Low growth in 1997: buy bonds

Last September in this column, I argued that the industrial economies could be heading for much lower growth than expected in 1997. Now I’m even more convinced that OECD growth will fall short of consensus estimates, which means that central banks will not be raising short-term interest rates until late this year. This affects all investment decisions. It means that the yen will be strong, and the Deutschmark and dollar weak in 1997; bond yield curves will flatten.

And lower economic growth spells lower profits. However, equities will rise for a while, especially in core Europe where profits are in for a positive secular shift.

But the big risk is from a global liquidity contraction, especially if a rising yen discourages Japan from recycling its current account surplus.

Until recently, I thought there would be a final spurt of growth towards the end of 1996 that would force central bankers to lift short-term interest rates. That has not happened: the low-growth scenario has materialized earlier than I expected. I now think that short-term interest rates will not rise until growth surges at the end of this year.

But don’t confuse this new interest rate forecast with great optimism about further liquidity injections by central banks. That won’t happen because short-term rates are already well below their long-term averages, both in nominal and real terms. Global liquidity has been outstripping economic growth. If anything, it’s real long-term rates that have further to fall below historical 10-year averages.

What are implications of low global growth in 1997?

• The yen will recover and the dollar and Deutschmark will remain weak. The yen will be driven higher by rising trade and current account surpluses, as I argued in this column in November. The Deutschmark will be weak because of slow growth in Germany and fears that a weak euro will be the result of EU economic and monetary union (Emu).

• Yield curves will flatten, mainly because long-term interest rates will fall further (except in Japan) rather than as a result of rises in short-term rates. That means investors should buy bonds.

• Low growth may damage budget arithmetic in Europe and impede Emu convergence. But the agreement on the stability pact to sustain fiscal prudence after monetary union will continue to drive European bond convergence. That makes peripheral European country bonds, such as those of Italy, Spain and Sweden, look attractive in 1997.

• Global equities will continue to benefit from the continuing generous liquidity cycle. But with productivity growth falling in the OECD, there is a risk that lower growth will also bring negative earnings surprises. So the risk-reward ratio favours bonds over equities.

Even so, some equity markets are worth pursuing. In 1997, I expect some emerging equity markets in Asia to catch up on the performance of OECD markets last year. I particularly like Singapore, Thailand and Malaysia, where the economic cycle is improving.

But the real equity story is government shrinkage and corporate rationalization in France and Germany. That spells increased long-term profitability in Europe to the benefit of the largest European equity markets.

Contrary to market consensus, I think the euro will be a strong currency, at least initially. The central banks of the nine countries likely to join the first wave of Emu currently have foreign exchange reserves equivalent to 22% of total imports. After monetary union, the European Central Bank (ECB) can reduce that to 15% to cover Europe’s imports from outside the euro area. Moreover, reserves now stored in Deutschmarks, French francs and other euro member currencies automatically become domestic currency. The resulting surplus could be distributed to governments and used to retire debt and cut budget deficits.

Appetite for euros

The large euro area will create demand for euro transactions and bank deposits, probably as much as one-and-a-half times the existing share of euro area countries in international trade. This will lift the global appetite for euros as a reserve currency. The ratio of international reserves to imports in euros is likely to be closer to 15%, the ratio for the dollar, rather than the present 10% ratio of the European currencies likely to join the euro. Other reasons for the euro being a strong currency are that the ECB will be run on the lines of the Bundesbank and the stability pact will maintain fiscal

discipline.

A strong euro carries three long-term benefits for European companies. Competition is concentrated in the product market and will be transferred from there to the labour market ­ a process set to accelerate as vital features of the single market are put into place (in energy, telecommunications, government procurement and services).

Good economic systems drive out bad as devaluation and subsidies cease to be tools of economic policy to produce the inefficient. The absence of exchange risk within the euro area will encourage inward investment from the world’s largest companies.

A strong euro is also the key to faster European growth. Higher global demand for euros will lead to lower interest rates and higher domestic growth in Emu countries. That, in turn, could reduce budget deficits closer to the levels stipulated by the Stability Pact and become self-reinforcing for the euro and for European equity markets over the long term.

In Japan, domestic recovery will be too weak to sustain earnings growth and a stronger yen will crucify exporters. So the equity market will spend another year stagnating.

The major risk to my low-growth scenario for 1997 is recession. That would mean a contraction in global liquidity for all financial markets and a downturn for equity markets worldwide.

But I don’t think there will be a global recession in 1997, even if lower growth could lead to disappointing earnings ­ and could prevent central banks from easing interest rates as much as they have done over the past two years. The real threat to global liquidity is that a rising yen could keep Japanese capital at home. If that happens, popular markets for Japanese funds, such as the New Zealand dollar bond market, could suffer ­ as would emerging markets in Latin America, a lot of emerging Brady bonds, and US treasuries.

It’s more likely that continued easy money will eventually cause growth to rebound towards the end of the year. At the first sign of that, markets will worry about overheating, a notion mostly dismissed in 1996 as the spectacular performance of OECD markets last year showed. That means: buy bonds over equities this year, but expect a correction as growth picks up towards the end of the year.

David Roche is president of Independent Strategy, a London based research firm.