WITH traders’ screens a sea of red and equity markets in freefall, Alan Greenspan, chairman of the US Federal Reserve this week faces his toughest choice to date.
On Tuesday, when the committee of the Washington DC-based organisation meets, will it cut interest rates in an attempt to put a floor under America’s collapsing share prices? Or will the US central bank maintain them at the current level on the basis of the evidence from the “real” economy — which is not yet in recession?
It’s a bit of a cleft stick for the sage-like central bank governor. If he makes borrowing too cheap, Greenspan could stoke up inflation. But too long a delay in easing monetary policy could make things worse, by turning a severe slowdown into a prolonged recession.
Last year’s speculative bubble in dotcom stocks, whose bursting in March 2000 is the root cause of today’s equity markets crisis, showed that investors cannot be relied on to use their common sense. Furthermore, Greenspan will worry that falling share prices could drag the real economy down still further.
When it comes to the crunch, investors have a habit of behaving like sheep, which always exaggerates the economic cycle, amplifying the booms — and exaggerating the busts. According to one Edinburgh-based financier, things are going to be no different this time around.
He said: “We have not yet seen the capitulation stage. Once we’ve seen that, we’ll know we’re nearing the bottom. This has much further to go, because we haven’t even seen panic breaking out. The worst has yet to come.”
New records are being set on a daily basis.
Japan’s Nikkei index is at it lowest level for 16 years, having lost 70% of its value since 1989. America’s Nasdaq is catching up fast — with a 60% loss in one year. On 14 March, the Dow Jones Industrial Average fell through the 10,000 barrier while the more broadly based S&P 500 has lost 20% of its value in a year, the classic definition of a bear market.
It is little wonder global investors in equity markets are praying that Greenspan will side with them and make a rate cut of between 0.5% and 1% on Tuesday. Several reports on Friday encouraged futures markets to fully price in a 75 basis-point reduction. This would bring US interest rates down to between 4% and 4.5%. The UK’s monetary policy committee and the European Central Bank could be expected to follow suit.
So where did it all go wrong? And are the economic troubles of the US and the political and banking crisis in Japan going to be contagious and effect UK plc?
THE US ECONOMY
A year ago, most US private investors and their cheerleaders on Wall Street believed the good times would never end. Money was poured into tech-based enterprises with little or no chance of making a decent return — as investors were bewitched by talk of a new era of near limitless financial returns.
At the height of the speculative frenzy, internet portal Yahoo! was worth more than General Motors, Heinz and Boeing combined. Wall Street technology analysts, the high priests of the new economy, became celebrities, their every word lapped up on Bloomberg, CNBC and CNN.
They talked about an epochal, paradigm-shifting scenario where technology was breaking the economic golden rule of boom and bust. But something had to give.
On 20 March, Barron’s published an article saying internet firms were burning cash at an alarming rate. Slowly, reality began to set in. Jeff Bezos, founder of Amazon, now warns small investors not to put their money into dotcoms — including his own firm.
For a while it seemed there was a distinction between dot.coms and companies making hardware for the internet (so-called “picks and shovels”), whose shares did not fall as sharply. But, since last autumn these “plumbers” have also been experiencing a downturn, with their share prices falling ever lower with every profits warning.
The correction towards more realistic price/earnings ratios has brought on the so-called “negative wealth effect”. As consumers lose their shirts on the equity markets, they are spending less on the high street. This is dampening consumer confidence and could exacerbate the current slowdown. Weak demand has put downward pressure on prices as companies struggle to shift stock, exacerbating the squeeze on corporate earnings and profits.
Robin Aspinall, chief economist at brokers Teather & Greenwood, says: “There is an inverse pyramid of debt. That burden was taken on to improve performance but that has made the whole system very fragile. If the banks start to call in this gearing there will be a huge squeeze on companies.”
So when and how will the engine of American growth splutter into life again? Economists are divided but there are four possible scenarios for equity markets.
“L” is the scariest one. In this instance, the US economy would spend a few years in a post-boom hangover, with little or no economic growth. The picture would be similar to the stagnation experienced in Japan since its “bubble economy” burst in 1989. Larry Summers, a former US treasury secretary, subscribes to this view, arguing America could become the “new Japan”.
“U”, in which an ugly recession is followed by a slow comeback, would be almost as bad.
“V” in which growth restarts almost immediately, perhaps even avoiding a technical recession would be a healthier scenario.
The best news, however, would be “W,” but only if America is in the second half of the letter (with the first half being the 1998 Russian-provoked crisis and subsequent Fed-stimulated comeback). It would be less good news if the US is in the first part pf the W, with the second being the recession induced by the Fed as its monetary easing brings on raging inflation.
Even economists who believe the US is going through a “phoney” recession think it will take more than a few months of retrenchment and corporate down-sizing to work off the wild excesses of the past few years.
Alistair Byrne, head of strategy at Edinburgh based Aegon Asset Management, said: “I think the slowdown this time is more serious than it was in 1998 and it could take longer to work through. The US economy probably won’t turn around until the end of the year. The market probably won’t discount that until the middle of this year.”
THE JAPANESE ECONOMY
Japan is not technically in recession but its banking sector is in crisis, equity markets are at a 16-year low and last week finance minister Kiichi Miyazawa admitted the country’s finances are “near a state of collapse”. The situation has been brought about by a combination of inept government and the fact its banks, investors and businesses have a different set of priorities to their western peers.
