Despite oil prices and interest rates falling significantly in 2001 and scope for further monetary easing this year, the key question remains whether or not the US economy will recover in 2002
There can be little doubt that the key issue for financial markets looking out over the course of the next 12 months is quite simply whether there will be a meaningful recovery in the US economy.
If this proves to be the case, it should at the very least help to underpin equities at around current levels, if not drive markets higher. The principal risk, however, is that the excesses of the 1990s take rather longer to unravel and that, as a consequence, any pick up in business activity during 2002 is anaemic at best.
On the face of it, the recovery story has much to commend it. The Federal Reserve has lowered interest rates from 6% to just 1.75% over the past 12 months, oil prices have slipped to the $20 per barrel area, resulting in a significant transfer of wealth back to consumers, and, should Congress eventually put party differences to one side, there is still the prospect of significant fiscal stimulus to help reassure households and the business community.
Moreover, the first tentative signs are now emerging of an improvement in the newsflow. The leading indicator series, which has historically proved a good guide to turning points in the cycle, has risen for two months in succession and, more importantly, is now above its level of a year ago.
In addition, the closely watched survey by the Institute of Supply Management (formerly the National Association of Purchasing Managers) has climbed back towards the level consistent with a stable manufacturing sector.
Doubts persist however. One worry is that these improvements largely reflect an over-reaction to the events of 11 September and do nothing to dispel concerns that monetary policy will be much less effective in the current cycle. This is partly because businesses, having built up a huge amount of capacity in the 1990s, remain reluctant to sanction new capital expenditure programmes.
Moreover this retrenchment may be compounded by a further attempt by consumers to rebuild their badly damaged balance sheets ' such a decision could curb retail spending in a material way.
Meanwhile, lurking in the background is the fear that a bout of outright deflation may not be that far away.
This has the potential, as can be seen from the experience of Japan, to wreak untold damage on an economy, particularly one whose recent performance has been built on a mountain of debt.
On the basis of headline inflation rates alone, this point could conceivably be crossed without too much difficulty. In the US, inflation has dropped to 1.9% while in the UK it stands at just 0.9%, its lowest level since 1963. But the reality of deflation is much more than a temporary dip in the inflation rate into negative territory: it has to with a wholesale shift in consumer behaviour, that is why the consequences are quite so pervasive.
More positively, the potential benefits to the world economy from the recent fall in oil prices could be hugely significant if sustained. The agreement by non aligned producers to curb output in line with the requests made by Opec has at least to date failed to push the price back within the $22 to $28 per barrel monitoring range. This is at least in part a result of weak demand. If the oil price were to remain in the current area, it would result in a transfer to the G7 economies of something in the region of $120bn. Of this sum, around two-fifths would accrue to the US.
Other parts of the world have been dragged down by the deterioration in conditions in the US. Europe is a case in point and it is hard to see very much of a recovery taking hold in this area without the assistance of a firmer tone to the US economy. The monetary authority may now be acting with rather greater pragmatism and is rightly ignoring the acceleration in broad money growth.
On the other hand, Wim Duisenberg does appear to have ruled out any further easing in policy in the near term, government action is being constrained by the straightjacket of the Stability Pact and consumers are being pinned back by the lack of any real growth in real income allied to the upward trend in unemployment.
In Japan, the position is even worse but this has little to do with the US and rather more with domestic policy failings. Despite the optimism associated with the election of Prime Minister Koizumi, not much has actually changed in reality. Prices are still falling, the bad debts of the banks continue to inhibit lending behaviour and the economy has slipped back into recession.
Even if some progress is eventually made in dealing with the key drags on activity, it is difficult to envisage very much growth over the course of 2002. Part of the problem is that the very restructuring necessary to put the economy on a sounder footing over the longer term could cause considerable disruption in the interim period. Unemployment will most certainly rise further and this is likely to have a damaging impact on consumer confidence.
By way of contrast, the UK is still enjoying near trend growth thanks largely to the much-maligned British consumer. The spending spree in the run up to Christmas was most reminiscent of the boom of the late 1980s. In addition, big increases in public spending are now coming on stream.
While the contribution of the former may weaken if unemployment turns decisively upwards, the latter should provide sufficient momentum to keep the economy afloat.
Although we suspect that a US recovery will become increasingly visible in the data from around the second quarter onwards, the damage this is likely to inflict on bond markets is likely to be relatively modest. To some extent, the recovery story is already being discounted. The yield on ten-year Treasuries has climbed from a low of 4.2% in early November to its current level of 5.2%. Crucially, with a further shake out of labour likely wage pressures should remain subdued. Increasingly competitive product markets meanwhile suggest that there will be no early pick up in corporate pricing power.
A potential risk lies in the increase in the supply of sovereign debt that could result from the deterioration in fiscal balances across the globe. This does, however, need to be kept in context. In the US, even with the worsening economic picture, the Federal budget could be close to zero this financial year while in the UK, the deficit will probably be less than 1%of GDP.
For equities, some recovery in US corporate earnings will be necessary just to underpin markets at around current levels. Although there has been a strong rebound in the major indices from the lows touched in mid September, investor sentiment still has a soft underbelly. Part of the problem as far as Wall Street is concerned is that from a valuation perspective, the market still stands out as being expensive.
The S&P Composite Index currently stands on a price earnings multiple of around 40 times. This is largely a result of the precipitous drop in earnings during the second half of last year. However, even if consensus expectations are met and there is a double-digit increase in profits this year, this would still leave the market trading some way above fair value. That may not prevent the US market making some progress but it does suggest that it is to have only limited expectations about the sort of returns likely to accrue.
Partly because they are trading on rather more attractive valuations, whether measured on a P/E basis or against bonds, it may be that both eurozone and UK equities outperform in this environment.
The principal risk is that the excesses of the 1990s take longer to unravel than expected and any recovery during 2002 is anaemic.
Tentative signs are emerging of an improvement in US newsflow.
Despite the optimism surrounding Prime Minister Koizumi last year, little has actually changed in Japan
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Will report to Mark Till