US growth will outperform all others

Which economic bloc is going to perform best this year, Europe or North America? The consensus is that the US is heading for very low growth, say under 2%, while Europe will do better, with 2.5% at least.

But, contrary to the European Central Bank, I reckon Europe will perform worse than the US over the next 12 months. Europe, with its decades of declining investment-to-GDP ratio, has none of the hidden springs of productivity the US can draw on. Furthermore, Europe is going backwards on economic reform. That’s particularly so in France, where half-witted socialists are attacking profitable corporations that rationalize their operations to make money for shareholders. No wonder the euro continues to languish. Perhaps if Silvio Berlusconi carries out the reforms he promises for Italy, it will kick Europe’s bureaucrats and politicians into action. But don’t hold your breath.

In the US, by contrast, the productivity gains that the new economy imparts to the old economy should ensure that enough American people are gainfully employed – despite the recent small rise in unemployment – to keep consumer demand growing at more than 2%. And the same productivity should mean that the corporate sector will be making enough profits to prevent asset markets destroying too much wealth. As the rest of the world gets sicker, the Federal Reserve will cut interest rates faster too.

There’s no resemblance between Japanese and Asian credit bubbles of the late 1980s and mid-1990s and the US situation today. I don’t think US financial excess is a murderer-in-waiting of US prosperity.

Many market observers are hoping that the arrival of Junichiro Koizumi as Japan’s new prime minister will finally stir up the stagnant Japanese economy. But I reckon it’s another false dawn. His nominally pro-reform policies are likely to be watered down to maintain unity in the three-party coalition government. Also, ironically, if Koizumi’s current popularity actually enabled the ruling Liberal Democrats to hold on to power in July’s upper house election, that could slow up reform even more.

That’s why I expect the yen to continue to weaken, especially against the US dollar. The dollar remains the safe-haven currency for the wealthy financial prisoners of every emerging market in the world.

As bad as the news on the US gets, it appears worse for holders of any asset in emerging markets. That’s what fuels demand for dollars every time the Nasdaq falls.

As for emerging markets, the outlook has worsened. Asia never undertook debt deleveraging seriously after the 1997-98 crisis. The result is that corporate balance sheets there are still a mess, with the public sector having to bail them out. Thailand and Korea now look to be caught in a corporate debt trap. Indonesia always was.

And the Philippines may well be. Capital allocation is frozen. Long-term economic growth will be just 2% to 3% a year and growth in the short term is set to get worse as Japanese imports turn down on top of the recession in global information technology.

Elsewhere, despite the recent extra handout from the IMF, Turkey looks set to default on its domestic debt before long. And Argentina will probably have to reschedule as well before the year is out.

Economy minister Domingo Cavallo’s medium-term plan to make the exchange rate more “flexible” by including the euro in the basket for the currency peg won’t avoid it. Moreover, in the short term, it further undermines the credibility of the existing exchange rate and raises risk perception for all emerging markets. It will also increase pressure on the Hong Kong/US dollar peg and the Brazilian real, where a widening trade deficit and falling inward foreign direct investment are already creating a larger external financing deficit.

The US’s new policy towards China will lead to trouble between Taiwan and China. It could even delay China’s accession to the World Trade Organization since concessions will be more difficult to make as the power of hardliners on both sides increases. And slowing economic activity in China means the renminbi’s exchange-rate bands will be widened to allow the authorities to pump more money into useless state enterprises to achieve statistical growth and to stabilize unemployment. All of this will make Hong Kong and its peg to the dollar look sicker.

Whatever way you look at it, the place for investors to be is still US dollar assets.