It’s just one piece of bad news after another for markets at the moment. Falling stocks of oil in the US and the Arab-Israel nightmare are keeping oil prices well above Opec’s stated target of $28 per barrel. Major US corporations announce each day earnings results that disappoint investors. The dot com and hi-tech sector takes a huge pounding.
To cap it all, the latest US inflation Figures show a disturbing pick-up. And that’s what will really frighten markets: a combination of slowing economic growth in the US, worse-than-expected corporate profits and rising inflation.
But I remain optimistic. I reckon we are reaching the final bout of selling in equity markets. Why do I come to that conclusion? There are three possible scenarios on inflation. Sure, if inflation worms its way into final prices, including capital and labour, we shall have a bear market.
Then all the sensible investor should want to own is cash.
But if cost increases are absorbed by a shift in relative prices, but not through a rise in general inflation, things would be better for investors. profits would suffer as input prices rose, but output prices didn’t. The demand for capital would fall in tandem with investment.
Poorer employment prospects would take down the price of labour too. In this scenario, bonds would look good. Equities might be dull as lower profits were discounted by the stable cost of capital. But there would be many winners and losers. Manufacturing would bear the brunt of lower profits, while services fared better.
But there is a third scenario based on the new economy. The new economy is a powerful force that can change the inflationary outlook by dramatically increasing competition. I define it to include the impact of the cyber economy upon the old economy, plus globalization.
In the new economy, productivity gains from the cyber revolution and increased competition from globalization raise the productivity of labour and capital by so much that price pressure from production inputs such as oil or semiconductors turn out to be a mere temporary inflation blip on the radar screen.
That state of affairs is reinforced by other structural changes in the global economy. inflation used to come from profligate spending governments and weak central banks that were unable to resist pressures to print money. But, with Fiscal deficits under control (indeed there are surpluses in many countries) and moderate money supply growth, this time it won’t be like that.
A further boost to the oil price remains a risk. Oil may be economically less important for OECD economies, but inflation expectations are psychological too. And oil is the one source of inflation that retains any vigour in the US today.
Oil prices are high because producer capacity is pretty full. But there is still enough spare to cut oil prices to $25 per barrel tomorrow morning. It depends upon a political decision by Saudi Arabia. And despite the Middle East crisis, the Saudis and the rest of the oil producers’ cartel Opec still seem committed to raising production next month to get oil prices down.
The irony is that governments could end the oil-price threat at one stroke by cutting fuel taxes. Outside the US, government duties constitute the bulk of gasoline prices in most OECD countries. The supply-side purists will argue against such Fiscal accommodation of an externally induced price rise. But with still enough slack in the European economy and big budget surpluses on the way, I don’t see much danger in governments doing this, provided the ECB keeps a tight hold on monetary policy.
Another risk is the possibility that productivity will slow down significantly in the US. Any reduction in US labour productivity would hit unit labour costs hard. If it’s prices that take the hit from this, then the Armageddon scenario will grip the world by the throat.
Finally, Europe’s still half-reformed economies – particularly its labour markets – combined with a single currency without credibility mean that Europe is much more vulnerable than the US to inflation that is generated by higher economic growth.
But, if anything, the economic risks in the world are on the side of the ice age rather than in the hell of inflationary Fire. If the panic about oil prices is stripped out, it will be apparent that inflation is not accelerating. Bond markets around the world and the gold price are telling us as much.
Global growth will come down from 4%-plus to less than 3% as oil costs, falling asset prices and the higher interest rates decreed by the world’s conservative central bankers all take their toll. But, by the end of the First quarter of next year, those same central bankers that hiked interest rates over the last year will be cutting them.
The market will take a while to adjust to lower growth in earnings. So this mini-bear market will feel like a big bear market for a little longer. But a revival of structural inflation won’t happen. The competitive impact of the new economy will take care of that. That makes this period of volatility and correction in equity markets a time to buy and not to sell. From now on, I’d be building up positions in both the old and new economy sectors. US stocks are still the most attractive in the world.
But I’d also be buying Japanese equities. The Nikkei 500 index has fallen as investors fear that the economy will not recover. But Japan’s jellyfish GDP will continue to Float along with the deep sea-swell of the global economy. That’s not what will drive the Nikkei back up.
First, Japanese equities will do well out of a Fight from Japanese bonds. Last month, Japan’s ministry of Finance published the first realistic statement of Japan’s public balance sheet. It showed that the net worth of Japan’s public sector (excluding the local authorities that are even more bust) was a negative ¥780 trillion. That’s fully 156% of GDP.
As Japan’s jellyfish economy slowly recovers and interest rates start to rise, the cost of servicing this public bankruptcy is going to increase sharply. Investor funds will flow out of Japanese government bonds. And there is really only one place they can go from there – equities.
Second, a recent visit to Japan has convinced me that corporate commitment to rationalization and adapting to the new global economy has got a lot stronger. In the Final analysis, Japan creates and makes so many of the products wanted by the new economy that it will take relatively little change in the way its corporations work to make Japanese equities attractive.
So choose companies that are rationalizing the best, such as Sony, Honda, Canon and even airlines such as ANA.
