In the first quarter of this year, the US Federal Reserve has cut interest rates by 150 basis points. But Nasdaq is down 25%, most European equity markets have fallen 15% to 20% and even the Dow, which had been flat for two years, is now off 14% for the year.
It’s true that if you strip out the technology, media and telecoms stocks from these indices, the old-economy stocks have held up well. But you can’t have it both ways – putting the new-economy stocks into the index when they go up and removing them when they plunge. So does the sell-off in hi-tech stocks herald a long-term bear market in equities and a hard landing for the US and global economies?
I don’t think so.
One big reason for optimism is that the overvaluation of equity markets relative to bonds during 2000 has swung back in favour of stocks. In the US and Europe, trailing P/E ratios are close to their long-run averages. Major equity markets look very attractive relative to 10-year bonds.
And market sentiment is increasingly out of kilter with economic reality. The US economy is slowing, but its households continue to spend. I reckon economic growth of around 2% to 2.5% is still likely. Forecasts for European growth are coming down but a 2% growth is still the range. Even Japan will achieve about 1%. With global growth of 2.5% to 3.0%, corporate earnings will not be that bad. The question is whether the depressing impact of corporate profit warnings will diminish, as growth prospects stabilize.
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The big risk to a soft landing in the US is if service-sector companies start to cut labour aggressively, matching the trend established by US manufacturers. The consumer could then stop spending and rebuild savings. A hard landing would become a real possibility.
But I still reckon the odds are against that. Falling interest rates should cushion the US labour force from the global economic slowdown. The Fed is seeing to that, with more cuts to come. Sure, US GDP growth is slowing fast. The latest headline rate for the fourth quarter of 2000 was the lowest for nearly six years. But the rational response to this slackening of demand is for producers to cut costs. And that’s exactly what’s happening.
First, capital expenditure plans have been revised – for the first time in eight years. Deployed investment contracted in the fourth quarter last year. Second, the payroll is being trimmed. It is a battle for sustained profitability. To keep margins up, producers need to cut costs as fast as top-line revenue growth slides. Officially, they’re succeeding.
Productivity growth is holding up well despite the slowdown in output and I expect efficiency gains to stay in line with the five-year average of 2.5% to 3%. If that is sustained, corporations won’t have to be too tough.
Unemployment may rise but the jobless rate will remain at historically low levels of 4.5% to 5%.
What is critical is how US households respond to job cuts. There’s a strong link between the labour market and consumer confidence. Over the past 30 years, a significant rise in the unemployment rate has consistently driven confidence down and reduced households’ propensity to spend. If productivity gains don’t hold up, a major slowdown becomes much more likely.
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That’s because real labour earnings growth in the US – the product of growth in employment and real wages – has slowed sharply during the past two years. Yet real private consumption has continued at a 5%-plus annual rate. The gap between growth rates of spending and earned income has widened to more than 3%.
That is sustainable only if US households can boost unearned income through financial asset gains, run down savings, or increase borrowing.
Almost 20 years of rising equity prices, coupled with sustained global disinflation, allowed households to build up liabilities relative to income. Indeed, since 1984, household liabilities have surged from two-thirds of disposable income to over 100%. But now, even though interest rates are at historically low levels and falling, the cost of servicing consumer debt is at its highest since 1987.
Equity prices are also closely linked to households’ propensity to save, via their impact on net worth. As wealth increases, households feel less vulnerable to changing job prospects and reduce savings.
But this virtuous circle can easily unwind. If the US equity market slips even more, capital gains will not be there to support increased debt service costs. Consumers will have to earmark earned income for that purpose. Recent equity falls already suggest a jump of around 1.5% to 2% in the household savings rate from December’s level – not disastrous, but still significant.
It’s important to differentiate perception and reality. Consumer confidence may be under pressure: but consumption is resilient. Auto sales have surged. There is a recovery in non-auto retail sales too, helped by better weather and discounting.
The locus of optimism has to be productivity – particularly in the US. If the new economy, in transforming the old, results in a sustainable rate of productivity growth of over 2%, profits and earnings power will survive slower growth. Lower interest rates will mean markets will price in sustained profits more generously. That preserves wealth and the spending power of consumer and corporation alike. Incomes of wage-earners would also stay real and rising because productivity does.
