from Barron's, November 20, 2000 ... I am surprised that it has not been posted here previously ... maybe it has and I missed it.
Ken Wilson
Just Beginning
Economist sees business growing "weaker .. everywhere"
An Interview With Nancy Lazar. She's a gal from Kalamazoo who would never boast, but Lazar deserves a toast (with apologies to Glenn Miller) for her economic strategy and forecasting at International Strategy & Investment Group, a firm she founded nearly a decade ago with fellow economist Ed Hyman. In July, amid the hand-wringing of the multitudes over the prospects for escalating inflation Lazar warned clients of an impending slowdown in corporate profits
and the overall economy. She can claim long experience tracking the economy; she began her career working with Hyman in 1981 at C.J. Lawrence. That, combined with the confidence that comes from the proprietary surveys of key segments of the economy she and Hyman collect weekly, keeps Lazar at the cutting edge and makes her calls all the more cogent. The scope and scale of ISI's research made folksy by the personal annotations of the economists in the
margins-led the former New York Post scribe Maxwell Newton to brand the team "the lynx-eyed Ed Hyman and the diminutive but dynamic Nancy Lazar," something they've never lived down. We met recently with Lazar in the firm's midtown Manhattan office to hear why she expects the U.S. slowdown not only to continue, but to result in a severe global downturn. Read on to learn what she sees as the bright spot in an otherwise bleak outlook.
Barron's: While others were worried about inflation in July, you predicted the current economic slowdown. What do you see on the horizon now?
Lazar: The slowdown is here. The question now becomes how prolonged and how deep and how pervasive will it be. Is it just a U.S. issue, or does it end up being global? On all those questions, we lean toward things being weaker, longer, everywhere.
Q: What leads you to that conclusion? A lot of people are still very sanguine about overseas economies.
A: The level of activity is definitely fine right now, no question. But at turning points on the downside it is always fine. Instead of growing 6%, U.S. and world GDP growth is now about 5%, and six to 12 months from today it's going to be weaker. These forces we have on the economy tend to lead economic activity. It is classic textbook stuff in which it takes roughly 12 months for central-bank tightening to impact the economy. Central bankers started to tighten in the summer of 1999, which means the slowdown so far is due to the tightening of last summer.
Q: Yet so many thought the Fed would have to continue to tighten and that remains its bias.
A: Absolutely. That is not unusual. The economy seems to have so much momentum that it's like trying to slow a big tanker ship. It's hard to know when enough is enough. But it's not just the Fed that has been tightening. It is global central bankers that have been tightening, and that may have shortened the amount the U.S. Fed needs to do. Even though the Fed stopped tightening in May, these other guys have continued to tighten. The European Central Bank just
tightened in October. Over the past 17 months, we've counted 150 central-bank tightenings and the U.S. Fed accounts for six of those. On a GDP-weighted basis, we are one of the bigger influences, but our Fed has had lots of company during this tightening cycle. That increases the odds of a more prolonged slowdown here and ups the odds of a global slowdown. We are likely to see the effects of these tightenings well into 2001, through the third and fourth quarter.
Q: What's the next move from our Fed?
A: There is still a good case to be made for the economy continuing to be okay, and therefore the Fed doesn't want to jump the gun and move to help the economy too quickly. My inclination, however, is that the next major move on the part of the Fed will be to ease as it becomes clearer things are slowing on a more prolonged basis. We're heading in that direction. Growth is slowing. Inflation seems to be peaking. But any easing will come a little later rather than sooner.
Q: What are the factors that may be masking the extent of the slowdown?
A: Consumer confidence is still high. Given the hit to the stock market, I would have thought consumer confidence would have gotten hit also, but it remains amazingly high.
Q: Yet retail numbers are going south?
A: Yes. There are plenty of signs the economy is slowing, but it's not falling off a cliff. Typically, when you go into a recession, consumer confidence has rolled over very, very dramatically.
