The Hindu Business Line : The `golden' opportunity

This is a golden opportunity to accumulate the yellow metal though gold has been consigned to the dark recesses of human brain, and most metal bulls and speculators must have given up. This is because of the imbalanced state of the US economy and the impossibility of a combination of strong dollar, low interest rates and resilient stock market, says V. Anantha Nageswaran.

AT THE outset, let me concede that I did not anticipate the US economy being able to generate more than 700,000 jobs in the four months of 2004. The employment report for April has shown all round strength. Job creation was pervasive, hours worked edged up and unemployment duration dropped. Even wage growth has picked up moderately. It is hard to find a chink in the report indicating underlying weakness.

I expected a variety of factors — productivity, tax incentives for capital spending, executive compensation being linked to profits, rising worker benefit costs — to keep job creation at best around 100,000 per month. This does attest to the powerful stimuli given in the last two years. Equitable or not (it was clearly not), this stimuli is working although belatedly. Hence, the April employment report must be a huge shot in the arm for the re-election chances of the President, Mr George Bush. Of course, the US economy would have been better off without such a boost to his re-election bid. That is another story for another occasion.

Despite such an embarrassing setback, I venture to state that, a month or two down the road, the picture is going to look very different. I have laid out my case in this column before but let me go over them again, for the sake of completeness.

Revisiting the big picture

I believe that the US economy is fundamentally imbalanced and that a cyclical upswing — as the one it is experiencing now — would neither be long nor powerful enough to wash away the excesses of the 1990s.

Those are excess capacity in some (or, most) tech sectors, excess household debt and excess current deficit (it is excessive both in absolute dollar terms and also as a percentage of GDP in the US). To this list of excesses is added the budget deficit and the Social Security and Medicare deficits that would come from the end of the decade as the baby-boomers really start to retire from 2008.

Hence, a combination of strong dollar (as the market is pushing it now), low interest rates and resilient stock market is just not possible. Whether the Federal funds rate is at 1.0 per cent or at 3.0 per cent, it would still be low, if the nominal GDP growth rate is running at 7.0 per cent.

If this combination of low interest rates and strong dollar continues, the current account deficit would really begin to swell — low interest rates would provide a continuous boost to domestic spending — investment or consumption, and together with a strong dollar it would bring back ever-larger and accelerating deficits.

On top of that, if the Bush administration returns to power, no power on earth would stop them from making the tax cuts permanent. The fiscal deficit, even if it does not balloon further, would not decline, as it must, for the sake of long-term health of the economy.

The sticky factor

Into this cauldron, we should throw the oil price outlook. Just by way of information, crude oil did cross the $40 per barrel on Friday in American trading. Regardless of whether the House of Saud meets with its destiny soon, the oil supply issue is going to be tight. Paul Erdman, in his recent column in www.cbs.marketwatch.com observes that Iraq is pumping less oil than it did before the start of the war.

There have been many reasonably well-informed and well-argued articles on the true state of oil reserves and excess production capacity in OPEC and non-OPEC countries. I tried to compile some of the evidence in my piece for Business Line on March 1 (www.thehindubusinessline.

com/bline/2004/03/01/stories/

2004030100130800.htm).

Regardless of the statistical fact that the real price of oil is much lower now compared to, say, 1973, it is not going to help the summer traveller in North America if petrol at the pump costs her wallet $2 per gallon. She would only compare it to the fact that it was less than a dollar three-four years ago. During this period, real wages grew far too modestly for the average household. Hence, the energy `tax' this time around is likely to be quite substantial.

If the crude oil price were indeed too low in real terms, then why does it lead every recession in the developed world? It was not just confined to 1973 or 1979. It has happened in 1989-90 and in 2000-01 too.

Will the new consensus become old again soon?

Therefore, just as the American job creation machinery is coming into form, other clouds have gathered: the unsustainability of China's growth, the uncertainty over oil price and the uncertain impact of higher bond yield on the housing market and other rate-sensitive sectors of the US economy. These would bring to halt the current economic upswing and improvement in the labour market, sooner rather than later.

