The world is in recession. But it won’t be by the end of the year. It will be the US economy that will show the way out of the mire. And it will be the US consumer that will hold the centre in the battle against recession.
The US corporate sector is cutting jobs but not enough to drive down unit labour costs sufficiently to stem the catastrophic fall in corporate profits. Write-offs associated with the new wave of corporate rationalization and with the end of the IT investment overspend are still huge as most CEOs try to clear their books, in order to make the next fiscal year (and their stock options) look better.
Later in the year, though, write-offs will subside sharply and I expect profits to recover quickly. The leading manufacturing indicator, the ISM index, has turned up and manufacturing inventories continue to fall. In the bombed-out technology sector, there are now flickers of life. Global semiconductor sales are rising, US orders for electronics products are rising, chip prices have shifted up and, most significantly, US IT inventories are falling.
Although the Democrat-controlled Senate has paralyzed Bush’s fiscal stimulus package, it cannot postpone its implementation for much longer. Even a watered-down plan will boost US household incomes by the summer.
The question is whether the US consumer will have the confidence to spend more, despite losses from two years of stock market decline. Much depends on the labour market. Hours worked are falling and redundancies are rising. Unemployment will reach 6% to 6.5% by the end of this quarter. But job cuts will subside by then. And even with 6.5% unemployment, incomes will rise by around 3%, as inflation will stay dead.
This time last year, contrary to most views, I reckoned that the dollar would stay firm and so it has proved. I keep that view this year. The dollar bears argue that the US current account deficit and external liabilities make the dollar vulnerable. They miss the point. The great US wealth-creating machine can supply sufficient savings to fund US imports and the globalized corporate sector generates demand for US dollars as the world’s transaction currency. And the US remains the most attractive portfolio investment destination. So the dollar’s trade-weighted index will budge little this year, helping to keep global inflation low.
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If the dollar remains strong and inflation low, commodity prices will not spike up. That’s particularly the case for oil. Sure, Opec has got an agreement with non-Opec oil producers to restrict supply and that has helped to stabilize prices in the $20 to $22 a barrel range. But as summer in the northern hemisphere approaches, world demand will subside, even though US economic recovery will start to come through. This will keep oil prices steady.
In Europe, corporations are not rationalizing at the pace of the Americans. And European governments have much less room for fiscal stimulation, with many likely to generate budget deficits close to the 3% of GDP limit set by the Stability and Growth pact. But tax and corporate reform already implemented will bear some fruit this year, particularly in Germany.
The fly in the ointment will be elections in Europe. France has a presidential election in March and a parliamentary one in May. Germany goes to the polls in the autumn. Further tax reform and market liberalization will be on hold.
Yet by year-end, reform could start up. France could re-elect Jacques Chirac as president and follow up with a centre-right majority in the National Assembly. Chancellor Gerhard Schröder will probably be re-elected, but this time with the centrist Free Democrats ousting the Greens as his partner, meaning more business-friendly governments in France and Germany and a centre-right leadership in the eurozone (Spain, Italy, France and Germany).
That augurs well for European equities and the euro in 2003. Meanwhile, European equities are cheap and will ride up on the incoming tide of US markets. Right now, there is no reason for euro enthusiasm.
Japan’s prospects remain dismal. The economy is still on its knees and the willingness and ability of the government of Junichiro Koizumi to deliver reform is dubious. But real reform would entail unprecedented wealth destruction. So Japan has only one tool to keep the game going: a weak yen and then a weaker one. I expect the yen to fall to 150 to the dollar from the current mid-130s by the year-end. Long term, Japan’s huge government debt is a ticking time-bomb that will eventually mean rising JGB yields.
As for emerging economies, the disastrous mess in Argentina will take time to play out. The new populist administration of Eduardo Duhalde may have a clear majority in congress but it is thrashing around to find some way of mitigating the impact of forced devaluation on its citizens. It wants banks and foreign creditors to take the immediate burden, so risks a disorderly collapse of the peso and hyperinflation. At best, GDP will shrink around 10% this year as foreign investment and credit dries up and domestic demand plummets.
The impact elsewhere has been minimal so far. Spanish banks and oil refiner Repsol are hardest hit, as they have $40 billion to $50 billion in investment there. At least half of that may have to be written off. US exposure of just $20 billion is insignificant. Economic collapse in Argentina and peso devaluation will exert downward pressure on the real and Brazil’s economy. And victory in the presidential elections in October for another populist leader, “Lula” (Luis Ignacio Lula da Silva), could slow inward investment.
A new world order since the September terrorist attacks has meant US dominance in world politics, accelerated globalization and trade liberalization. Out of this, there are clear emerging market winners.
Last year, Russia was the best-performing emerging equity market. This year it will not be oil as the driver, but economic reform. President Vladimir Putin is pressing ahead with corporate liberalization and more foreign investor-friendly policies as Russia prepares to join the World Trade Organization in return for backing US military action in Afghanistan.
Above all, Turkey has been the biggest beneficiary of the new world order. While Argentina dangles in the wind, Turkey has had no problem in getting credit from the IMF. That has enabled the governing coalition to push through banking reform and sustain a strong lira policy to try to dampen inflation.
Overall I’m bullish about the world economy and global equity markets this year. There are risks. The US economic recovery might not materialize as Americans stop spending under the weight of rising household debt and unemployment. A US attack on Iraq as part of the anti-terrorist campaign could cause a sharp jump in oil prices that depresses the world economy. Japan’s yen devaluation could get out of control and provoke devaluations across Asia, causing global deflation. Argentina could spiral into political disarray that spreads across Latin America. But risks have less than a 50% probability. In my view, it’s less than 20% in these cases.