Q: Besides the tightenings, what are some of the other forces affecting the global economy?
A: The other big drag on global growth is the oil-price increase. Historically, there is a high correlation with changes in oil prices and changes in the economy, with changes in oil prices leading by one year. A good example is 1986, when you had the crash in the price of oil and the economy continued to deteriorate before lifting off the next year. The same thing occurred in 1998: Oil prices were down and the economy stayed weak but it helped lift the economy in 1999.
Q: The U.S. has enjoyed 10 years of strong growth, and so a slowdown may not be surprising. But you can't say that about foreign markets, and everyone has relied on them to pick up the slack if the U.S. faltered.
A: That is a key issue right now. Unfortunately, we're so tightly linked that if the U.S. slows, Japan will slow, and the same is true for Europe. In Japan, domestic GDP is virtually zero. The growth in Japan has been in exports, which have been growing at double-digit rates. Lots of those exports are coming to the U.S. Throughout Europe, retail sales are relatively sluggish, vehicle sales are declining because of the increase in energy prices. Exacerbating the decline is the depressed euro and a higher system of taxes. And again, European exports have been very strong. The domestic economy doesn't seem to be strong enough to withstand a slowdown in the U.S.; if we slow, Europe slows. This oil shock is a bigger deal, if not more so, outside the U.S., particularly where currencies have declined. I've been to Europe several times in the past several months, and they are really hurting over there. In Europe there is one difference: They're cutting taxes, and that will be a cushion for European economies. Thank goodness, because these other drags are so significant they're going to offset the tax cuts. But the cuts help.
Q: What was the case in 1998?
A: Europe got hit harder than we did from the Asian crisis. German GDP growth was 0.6% in early-1999, whereas U.S. GDP growth slowed to around 3.9%. Europe is more heavy-industry-oriented than we are, and so they are more vulnerable to these shocks. We're more service-oriented.
Q: Do you see any safe havens?
A: This is a global slowdown, and that's the surprise. But -- and I'm struggling with this -- I don't think this is necessarily a bad outcome. Just six months ago we were all worried about inflation getting out of control. The thought was the Fed would have to continue to tighten and there would be a very, very high probability of a hard landing. But the economy has slowed by the skin of our nose and inflationary pressures have eased. In that sense this is a good scenario. Once it's acknowledged that growth is weaker than expected, the Fed is going to ease and that will be good news for the stock market.
Q: So it's a matter of how quickly this is acknowledged?
A: Near-term, earnings expectations are still too high. As global growth slows, those expectations will have to come down more and more, and that is going to create indigestion for the stock market.
Q: What are you forecasting?
A: We see S&P 500 operating earnings increasing 8% in 2001, with risk on the downside. We have odds of a recession at 40%; if these odds go up, you will see a sharper drop in profits in 2001.
Q: What are your most important measures of economic health?
A: There are some key things we look at on a timely basis to gauge whether or not growth is stronger or weaker. One is our company survey. We talk to 150 companies every week and ask them how business is this week versus last week. Our index has clearly rolled over. Our companies confirm the slowdown is here. This is a good coincident indicator to watch going into 2001 for any signs of pickup in activity but, right now, it shows growth is still slowing.
Q: What industries do you survey?
A: Retailers, manufacturers, technology companies, banks, homebuilders and auto dealers are the six key ones that are critical to our survey.
Q: What's another gauge?
A: Commodity prices. Commodity prices are a simple, timely gauge of global economic activity. Two of my favorites are lumber, a good leading indicator, and scrap-steel prices, which is a favorite of Greenspan's. It's a good cyclical indicator. It tends to catch swings in business cycles. It's surprising, because it is so Old Economy oriented. Lately lumber prices, after declining sharply, have stabilized. But scrap steel has broken out on the downside and prices are the lowest in 14 years.
Q: And gold?
A: Gold, I think, is still very useful. The fact that gold moved below $270 and stayed below $270 is a signal that inflationary pressures have receded.
