The global economy is headed downwards, stock markets are plummeting and fear looms large in the headlines of the financial media. The change of mood could hardly be more extreme.Just a few months ago, faith in the New Economy’s boundless forces of renewal was unshakeable.
After the dream came the rude awakening. So where did it all go wrong? Was the New Economy no more than a bubble that has now burst? Or are we merely correcting its excesses?
Has capital been misallocated on a scale similar to that of Japan in the 1980s, and are we now about to spend a decade repairing the damage? Or is the slowdown merely a cyclical phenomenon triggered by interest rate hikes and an oil price shock? Long disregarded macroeconomic issues of this nature have now moved back up the agenda, and are again crucial factors in the judicious allocation of assets.
The classical leading indicators of the business cycle are pointing to a recovery in the second half of the year. Since their peak in January 2000, yields on 10-year US government bonds have fallen from 6.8% to below 5%; the Federal Reserve has cut interest rates by 150 basis points in three stages since December; and the oil price has stabilised at a level below the 2000 average. Just-in-time production processes and improved supply chain management also mean that inventories and output can be adjusted to reflect the changed environment more rapidly than was the case in previous downturns. As a result, corporate profits could begin to pick up again as early as late autumn and the stock market could very soon bottom out.
Unless, that is, substantial overcapacities have been built up in recent years. Since 1990, production of computers, semiconductors and telecommunications equipment in the US has risen 50 times faster than the manufacture of other goods. As a result, money may have gone into investments that will never produce a return. Prime examples of this were the internet startups in the business-to-consumer segment and the billions shelled out by telecom operators desperate to acquire UMTS licences. The IT consultancy Renaissance Worldwide claims that data transfer capacity in the US has increased four-hundredfold within the space of just three years, while effective demand has risen by a factor of only 20.
Yet the comparison is misleading. Unlike the situation in Japan, the productivity of capital has risen significantly in the US (whereas labour productivity rose faster in Japan than in the US). The ratio of GDP to total capital stock rose continuously in the US between 1982 and 1998, at an average of 1 ?% per year. This argues against the logic of years of capital misallocation. It was not until 1999 that capital productivity fell slightly. No data are yet available for 2000. At the most, there may have been some overinvestment during the past two years. Even if this were the case, there are still differences with Japan. The average life of an investment in IT is 33 months. In the absence of new investment, the capital stock shrinks by half after only 17 months. The adjustment to a contraction in demand is thus swift. In Japan, on the other hand, the catastrophic results of investment in real estate and the capital goods industry are still clearly in evidence.
This reasoning delivers two possible scenarios for the future development of the economy. The main scenario is one in which annual growth in the US economy slows to 0.5% and then speeds up again towards the end of the year. Global corporate profits growth would decline from +5 to –5%. In our view, this scenario is already factored into the current level of equity prices. The risk scenario would demand the reduction of excess capacities, and given the length of time involved, would necessarily imply a sharp retrenchment by US consumers, resulting in a deep but brief recession. The stock markets are only just starting to get to grips with this scenario. Whichever of the two materialises, there is no prospect of good news on company earnings before the autumn.
As far as liquidity is concerned, the picture is completely different. The most important factor influencing the medium-term outlook for the equity markets is the development of M1 money supply in the G7 countries. Changes in this measure explain 45% of the annual change in the MSCI World Equity Index. The contraction in M1 over more than 12 months was halted in January when the Fed switched to a more aggressive easing of policy.
The Bank of Japan followed suit in March with a shift from an interest rate-driven to a money supply-driven policy, and we have no doubt that the European Central Bank will sooner or later move in the same direction. Although the mechanism by which a more aggressive monetary loosening impacts on the real economy is still the subject of debate, there has been not a single instance since 1980 of an injection of liquidity failing to have a positive effect on the equity markets within 12 months.
For this reason, and despite the negative earnings outlook, we no longer dare to be underweight in equities at the current levels. On the contrary, we have been reducing our performance-related underweighting of equities since the beginning of the year, by buying Japanese stocks and cutting back our underweighting in US and European telecommunications companies. In view of our risk scenario, we remain cautious on US consumer cyclicals. Given the lack of action by the ECB, we have set the duration for euro bonds two years above the benchmark.
Rainer Marian is chief investment officer at Julius Baer Asset Management in Zurich