I expect the US equity market to fall 30% to 40% this year. The catalyst for the turn in sentiment will be static (or falling) corporate profits, rising inflation and higher interest rates. Mania will drive the collapse. When the dust settles, the US economy will slide into recession. Consumers will retrench to pay down debts. The dollar will fall. It will be the dawn of a two-year bear market.
To be bullish about US financial asset markets today, you have to believe that the economy has reached a “higher plane of sustainable productivity”. Never before have investors in US equities discounted such a high rate of real profit growth. Even allowing for a rise in average inflation over the next few years to 2.5% to 3.0%, current valuations assume a real rate of profit increase around twice the long-run average.
There’s no doubt that the US economy has enjoyed a long expansionary phase. Seven years of uninterrupted growth, with barely a hint of inflationary excess, have been underpinned by a big up-tick in technological investment. But the evidence for a secular rise in productivity growth is patchy. It’s true that manufacturing productivity is high and still accelerating. But that’s because the data fail to include work outsourced and casual employment. Productivity growth for the whole economy, where the figures account for all hours worked, is no higher than trend.
GDP growth per unit of job creation isn’t much different from that in the past. And any decline in the number of workers needed to generate each additional unit of output has been offset by the increase in investment spending required to drive growth. Indeed, the scale of investment has been extraordinary. As a share of GDP, investment has risen from 13% in 1990 to 17% in 1997. Specifically, half the real annual increase in investment has been in the hi-tech sector.
However, the marginal return on that investment is falling. Put more simply, it is taking more and more dollars of investment to generate each additional unit of GDP. Taken to its logical conclusion, if real GDP growth is going to be sustained at, say, 3%, investment spending as a share of GDP will have to keep on rising.
Even if companies keep on investing more of their retained profits, they’ll have to take on new workers. Skilled employees will be paid more as their scarcity value rises. And rising labour costs, coupled with rising volumes of investment spending, will damage operating margins.
That’s the cyclical counter-theory to the productivity miracle. But what’s the evidence?
First, it’s clear that real wages are rising at their fastest rate in a decade. Overall compensation, including non-wage benefits, is also turning up. And there are incipient signs of this feeding into measures of core inflation, particularly in the goods sector.
The 1960s experience confirms that unemployment rates below 5% are problematic. The 1990s appear no different in this regard; when people feel confident about their job prospects, they go out and spend. Household confidence – the key lead indicator – is already at record levels. Once again, private consumption is set to boost GDP growth to a 4%-plus annualized pace in the first quarter of 1998. The impact of such bountiful confidence on asset markets has been stunning. And the bubble is spreading to other assets. Property transaction volumes have soared. “Real” house-price inflation has jumped to historic highs too.
Naturally, the Fed has been reluctant to raise interest rates without any sign that inflation is a problem. With the headline CPI rate below 1.5% and falling, and the real cost of short-term capital above the long-term average as a result, a “wait-and-see” approach has prevailed. But the time for this strategy is running out. First, some measures of core inflation are picking up as joblessness falls. Second, capacity utilization in the manufacturing sector may be within its historic “non-inflationary” range, but the fabled output gap has almost certainly been eroded. Third, and most important, real wage growth is accelerating to a rate where it will soon eclipse productivity gains.
When this happens, the Fed will be forced to douse the flames of US overheating. Interest rates will have to go up, just as Asia goes into deep freeze. The iceman cometh breathing fire.
The repercussions for the equity market will seem nothing short of catastrophic. Equities and bonds in the US already discount the best of all possible worlds. On average, US stocks are 30% to 40% overvalued, and that’s how far they should fall.
What makes things worse is that much of the boost to equity prices has been little more than a mirage. If you add the cyclical impact of lower-than-average financial costs to more structural accounting fudges (among them share buy-backs, asset write-downs and so-called “restructuring” charges) you find that a good deal of the S&P’s multiple-expansion is unwarranted. Indeed, real efficiency gains in operating results have accounted for only a third of the rise in corporate profits since 1990 on our calculations.
The bond market is similarly overcooked. The forward market is pricing in barely any change at all in the yield curve through end-1998. On my expectations of overheating in the corporate sector that’s unrealistic. I expect bond yields to rise by 75 to 100 basis points by year-end. Short-term interest rates could go up by as much.
What about the dollar? The greenback has been strong for three years. With Japan slipping fast under the waves and Emu uncertainty keeping the Deutschmark weak, the dollar looks set to rule for a while longer, especially as the Fed is likely to raise rates before the Bundesbank or the Bank of Japan this year. But the US current-account deficit will widen and capital inflows are unlikely to compensate. Above all, when the US equity market crashes, then the dollar will go down with the equity ship.
David Roche is president of Independent Strategy, a London-based research firm.
