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Monday, Aug 05, 2002

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The coming train-wreck

V. Anantha-Nageswaran

IN THE last two weeks, a spate of key economic indicators from the US and from Europe has turned down — rather significantly. We will quickly recall them here:

  • Philadelphia Federal Reserve District (the entire Eastern seaboard) manufacturing index was sharply down in July;

  • Durable goods orders for June were down 3.8 per cent when consensus expected +0.6 per cent;

  • University of Michigan consumer confidence dropped more than expected in June;

  • Conference Board consumer confidence slid to lowest levels since October;

  • Second quarter GDP was half of what consensus expected. Without inventory build-up, growth would have been negative. Growth for five consecutive quarters ending Q3, 2001 has been revised even lower. The US had experienced three consecutive quarters of negative GDP growth in 2001 up to Q3;

  • Jobless claims surged higher unexpectedly this week;

  • Construction spending was unexpectedly negative in June and, further, May spending was revised lower to -2.0 per cent from -0.7 per cent;

  • The US Government acknowledged that the budget deficit for the fiscal year ending September 2002 would be higher at $165 billion. Independent private sector estimates put it much higher. In Europe, the German Business Confidence Index (IfO index), the French business and consumer confidence have dropped. French unemployment rate climbed higher to 9 per cent. This is not a surprise. In 2001, Europe was not immune from the US contraction. The decline in European business and consumer confidence and the rise in French unemployment suggest that it would be no different this time.

    We are turning more bearish on the US

    I have been reiterating my bearish stance on US equities to the clients of the bank. That call got a bit more desperate today. I had reduced global equities to 15 per cent of a client's portfolio. Here is why.

    The GDP report for Q2 did not signal any demand growth at all. On the contrary, demand remains weak. Real GDP grew at half the rate expected — 1.1 per cent versus 2.3 per cent expected. Real Final Sales — GDP less inventories — actually dropped 0.1 per cent. Which means the GDP growth came from producing for inventory. Demand remains really weak. Nominal GDP grew at a rate little over 2 per cent — indicating total lack of pricing power in the economy. Gross domestic purchases — irrespective of whether goods are produced in the US or not — rose 2.8 per cent at half the rate of Q1 but imports rose at 23 per cent in Q2!

    This means two things:

    (a) Americans are buying too much abroad. Domestic capacity remains idle;

    (b) The American dollar was still too strong tempting them to spend more abroad than locally

    GDP growth in the first three quarters of 2001 was negative. The US has had a real recession. However, the housekeeping that happens during recessions — rise in domestic savings, reduction in imports and reduction in leverage — did not take place. On the contrary, the US is still going strong on imports, savings rate is too low (implying continued dependence on foreign savings) and both corporations and households remain mired in debt. There is lot of work to be done.

    Corporate profits from current production — profits before tax with inventory valuation and capital consumption adjustments — was revised down for all three years: $19.4 billion for 1999, $88.3 billion for 2000, and $35.5 billion for 2001.

    This clearly shows that reported profits to SEC by US corporations were even more exaggerated than before (see chart). This once again underscores the argument that the overvaluation towards the turn of the century was exceptionally high and has a long way to go, to correct itself.

    The ISM (used to be known as NAPM) report released on Thursday was equally worrying. New orders have dropped alarmingly. Inventory build-up is also screeching to a halt in manufacturing. In Q2, it was inventories that held up growth. If producers, sensing absence of demand, stop producing for inventory, where is the support for GDP and profits growth?

    Second, the only thing went up in the ISM report was the index of prices paid by manufacturers. Purchasing managers cited higher prices for steel and for energy as key concerns. We have been hammering away at this. Higher prices for oil would raise input costs and in a weak demand environment, it cannot be passed on to end-users but have to be absorbed. Profits will be hit. The Centre for Global Energy Studies predicts that OPEC would not raise output in September with demand growth flat this year. In the meantime, with tensions between Israel and Palestinians high and with the war on Iraq under active consideration at least in the minds of the public, if not elsewhere, oil prices will remain to the north of $25 per barrel.

    Essentially, we now await the sell-side economists — who have consistently overestimated demand and economic growth as has been evident in recent data — to downgrade their growth, profit and interest rate expectations and wait for such revisions to be priced in. Consequently, we expect a volatile August-September (perhaps, until mid-October) period with a downward bias. Hence, the reduction in equity portion.

    What is the scene with Europe?

    With the ECB going on vacation after its no rate-hike decision yesterday, no action is expected from them for the next few weeks. That is a pity. All underlying (second pillar) demand data in the Eurozone point to weakness. Morgan Stanley economists have downgraded Eurozone growth to below 1 per cent this year. A rate cut from the ECB, ahead of the Federal Reserve, would do wonders for confidence in the Eurozone and would be rewarded immediately with a firmer Euro. If that happens, we would turn bullish on Europe agains. There is also a possibility that Europe de-couples from the US and raises (hope springs eternal!) and if so, we would gladly raise European equity allocation. For now, we expect Europe to fall in sympathy with the US, on renewed US and European growth concerns.

    Asia would be a relative star but absolute returns?

    Asia would continue to struggle to find an identity for itself. There are many fans for the region simply because it has suffered excessively in 1997-98 and also between 2000-2001 in financial markets. Its fundamentals — measured by current accounts, short-term external debt, etc., are sound — and there is no hot money waiting to flee the region. Nor are Asian stocks rich in valuation. These are all the positives.

    However, the negatives are that the region — despite its brave efforts to distance itself from US economic (mis) fortunes — has not yet arrived there. With the possible exception of Korea and Thailand, others are still reliant on US growth. Singapore, Malaysia, Taiwan and Hong Kong would be particularly vulnerable. China would also feel the chill.

    In fact, a recent seminar in which Nobel Laureate, Professor Lawrence Klein, presented his regression estimates of GDP growth for China actually confirmed that there is a lot of fluff in China's GDP reporting. Actually, the seminar was intended to convey the opposite message! More on that on another occasion.

    Personally, I have never been more pessimistic for global growth in the short-term (three to five years) than I am now. I somehow get the feeling that we simply would have to get out of the way of an oncoming train-wreck. To do that, investors have to take the knife to their equity holdings or see them suffer a death by thousand cuts.

    To sum up, I can do no better than quote verbatim Mr Ryoji Musha, the equity strategist of Deutsche Bank in Japan:

    "The rebound on the New York stock market at the end of July has proved short-lived, dashing expectations that the S&P 500 was recovering after hitting a major bottom at 797 points on 23 July. A fall to 48% of the S&P 500 peak 28 months ago, or to half its value, means the steepest drop since those seen during the period of the Great Depression in the 1930s. This appears to be a bear market on a scale seen only once in 50 or 100 years...

    If we acknowledge the irreversibility of this drop, it will make it easier for us to look into the future. The problem continues to lie in the unwillingness of many investors, economists and authorities in charge, including the Fed, to acknowledge the formation and subsequent bursting of a secular bubble. For those who embraced and even worshipped the bubble, going as far as dignifying it by calling it `the new economy', this acknowledgement is apparently impossible because it would imply admitting their mistakes. In our view, stock prices will likely keep falling until the last of the stock bubble's stalwarts surrenders. Then, the sooner they realise their mistakes, the better for stock performance, in our view."

    Source: "Bubble can no longer be denied'' (August 2, 2002)

    Deutsche Bank Research

    (The author is the Regional Head of Investment Consulting in Credit Suisse, Asia-Pacific. The views are personal. Send feedback to

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