What's the next big thing for the world economy? This time last year it was Asia's rebound, global r...
What's the next big thing for the world economy? This time last year it was Asia's rebound, global recovery and the reversal of deflation fears. Now that the e-business revolution is going global, it should be grasping the opportunity for an extended cycle of strong world growth without inflation. But that depends on making an awkward transition in coming months.
Typically, when growth is this strong, tighter global liquidity conditions provoke a financial crisis (the equity crash in 1987, Mexico in 1994/5, Asia in 1997). What is needed now is a more 'controlled shock' that cools the US consumer boom without spilling over to disrupt recovery in the rest of the world. There is no recent precedent, but there are some reasons for thinking it can be done.
First, low inflation means that policymakers have no licence to kill the expansion: their goal will be to temper demand in order to prolong the cycle. Greenspan's Humphrey Hawkins testimony was based on the idea that curbing demand will necessarily involve lower US equity returns. But also that tightening should proceed gradually, implying that it could be postponed or cancelled if the equity decline became too severe. Second, despite pockets of increased leverage in the US equity market, system wide leverage seems relatively low, reducing the risk of contagion effects escalating throughout the system.
So, our central view remains that the transition will eventually be made, after a fairly prolonged corrective phase in the US equity market. The implication of Greenspan's recent testimony is that the Fed wants the stock market to range trade, and that is precisely the outlook our US equity strategist Christine Callies has for this year. She expects the S&P500 to be confined between recent highs and 1,250 points or just below for some time, with a move towards 1,560 points possible by end-year if the economy slows and interest rates retreat. Note that despite record mutual fund inflows, a sharp increase in net new supply from the corporate sector is pressuring the market. International capital flows are also shifting, with cross border equity flows into continental European markets picking up sharply at the expense of Asia and Japan.
Europe is now our favoured region for equity investment as growth momentum picks up the most there, the e-business story accelerates and the euro very gradually recovers. We still like Japanese equities, expecting domestic investors to raise their allocations quite sharply in the new fiscal year.
However, we expect a somewhat weaker yen this year as moderate capital outflows replace last year's huge inflows. Longer term, we remain positive on emerging debt and equity markets, which have the most to gain from an extended cycle. Short term, however, they are vulnerable to the more volatile equity environment and what may turn out to be a Y2K-related inventory blip and commodity price setback.
The tough question relates to the extreme out-performance of 'new economy' stocks versus 'old economy' stocks. While our analysts continue to affirm the huge growth potential for many firms in the tech, telecoms, media and bio-tech areas they also point to more and more firms with solid cash flow or earnings prospects which now trade on extremely cheap valuations. Recently, the divergence has been even more extreme in Europe, Japan and some Asian markets than in the US. This feels increasingly like a capitulation trade which has started to overshoot.
Near term, a fairly sharp setback to new economy stocks is becoming more likely, especially if retail money flows slow down; longer term, out-performance is unlikely to be restricted to tech. In our view a more selective approach is now called for. In the new economy arena, that means a focus on the quality stocks with the best prospects of emerging as dominant players in the long term, and some of the new frontier stories outside the US and in the bio-tech area. In the old economy, the sell off is also creating potential opportunities.
Extremely low valuations and high dividend or even free cash flow yields, by no means always in companies with exposure to margin destruction, will attract private equity funds and stimulate corporate activity or share buybacks.
In between, investors are also seeking out hybrid or crossover opportunities in which old economy companies either transform themselves altogether or fight back with their own internet or e-business strategies. Going forward, divergence in performance across sectors should become less extreme as the boundaries between those sectors themselves become less clear cut, But differentiation between winners and losers within sectors will likely become even more extreme.
Meanwhile, yield curve dynamics in the US (and Europe) have been changed by the prospect of shrinking supply relative to the demand for high quality long duration assets. And more fundamentally by the prospect of strong near-term growth and low long-term inflation. Thirty-year yields have probably already peaked, leaving higher short-term bond yields and wider credit spreads and/or weaker stock prices to do most of the work in curbing demand growth. We believe it would take a real equity crash to produce a fundamentally steeper curve; the more orderly slowdown in nominal growth we expect in the second half should leave bond yields a bit lower and yield curves flatter or more inverted than we have been used to.
In short, the e-business revolution is accelerating and going global. That promises to produce a prolonged technology investment boom and ultimately a far more productive, flexible and responsive economic system. Decent old economy growth, firmer commodity prices and low overall inflation should be achievable simultaneously if financial stability can be maintained. For this year, at least, we think it can be.
At this time last year, our key macroeconomic call was that there
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