Every indicator we look at shows that the world is in recession. That’s the reality. It’s always easier to drown if everyone else in the pool is drowning too. So who will be the lifeguard?
It has to be the US. Two things will make it so: decisive action by the authorities – fiscal, monetary and military – and the response of the consumer. The corporate sector will lag. There are plenty of investment opportunities out there. The world is hardly half-wired for the digital age and technological change is still speeding along. But profits will have to come first. So demand has to lead.
Once it does, profits will bounce back rapidly. Two things will cause that. The first is the huge rationalization that US Inc is undertaking – our anecdotal survey of blue-chip companies suggests US corporate rationalization is more than 50% faster than in Europe and more than twice as fast as in Japan.
The second is that write-offs, associated with the new wave of corporate rationalization and elimination of the IT investment overspend, have cut about $100 billion from S&P500 company profits this year. We find no evidence of an investment bubble in other areas of the US economy.
If write-offs fall back to a more normal level next year, S&P500 profit margins will jump by 1.5 percentage points and profits will grow over 25%. It makes sense to think that most CEOs are dumping the garbage this year when their share price has been destroyed, in order to make next year (and their options) look even better. Add in 5% nominal GDP growth and reported profit growth will top 30%.
But for all this to happen, domestic demand must stabilize and then grow, not collapse. When it comes to demand, the US consumer is the cavalry that has to ride to the rescue of the rest of the world. We think it will – but it may be a bit of a slow canter, rather than a charge.
First, let’s get rid of a few shibboleths. US households save less than the thrifty Japanese but they are smarter investors. So they have higher net wealth – whether measured as a ratio of disposable income or GDP. In dollar terms, supposedly prodigal US citizens are richer than their Japanese peers.
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US households spent a relatively small proportion of their capital gains during the equity boom of 1995-2000. Indeed, the savings rate adjusted for realized capital gains stayed pretty high at 8%. So there is a wealth reserve to maintain living standards, now that the going is tougher.
Since the equity peak of March 2000, households have lost $2.5 trillion of net wealth, or 5.5% of the total. On most estimates of the wealth effect on consumption, that would feed through into something like a $100 billion reduction in consumer spending.
By chance, that amount is almost offset by the recently announced fiscal stimulus package. And that’s before the impact of Federal Reserve chairman Alan Greenspan’s massive easing of monetary policy.
The question is whether consumers will have enough confidence to spend more, despite the loss in wealth. Much depends on the labour market. Hours worked are falling and redundancies rising. I reckon that unemployment will peak at 6% to 6.5% quickly. But at that level of unemployment, real incomes will still be rising by around 3%.
So the amount that gets spent depends on what happens to the savings rate. There is a historically firm relationship between changes in unemployment and changes in savings. If that relationship were to hold and unemployment peaked at 6.5%, growth in consumption would trough at 1.6% year on year. Then it would start to recover as unemployment fell.
The real danger lies above the 7% unemployment level. Much beyond that, consumption would start to contract and the world would face deflation. So it’s a narrow call. The trough in growth and the adjustment in employment and savings will probably sweep through the system like a tropical storm and be on the wane by the end of the of the first quarter of 2002.
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By then, markets should fly based on a revival in confidence and macroeconomic growth. Then wealth creation will take over as the driver of demand and productivity as the driver of supply.
The dollar will remain strong, supported by two factors. The first is a gradual acceleration of globalization that I expect to result from the new economic configuration coming out of the alliance against terrorism. The second is the unattractive nature of the alternatives to the greenback. Japan’s unending travails will weaken the yen towards ¥140 to the dollar by the end of 2002. And then there is the euro’s mediocrity. This will keep the trade-weighted dollar index fairly strong.
What happens to emerging markets against this backdrop? In recent years, emerging markets for debt and equity have been gobbling up investor wealth in truly lupine fashion. And emerging economies in Asia and Latin America will recover more slowly than the US. However, I reckon equity markets will anticipate all this and move with the US market. And several emerging markets look cheap in relation to history, on both price to earnings and price to book value.
The circular conundrum we face is that, if equity markets don’t collapse, neither will the world economy. And if the world economy holds up, so will equity markets. The serpent bites its own tail. Hopefully, it won’t bite us.
I remain optimistic about the world, capitalism and equities for the long haul (bonds are dead meat, along with balanced budgets). But my sense is that equity markets have got a bit ahead of themselves – given our time map of equity market recoveries from catastrophes. The consensus about a V-shaped recovery could get a jolt or two down reality road.
