By Michael Burke, B&M Research
L, U or V-shaped. That’s the only issue up for discussion: What shape will the US economic recovery be? No sooner had financial markets participants (mainly) accepted the idea of a US slowdown than attention switched to the guessing-game on the shape of the recovery. “Forget the downturn itself, Mr Greenspan will take care of that,” runs the argument.
But if your car were still making the same old clunking sound as you drove it off the garage forecourt after the mechanic had worked on it, then maybe you would ask what was the original problem and has it really been fixed? At the time of writing, all the main US stock indices are below their level on the day of the Fed’s emergency rate cut on 3 January, suggesting that some deep-rooted problem has not been addressed.
THE OLD CLUNKING SOUND
The main outlines of the current US downturn are as follows: The US slowdown is concentrated in the corporate sector and is brought on by a steep drop in profitability. The profits crisis is itself a function of the previous boom investment, which is not being validated by sufficiently increased domestic demand, or increased share of world markets.
Two other factors are exacerbating the corporate downturn: the high cost of capital and the dependence of corporate America on a rising stock market for reported earnings, assets and cashflow (including via “holidays” on corporate pension contributions).
The corporate crisis could easily spread to the whole economy, especially to the consumer sector if there is even a temporary shakeout in the jobs market, or simply from a collapse in confidence.
This vulnerability of the consumer sector arises because it too has been dependent on stock markets rising to finance consumption, and the savings ratio is now in negative territory. Monetary easing will therefore be aimed at preventing further stock market falls and, if possible, reflating them.
Fiscal policy is unlikely to be eased in time to affect the crisis in the first half of 2001. Apart from the intractability of the profits downturn (which may have to be dealt with by prolonged disinvestment), the main additional danger is that an easier monetary policy combined with a decline in profits will lead to a falling US dollar.
A falling currency could prove disastrous, given the US current account deficit and the dependence on foreign capital inflows. If the US dollar’s decline is outweighed by capital gains on US financial assets, then foreign investors are not obliged to sell their US assets. This is often the case in Fed easing cycles.
But if the US dollar’s fall were to become disorderly, or were threatening to overwhelm the gains on US assets, wholesale capital flight could occur.
Alternatively, a scenario in which a combination of relative growth, official policy and regulation were to make both Japan and the EU more attractive destinations for international capital, slowing capital inflows can undermine the USD.
From this, it follows that one key objective of US monetary policy must be to lower the cost of capital for US corporates. In fact, despite a 170bps fall in B2-rated corporate debt since the beginning of this year, yields still remain well above their peak seen in the 1998 crisis. If the response to date is any guide, getting rates down to 1998 levels would require a fall in rates of up to 2%, to 4.5%. If we assume that the current level of yields already discounts further easing, then targeted Fed funds may have to drop to as low as 4% to get 10-year B2 yields down to 9%.
The repetitive nature of recent crises is clear. There is a global shortage of capital, which means it is insufficient to sustain growth in all of the world’s leading economies simultaneously. This was in evidence again in the middle of last year, when the brief attempt of the US, Japan and the Euroland economies to mount a synchronised business expansion quickly collapsed into the current crisis. The same occurred in 1994-1995 and 1997-1998.
The shortage is manifested in a sharp rise in the price of capital (yields) every time there is an increase in demand for capital (investment). Classically, any rise in demand for a product will lead to an increase in its price (if supply remains stable). In the chart, we show the aggregate year-on-year growth rate of investment in the G3 versus the 10-year yield on US dollar B2-rated bonds. The correlation is striking.
Characteristically, investment growth is a lead indicator for the whole economy. A curbing of investment as yields go higher leads to a curbing of growth. G3 GDP growth has been fairly miserable over a prolonged period. And repeated dips in investment growth have been a primary cause in this weakness, and are themselves a function of the capital shortage.
Crucially for the current situation, the cost of capital to US corporates cannot decline without a sharp drop in investment growth in the G3 as a whole. But, if this is achieved solely via a decline in US investment, the consequences for the US dollar could be severe, implying both a relative decline in US GDP growth, and a decline in relative competitiveness.
Therefore, along with an easier domestic monetary policy, hopes for a US soft landing must in part rest on a slowdown in investment growth in both the Euroland and Japanese economies. This is not an entirely forlorn hope of US policymakers, not least because of the negative effects of the US slowdown on other leading economies. But the evidence so far is limited, and without it the risks of a hard landing for the US economy and US dollar increase.
Michael Burke is a partner of London-based B&M Research