the US consumer. If household savings get rebuilt as investors take profits, Greenspan could get to his "sustainable" growth rate quite quickly. He'd then be able to take his finger off the interest-rate trigger.
So this correction will prove to be a buying opportunity, especially for traditional economy stocks. But as the economic clouds darken, the next few months will seem pretty grim.
David Roche is president of Independent Strategy, a research firm based in London. www.instrategy.com
