Nasdaq is still collapsing and there are worries that the US economy could be recession bound as the tech investment boom ends. But I remain optimistic. I reckon the global economy is in for a super-soft landing to sub-3% growth in 2001. Oil prices will stay around $25 a barrel and global inflation will fall, boosting real incomes. Risk appetite will recover. The mini-bear market is almost over.
Last February, I predicted that the next shift in the US economy would be to lower growth and low inflation. This would be volatile for investors and disastrous for dot com investors. But it wouldn’t herald a global equity bear market or global deflation. Indeed, it would raise the curtain on a more sustainable growth rate for the US and the world.
The new economy – including the impact of technology, globalization and rationalization – vaccinates the world against high inflation with the serum of competition. It also drives growth by the transmission chain of new technology creating new products that create new demand. In turn, that makes money for somebody. That creates wealth to finance further innovation and demand.
We are now at the nadir of the winter of discontent in financial markets. Some believe the dollar will crash, bringing down US financial markets and the economy with it. Others reckon the Federal Reserve will lag the weakening economic cycle, causing financial markets to cave in first and then the dollar.
Is there any evidence for such pessimism? It’s true the world economy is slowing. In the US and Europe, consumer purchasing power has been hit by energy prices and wealth destruction in dot com equities. In Japan, the consumer has stopped spending. Exports and capital expenditure there keep things staggering along. Most emerging markets have hit the growth ceiling or are over the top of their economic cycle.
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Despite all this, there is no evidence of excessive investment leading to overcapacity. The inventory cycle is non-existent as the new economy paradigm would suggest should be the case. Only technology investment has risen as a share of GDP in the US and, to a lesser extent, Japan. My guess is that in the US this will slow from nearly 25% this year to some 5% next, but pick up in other regions. I don’t believe hi-tech demand will fall absolutely, although it may appear to do so for a while as excess inventories are worked off. New products and applications are still appearing at a fast pace, and Europe and Japan still have to catch up with the US.
The real damage that will be done by lower US hi-tech spending will be felt by the producers of newly commoditized products with nothing new to offer, as value-added switches from the faster chip maker to the purveyor of goods and services that bring you broadband. High on the danger list are PCs, laptops and mobile phones.
Many US tech companies have had their share prices slashed by profit warnings. But the real hit will be where the newly commoditized products get made: Taiwan, Singapore, Malaysia and the Philippines. Such are the benefits of being a highly globalized economy. The downside gets shared with many other countries, lessening macro damage to the US.
Asia’s electronics exports are a high proportion of regional GDP and the US market is critical. If US imports contract absolutely for one quarter next year and then expand by 10% year on year, growth in Taiwan and south-east Asia will be slashed. The resulting fall in real GDP growth for Asian countries caused would only partly be offset by volume gains in Europe and Japan.
Prices will also be hit. These are critical because Asia’s terms of trade have already got a walloping from falling DRAM prices and rising oil prices. The next hit will come from a frightening collapse in IT exports and prices.
The US credit cycle – measured via the rise in corporate and household liabilities – is plodding along its slowly rising trend line in relation to GDP. There is no evidence of a Japanese-style credit bubble. The credit cycle elsewhere is a bore. In Europe, credit growth to the private sector is relatively strong, but not a harbinger of crisis. In Japan, the credit cycle is never-ending. The failure of most emerging markets to deleverage won’t cause a global crisis, just weak domestic growth.
What really matters is not these traditional economic measures of excess, but how strong the income side of the economy will be to support capital expenditure and consumption. That partly depends on how much wealth destruction financial markets wreak.
So far, the damage done to US households’ wealth has wiped out two years of gains in net worth. That will cut consumer expenditure growth to around 2% to 3% from a 6% rate at the peak of the cycle in the first quarter of 2000. But the broader indices would have to fall another 30% or more to destroy sufficient net worth to cause consumption to contract.
The income sides of most the world’s great economies are okay. Real labour income growth in the US is slowing, but is still positive. It will accelerate sharply next year as oil prices, which subtracted a lot this year, drop out of the stats. Real wage income levels in Europe and Japan are positive and will remain so. Savings rates point to lower consumption growth in the US and are broadly neutral in Europe and Japan. Corporate income is the last bit of the jigsaw. US corporate profits are still growing at 15%. Next year, top-line revenue growth will be much lower than this year. But productivity gains from past technology investment will keep margins pretty stable, so 10% profits growth is my best guess.
In Europe and Japan, corporations are not seeing energy and other import price increases spread into wage costs. So their margins will be okay too. Japanese and European corporations need to invest to close the technology gap with the US. They can probably afford it.
The US dollar is the biggest risk to this happy ending. In the new economy, the US current account deficit, which supplies dollars to build the new global economy, is really the hallmark of successful globalization by US Inc. And key players in the new economy such as B2B and global investors and producers have also happily lapped up the dollars supplied by the US deficit. Oil producers have absorbed dollars too as energy prices rose. So one risk to the dollar is a decline in the pace of construction of the new economy. And US IT orders are falling. Oil prices look set to fall too.
But most of all I fear the global investor (non-US) who may just say: “Hey, I’ve been long the US for aeons. The miracle looks a bit tarnished these days. Maybe I should take some money home.”
Dollar weakness will not turn into a rout because there’s less speculative money. But if the dollar declines in a disorderly fashion, a vicious circle could be initiated through capital flight from the US. This would force the US to cut demand to shrink the deficit. Global deflation would follow. Then nobody would want to own risky things such as emerging markets and Argentine debt.
But I reckon this doomsday scenario has no more than a 20% chance of happening. I’m staying bullish.
