In my view the bear market in equities will resume beyond the so-called summer rally. Crucially, the huge fall in household wealth will dampen consumer demand and rising risk aversion will delay a revival of global investment. There will also be much weaker corporate earnings growth, making equities overvalued; a weaker dollar spreading deflation into emerging economies; and poor leadership from the US administration on global economic policy and geopolitics.
But the most important factor suppressing equity market revival is intensified disinflation in the US. This means that US corporations can only recover profit margins at the expense of consumer purchasing power. That increases the risk of a double-dip recession at worst and weak corporate earnings growth at best. Profit margins won’t recover and more jobs will be lost, drastically postponing economic recovery.
Global ripples
Disinflation also applies globally. As the euro and sterling have strengthened against the dollar, eurozone and UK inflation is slowing significantly. I expect this to continue.
Among the cyclical drivers is the high risk of a double-dip US recession. In the second quarter this year, final demand fell, as it did in the “first” recession of 2001. I expect it to contract further over the next six months until further corporate rationalization creates conditions for higher and sustained profitability. This puts a powerful limit on pricing power.
At the same time, the share of US corporate output value going to employees remains high. Indeed, the growth in their compensation would have to fall 1% to 2% for a significant, sustained recovery in corporate profit margins, even assuming annual productivity growth remains above its long-term average of 2.5%.
For the moment, tax refunds and low inflation are keeping real disposable income growing enough for consumers to sustain spending. But if compensation growth slows even more and tax refunds wear off, consumer spending will slacken. This is the scissors dilemma: corporate profit margins can only recover at the expense of weakening consumer demand. And that threatens a new bout of recession.
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The US economy is still loaded with capacity, instigated by a huge overestimate of demand. In the tech sector over the past 10 years, capacity grew over 12 times. Demand eventually buckled. That spread to the rest of the economy and investment plans were scaled back. Even so, it will be a while before demand matches capacity.
US Inc has now become a victim of its own success. Globalization has played a large part in the secular inflation slowdown since the 1990s. Throughout that time, US multinationals, from Nike to GE, have shifted production overseas and re-exported cheap products back to the homeland. In the long term it makes sense. US consumers buy more with their buck and drive growth without accelerating inflation, while emerging economies gain export revenues. That works fine in booms but when the US economy starts to stutter it can’t stop globalization on a whim.
Consumers have been weaned on products ranging from cheap sneakers to Toyota Land Cruisers. Cheap foreign-made goods have swamped the economy and gained critical market share. They constitute over 16% of retail sales and domestic producers are forced to cut prices to match them.
Secular disinflation over the past decade has made it difficult for corporations to regain pricing power. Non-financial corporates were able to raise prices by 5% a year at the beginning of the 1990s, similar to the core inflation rate. By the first quarter this year, corporate prices fell some 1% after a 3.2% annualized decline in the fourth quarter of 2001.
The real casualties of disinflation, lack of investor confidence in corporate governance and weakening public finances are the US dollar and equities. In the late 1990s, superior returns on US financial assets made the US dollar the favoured destination for foreign savings. Merger and acquisition capital piled into the US and flooded out of Europe. US foreign affiliates conducted business in dollars, reinforcing the greenback as the global transaction currency and creating extra demand. And with an (as yet) untested euro and dire financial troubles in Japan, there was no competition. Improvements made in fiscal accounts added to dollar hype, which in turn was amplified by a propaganda diet served up by successive White House administrations.
All that has changed. Market forecasters now expect deficits for as far as the eye can see. While the US economy boomed in the late 1990s, it continued to ring up an annual current account deficit worth $450 billion – 4.3% of GDP. This did not matter when the dollar was the main transaction currency and net investment flowed into the US.
But now Enron, Global Crossing, WorldCom and other accounting irregularities have destroyed investor confidence in corporate America. And capital flows now drive the dollar. In the first half of this year, net inward portfolio flows have been insufficient to cover the deficit. Foreign investors are unlikely to pile into US equities, where valuations remain rich and the profit outlook is bleak.
Don’t expect this summer rally to last.