Q: What about consumer spending?
A: Consumer spending has started to slow, and the extent of the slowdown on the consumer side, I think, will be determined by swings in stocks. If the stock market remains sluggish, then consumer spending will remain sluggish. There is a very high correlation -- 99% -- between stocks and holiday sales. We've been tracking this since 1995, so it's a relatively short period of time. Capital spending is the other side of the equation that will also slow. Consumer spending and capital spending have certainly been the strongest parts of the U.S. economy.
Q: Is it troubling to you when executives at companies that have disappointed -- say, Eastman Kodak and Hewlett-Packard -- can't seem to pinpoint the source of their problems?
A: It's been 10 years since we've had a real sustained economic slowdown. Someone once described the three stages of a business cycle. There's the prosperity stage. There's the crisis stage. Then there's the reliquefaction stage. We've had lots of years in the euphoric stage, and now we are probably in the crisis stage. Lots of things are cracking. Junk-bond yields are hitting new highs. Nasdaq is down 41% from its peak, the biggest drop since 1974. The good news is, the next stage will be the reliquefaction stage. That will in part be determined by the Fed stepping in.
Q: Do you think there is also a denial stage in business cycles?
A: There is a sense in the investment community, in general, that if the economy slows, Greenspan will save the day, and earnings may slow, but not by much. We fear there is too much complacency, which makes us more concerned that activity will come in weaker than expected.
Q: What about the dollar?
A: It's possible the dollar could weaken, but the argument against that is the slowdown will be global. Maybe the dollar doesn't go up much, but I have a hard time getting too cautious on the dollar as long as this looks like a global slowdown. Another part of the story is Japan. Japan has been doing better. There is some talk that Japanese corporate profits have clearly recovered. My inclination is that's old news and that they are very late to the global economic environment. Domestic finance is very weak, vehicle sales are flat and department-store sales are declining. There is still deflation. Government spending is declining. If global growth slows, Japan slows, just to reinforce this notion.
Q: There's already concern that Japan is slipping.
A: The recent data from Japan are weaker than expected. The Economic Planning Agency lowered the GDP outlook, the economic assessment for Japan, for the first time in two years. And the stock market has figured it out, with the Nikkei and the Topix breaking down. So, are there any safe havens? I guess not.
Q: What about emerging markets?
A: The developing countries are also at risk. If anything, they're going to get even more severely hit by these drags on global growth. They, too, are very dependent on exports. Here, I would specifically focus on the Pacific Rim, where exports have been the strongest part of the economy. If global growth slows, they slow. Domestic demand is already slowing. We just got a chart on Thai auto sales, and the growth rate has slowed significantly. They were up 80% last
fall and now they're up just 5%. It's not just Thailand. I'm amazed at the breadth of the slowdown in the Pacific Rim. Singapore tech activity has clearly slowed, as measured by the Singapore PMI index, all of which highlights this slowdown in capital spending around the world.
Q: But having just emerged from hard times, do these economies have far to fall?
A: They rebounded pretty sharply and some of their GDP growth rates surged. The Pacific Rim leading indicator moved from negative to plus 15%. Now the indicator has gone back to zero, and that suggests the stock markets are figuring out what's going on. The next leg will be for the economic data to more clearly show it. Every part of the world right now is vulnerable and the PacRim is still fragile.
Q: This sounds so bleak. Are there any bright spots?
A: From the standpoint of economic activity, probably not. The good news is inflation is probably plateauing, and so it's probably the sun at the end of the horizon.
Q: I've noticed your charts show we've hit a fifth peak in inflation over a 25-year period and the peaks are getting lower. Have we mastered the art of taming inflation?