Whereas in Britain and the USA, investors look for a return on their money, their peers in Japan focus on goals such as creating full employment and taking out foreign competitors. Return on capital isn’t really on the list, and most Japanese companies have consistently destroyed value without feeling the need to apologise.
But the model isn’t working any more, Japanese equity markets have plunged by 34% in the last 12 months and Japanese consumers are getting nervous. Patterns of lifelong employment are breaking down, salaries are static and many companies are having to embark on painful restructuring programmes.
Fear about the future has meant private consumption levels are “anaemic.”
The bubble economy of the 1980s briefly propelled Japan to superpower status. But when the bubble burst, policymakers were unable to believe the Nikkei would not rebound. So they initially raised interest rates rather than easing them. This blunder created a “lost decade” — the 1990s — when low inflation turned into deflation .
Once entrenched, deflation proved very hard to eradicate. The normal method of boosting growth — cutting interest rates — doesn’t work when prices are falling, as it is impossible to make real interest rates low enough.
Instead, Japan’s government injected ever larger doses of public spending , through infrastructure projects, as well as through tax cuts and the issuance of vouchers, into the economy in an attempt to stimulate demand. This has failed, with the nasty side-effect being a mountain of public debt worth more than 130% of gross domestic product.
The bust has been worsened by a collapse in land valuations and a dysfunctional banking sector. Property was used as collateral for loans, which has left Japan’s banks with Yen 200bn of bad debts on their balance sheets. Yet many of these banks are gaily continuing to lend to companies which in the UK or USA would have gone bust years ago.
British fund managers — many of whom have holdings in Japan’s banks — are hoping the Japanese government will bail out the sector by nationalising the banks.
Western investors would also like Japan to sweep away the opaqueness that makes annual reports and accounts so hard to fathom. Fraser Chalmers, of Standard Life Investments, believes “Anglo-Saxon transparency” must take root before the picture can really ameliorate.
Economists believe that the best way out of the current mess in Japan would involve drastic surgery to the banking sector and for the Bank of Japan to print more bank notes and allow the Yen to weaken.
But Iain Beattie, deputy chief investment officer at Edinburgh Fund Managers, said: “I doubt the authorities will have the stomach for that”
THE UK ECONOMY
THE London equity markets may be heading into uncharted territory, but after eight very good years, the economic fundamentals in the UK are brighter than in either the US and Japan — and much healthier than most stock market commentators would have us believe.
As chancellor Gordon Brown did not tire of telling us on Budget day, the UK has achieved economic stability for the first time in a generation — with declining interest rates, lower taxes, low unemployment, low inflation and steady economic growth.
But even this has not been enough to prevent stock market contagion, largely from the dotcom sector in the UK and US, from infecting the Square Mile. Last week the FTSE 100 plummeted by an astonishing 6%, falling to 5562.8 at Friday’s close, its lowest level since December 1998.
But to get things in perspective, the technology, media and telecoms sector represents a mere 7% of the UK’s economy, and without the influence of collapsing TMT stocks, both the London and New York stock exchanges would be up by around 15% in the last year.
Andrew Milligan, head of global strategy at Standard Life Investments, said: “Even if UK equities move down quite sharply, it is not going to push the UK into recession. In Europe and the UK consumer spending is robust, with growth in domestic demand still solid in the UK. The February figures show British retail sales up 5.8% at an annualised rate.”
But Milligan acknowledged a severe US downturn would have a marginal impact on UK and European GDP this year, perhaps shaving growth levels from 2-3% to 1-2%. Jeremy Peat, chief economist at the Royal Bank of Scotland, believes zero growth in the USA would reduce UK growth by only half a per cent.
Should things get really bad, the monetary policy committee of the Bank of England is unlikely to shy away from using its powers to ease the pain. Last week Ian Plenderleith, a Bank of England executive director and a member of the MPC, said the bank was not averse to monetary easing. “Interest rates would fall quite sharply if the authorities felt the UK economy was at risk,” said Milligan.
Paradoxically, most economists believe that were it not for “sentimental” equity markets factors or the threat of a US recession, the UK economy is actually rather buoyant.
Milligan said: “Using the domestic data on its own there is no need for a cut.” Jeremy Peat doubts whether UK interest rates will fall below 5.25% this year, “unless the US goes into free fall.”
UK INVESTORS
How are institutional investors in Scotland’s £350bn fund management industry responding to these increasingly turbulent times in the equity market? Re-adjusting their portfolios and shifting money out of equities and into bonds, private equity and alternative investments such as hedge funds is one obvious solution.
But Iain Beattie, deputy chief investment officer at Edinburgh Fund Managers, does not see this as the answer. “My advice to our fund managers is keep your hands on your desk, if necessary nail them there, and do not be tempted to deal.”
“If they’ve done their research right and they genuinely believe in the companies in which they have invested, then they should stick with them.” There is the related problem — if every institutional equity investor dramatically sold down equity portfolios and shifted the funds into other asset classes, it cause the equity markets to plunge still faster, reducing the value of their residual shareholdings.
Most investment houses are convinced the turning point will come within the next couple of months and at least before the end of the year.
Beattie believes that if the situation becomes particularly dire, the world’s four leading central banks — the US Federal Reserve, the Bank of England, the Bank of Japan and the European Central Bank — may act in consort.
“There’s plenty of scope for that, especially if America really does take a turn for the worse. Combined with fiscal remedies would help get some confidence back into the marketplace.”
He added: “Equity markets still go in cycles. That’s why they will recover.”
This article was published in the Sunday Herald on 18 March 2001