On Friday, Wall Street was scrambling to revise its forecast of the timing of a Fed rate increase. There were substantial revisions. Even the bears — both absolute and relative — on the US economy had revised their forecast as to when the Federal Reserve would begin to tighten monetary policy. A Bloomberg news article produces the following useful table:

However, my feeling is that the oil price would do the job for the Fed chief, Mr Alan Greenspan. It might cause inflation to rise in the short-term. But, more than that, by causing a slump in global economic activity, it would take away any need for interest rates to rise. Before long, the Street would be clamouring for rates to drop.

Countries with higher rates would have room to do so whereas the US with the Federal funds rate at 1.0 per cent would be left with little stimulus to impart. Fiscal policy too is shackled. This risk is not in the price of US equities at all. The US economy would be faced with a protracted stagnation and the dollar a major slump. We have not even considered the issue of what would a slump in US equities mean for consumer confidence and spending.

Headwind from US equities is an unaccounted risk

The US Equity Strategist of Solomon Smith Barney (Financial Times, May 6) reckons that there could be a double-digit correction in US equities this summer. He reckons that analysts' earnings revisions are unsustainable. This was written before the price of crude oil hit $40 per barrel. US equities, despite the impressive rise in earnings, are still richly valued. Relative to the bond yield, US earnings yield looked better. However, if the 10-year Treasury yield reaches 5.5 per cent, this relative cheapness of US equities too would vanish. Then, add to this mix the peaking of corporate earnings and higher oil price, US equities could be set for a steeper fall than the strategist of the Solomon Smith Barney reckons. That would be an additional headwind for the US economy. Thus far, it has scarcely found a mention in consensus discussions.

Further, we should not dismiss lightly two powerful interpretations of the global economic cycle:

(1) East Asian stock markets (and that includes Japan lately) are far from cheerful. They are normally leading indicators of global economic cycle, and

(2) On Friday, despite the sharp rise in the US bond yield, the 10-year Australian Treasury yield barely budged. Admittedly, it might not have been actively traded in New York. However, the spread to the US 10-year bond has narrowed significantly now to 119 points from around 160-180 at the turn of the year. If the global economic cycle is improving or is about to accelerate, the Australian bond market would not be so composed since the Australian economy benefits foremost from such an upswing.

Hence, despite signs of rising euphoria on the US `goldilocks' economy (interesting that no one has uttered this phrase, widely in circulation in the 1990s, again!), the current strength of the dollar presents an important opportunity to unload the currency if one has them in plenty. Yes, gold has been consigned to the dark recesses of the human brain now. It lost nearly $20 per ounce in two trading days. Most gold bulls and speculators must have given up. Needless to add, this is a golden opportunity (pun intended) to accumulate the yellow metal.

A postscript on ECB

Most commentators have expressed disappointment that the European Central Bank has left rates unchanged at 2.0 per cent. However, it is not a surprise. In April, both Mr Otmar Issing (ECB Chief Economist) and Mr Jean-Claude Trichet (the President of the ECB) were in New York and their speeches were implicitly critical of the Federal Reserve approach towards asset prices: that is, intervene when they are too weak but stay aloof when they are too strong, relative to fundamentals.

This is what Mr Trichet had to say: "... If a central bank were to react in an asymmetric manner, namely only with looser policy at times of asset price busts but not with tighter policy when asset price bubbles emerge, the central bank may create through its own behaviour a moral hazard problem among market participants. It is crucial for a central bank to avoid this, since a perception that it insures investors against the risk of large losses could easily contribute to the formation of new bubbles in the future... "

When the short history of central banking in this decade is written, historians would do far more justice to the ECB than contemporary market commentators and journalists do.

(The author is Director, Global Economics and Asset Allocation in Credit Suisse, Singapore. The views are personal. Address feedback to nageswar@singnet.com.sg)

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