The Hindu Business Line : Which way will wind blow in May?

If consumers are taking a cautious line and there is little reason to take capital-spending indicators seriously, where does it leave the economy? This also does not help rosy expectations for corporate profits that Wall Street has pencilled in. For now, only the adage, `Sell in May and go away' for equities, may work, says V. Anantha-Nageswaran.

THE US President, Mr George Bush, said recently that he would like Mr Alan Greenspan to remain the Chairman of the Federal Reserve for a fifth term starting 2004. Mr Greenspan has accepted the `invitation'. In hindsight, he might wish that he had waited to offer his consent.

Two pieces of economic data appeared on the horizon in America on Friday. Both point in different directions. Well, we economists have to work to earn our salaries, don't we?

American consumers are pulling back?

Initial jobless claims went up. In English, claims for unemployment benefits filed by those who become newly unemployed have risen. Why does it matter? Well, this is a weekly number and last week was the second week, since US Marines famously pulled down the statue of Saddam Hussein.

Claims for unemployment, instead of falling, have risen now for the last two weeks and are well above what many regard as the threshold of 400,000 that signifies weaker labour market above that and an improving labour market below that.

That this has coincided with a spectacular collapse in mortgage refinancing activity in the last four weeks has kept recession enthusiasts' hopes (?) alive. They still can say, "I told you so". Between March 14 and April 18, the index of applications for mortgage refinancing has plunged from above 9000 to around 5100.

Truth be told, in about 10 days in March between the time the stock market bottomed and staged a remarkable rally in mid-March, the 30-year mortgage rate rose by 48 basis points from 4.75 per cent to 5.24 per cent. Then, it plunged to 4.82 per cent by end-March. However, despite the stock market continuing to rebound in April, the yield had stayed flat at around 4.8 per cent. Thus, combined with steady rates at lower levels and a booming stock market, consumers must have flocked to take advantage of the refinancing opportunity. On the contrary, the index has staged a spectacular collapse. Are consumers slowly beginning to realise that their balance-sheets are due for some sort of repair? Figures tell us that such repair work is overdue:

Household mortgage debt is 29.3 per cent at end-2002, of all outstanding debt for all domestic non-financial sectors, up from 27.9 per cent at year-end 2001.

Gross national savings dropped to 15 per cent of GDP — the lowest national savings rate since the 1940s.

Outstanding debt of domestic non-financial sectors climbed from 191.4 per cent of GDP in year-end 2001 to 197.8 per cent at year-end 2002.

Between year-end 1999 and year-end 2002, the combination of a burst stock bubble and rising debt levels drained households' net worth by $3.1 trillion or 7.4 per cent. Despite sizeable growth in the value of real estate and consumer durables owned by households, the largest annual drop in this three-year period occurred in 2002 ($1.7 trillion or 4.3 per cent)

Consequently, the ratio of household net worth to disposable income has now sunk below 1995 levels. In no period since the 1930s, have so many American families lost so large a share of their savings in such a short period.

By the end of the fourth quarter of 2002, owners' equity as a percentage of household real estate dropped to 55.6 per cent — the lowest level since 1993, when the ratio fell to 59.0 per cent in the wake of falling home prices. Given this trend, more households could see their equity disappear altogether if housing prices fall.

Will capital spending pick up the slack?

Thus, if consumers are waking up to the lowest level of net worth and home equity in years, then the only way the economy can continue to stay afloat is if capital spending is picking up the slack. Recent data has given some cause for cheer. Durable goods orders for March 2003 were up 2.0 per cent when consensus expectations were for a drop of 0.6 per cent.

More importantly, orders for durable goods (excluding defence and excluding aircraft) have now increased in three out of the last four months. Economists consider this data as a barometer of capital spending.

Hence, any sustained strength in this indicator is a good sign of future capital spending, employment and growth. We are not yet ready to celebrate, however. .

The kind of bounce seen since November 2002 has been seen before in end-2001 and in mid-2002 only for it to taper off later. Now, why should it taper off this time? Altman Z-score is a measure of the solvency of corporations. Simply put, the formula enables analysts to take into account whether the firm's assets are put to productive use. Otherwise, the liabilities incurred to acquire those assets cannot be serviced adequately.

At the end of December 2002, around 60 per cent of the S&P500 with December year-ends have provided enough information to allow us to calculate their Z scores. Of those who have reported, 34 per cent currently have Z scores below 1.8, the critical level for assessing solvency (Source: "Fair Value: It just isn't good enough", Global Strategy, Dresdner Kleinwort Wasserstein Research, March 27, 2003).

Corporate net worth at year-end 2002 is some 2.3 per cent below its 2000 peak.

Debt as a share of net worth rose to 56.1 per cent at year-end 2002, compared to 49.8 per cent in 1997.

Debt as a percentage of outstanding equities soared to 62.7 per cent, up from 32.7 per cent in 1998.

Not to mention, durable goods orders statistics are notoriously fickle subject to extensive revisions down the road.

We are headed for interesting May

So, if consumers appear to be taking a cautious line and there is not much reason to take capital-spending indicators seriously yet, where does it leave the economy? Well, not yet in the recession camp. After all, crude oil price has dropped from near $40 a barrel to around $28 in the US. Petrol prices are on their way down.

Hence, consumers should be somewhat relieved. In the absence of fresh shocks, recession risk should now be rated at around 20-30 per cent.

(Further, if the virus causing SARS were not contained in China, one of the major sources of demand for PDAs, mobile phones and personal computers would dry up quickly. Anecdotal evidence already points in that direction. For now, this is no one's base case.)

However, this does not help the Federal Reserve nor the rosy expectations for corporate profits that Wall Street has pencilled in, for the remainder of this year and next.

For the Federal Reserve, it would mean continued lower growth below potential and that would mean that inflation steadily grinds down, pushing real rates high, if they do not act on nominal rates. For Wall Street, stock prices would become more indefensible — a familiar territory for them, of course. That does not bother most men on Wall Street much.

Hence, if both the ISM survey index for May and employment data for April due next week are on the weaker side, the chances of a Fed rate action on May 6 go up significantly. What next then? That question would haunt equity investors and set up the market for declines down the road.

Should there be no perceptible improvement after this rate action, then we are likely to be looking at the Federal Reserve ready to deploy its Plan B — that of direct intervention in fixed income markets to boost money supply.

What consequences will it have are not easy to fathom yet. In any case, that topic requires a separate treatment. For now, it is safe to say that the adage that one `Sell in May and go away' for equities would work very well this year.

(The author is Director, Global Economics and Asset Allocation in Credit Suisse, Asia-Pacific. The views are personal. Please send feedback to anantha@nageswaran.com)

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