After an extraordinary end to 1999 - which saw economic expansion rates near 7% - and a strong start...
After an extraordinary end to 1999 - which saw economic expansion rates near 7% - and a strong start to the new year, expectations for growth this year are rising strongly. They are leaving the 3%+ consensus forecast which was prevalent last year, far behind. The first half could see activity rise by 5%, the second by over 4%, unless further action is taken.
Why this is a concern is that the sustainable non-inflationary growth rate is probably around 3.5%. A prudent Fed therefore needs to take action to slow things down. The problem is that rates are higher and many areas of the market are lower, but so far there has been little effect, either on the economy or on confidence.
One reason is that technology has remained strong, the NASDAQ index rising over 20% so far this year. Cash flows out of old economy stocks and bonds and the TMT sector suggest that investors have lost little of their enthusiasm for the new paradigm. Investors are not looking at today - they are looking at tomorrow. In a world of low inflation, low interest rates, a steady administration, promised tax cuts and a strong jobs market, tomorrow looks good. Certainly good enough to ignore the cautious tightening programme implemented so far by Greenspan.
From the perspective of the Federal Reserve, more needs to be done to break a cosy but dangerous cycle, where an overheating economy is supported by an over-extended stock market in a world economy which may not be as supportive in the future.
What evidence is there that the consumer is overstretched? A good place to start is the savings ratio, down from a 40-year average of 8.2% to 1.9%.
Why the need to save is under question is because the equity market has made people wealthier.
Financial assets now account for 500% of disposable incomes, up from 350% in the early 1990s. The confidence to spend is shown in the leakage from mortgage debt and into spending on durable items. Household debt is now at 95% of personal disposable income against a long-term average just slightly over 70%. Loan delinquency is rising in all categories except mortgages.
A manifestation of the strength of consumer demand extending beyond the US is the trade deficit, which rose to a new high of over 4% of GNP in the final months of 1999. A dominant feature in this deteriorating position has been the surge in imports of consumer goods.
So far the imbalance has been funded without strain. Overseas investors have been happy to increase US holdings, but the decision should be more balanced in future; Europe is expanding, Asia recovering. Demand for funds in these areas is rising as a result. Pressure on the dollar could have other side effects. Overseas investors hold 40% of the marketable float of T-bonds
From the perspective of the US authorities, it is therefore very important to ease the pressure on the system. This effectively means reducing final demand.
Efforts so far have failed, but that does not mean the game is over and they have stopped trying.
We expect interest rates to be increased high enough and for long enough to introduce a note of caution in the consumer. A sure effect will be slowing growth and falling earnings expectations - a challenge for a market rated as highly as the United States.
Our view is that Wall Street is vulnerable to a correction. We are underweight against benchmarks, and have portfolios concentrated in stocks with above-average earnings expectations and real (rather than simply balance sheet) value.
John Kelly is investment director at BGI Funds
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