A: We are in a secular disinflationary environment, and the quickness of these inflation numbers -- these leading indicators of inflation -- to roll over highlights that we are still in this disinflationary environment. If anything, there are signs of deflation on the horizon. Some of the leading indicators on inflation, like PPI core crude, is negative on a year-over-year basis. U.S import prices, excluding oil, seem to be plateauing. Why? What's helping to contain inflation? Certainly global competition, which is as intense as ever. Global deregulation. Maybe even higher on the list would be the technology boom. All of these commingled result in a productivity boom. Here in the U.S., you have the dollar helping to contain the rate of inflation. If there is one golden nugget in this global
slowdown, it's that inflationary pressures seem to be easing.
Q: Are you concerned about labor and wage costs?
A: The global slowdown is helping to contain labor costs and productivity is containing wage inflation. Unit labor costs around the world are declining. Globalization, productivity and now the slowdown have helped contain wage inflation.
Q: Would you characterize the runup in tech stocks as a bubble?
A: I don't know if I would call the tech boom a bubble, but I believe very strongly that we are experiencing a cyclical slowdown in tech, which will last longer and be potentially deeper than expected. A simple point to make is that tech is cyclical.
Q: A point people seem also to have forgotten.
A: If anything, technology is more cyclical today than in the past.
Q: Why is that?
A: It's a bigger share of capital spending. If companies have to cut back on capital expenditures, it is more difficult today not to cut back on tech. In the old days, when tech was 5%-10%-20% of your cap-ex budget and you had to cut back, you could leave tech alone. Today, tech is approaching 50% of cap-ex and that makes it more vulnerable to a cyclical slowdown, not less. Also, a lot of the boom in tech has been financed by debt. Nonfinancial corporate debt has been growing very rapidly for two years, 13% for two years. I can't prove this is all tech-related, but a good chunk of it is. If you look at the corporate financing gap, which is the difference between corporate cash flow and capital spending, you have had this huge deficit. The level
of cap-ex has been rising faster than the level of cash flow, which has led to a plunge in the corporate financing gap. And that corresponds with this surge in debt growth. A lot of the junk-bond problems are tech-related. So, the fact that tech cap-ex is now such a big part of cap-ex and that a lot of it has been leveraged make tech a more, not less, cyclical industry. It is cyclical to start with, it moves with the business cycle, but it has just been a long time since we've had a slowdown. The tech slowdown is here along with the global slowdown, and the question there, too, is how prolonged and deep will it be.
Q: You mentioned that the Nasdaq is already down 40%. Do you we have further to go?
A: The Nasdaq tends to lead cap-ex, and so the Nasdaq is foretelling what is going to happen to the tech sector. But I'm not sure the markets have fully discounted the duration of the slowdown. That would be my concern.
Q: And once they figure it out?
A: Tech stocks will turn up before tech activity turns up. But for now, I'm concerned the extent of the slowdown isn't discounted yet in the market. You've seen some very dramatic moves on the tech side. DRAM prices are down over 60% in just a four-month period. The growth rate in U.S. semiconductor orders has slowed from 38% to 4%. We've counted over 500 dot.com company problems.
Q: Problems or total busts?
A: Problems. Some are just layoffs or IPOs pulled.
Q: In what time period?
A: In the last seven months. Again, this tech slowdown is global, and certainly a lot of company news points in that direction, as do the data. European semi sales are slowing, and Siemens' problems and Dell suggesting that some of its problems were European-related point to a global slowdown. It isn't just semiconductors. Telecommunications orders have slowed from 40% to less than 20%. Every sector of tech has slowed. The tech slowdown will continue as long as global growth continues to slow.
Q: Any sectors showing resilience?
A: I would rather stick to the basic economic outlook. One thing I'll say, just because I feel strongly about this point, is that there are certain sectors of the market, like cyclicals, that look cheap. But if you look historically, they typically don't do well or start to outperform until after you've had some Fed easing. And we are not there yet. If growth does tend to be weaker for longer than people expect, the cyclical sector is likely to continue to get hit. There's a reason they're cheap, and near-term there's a reason they could get cheaper. These guys get hurt the most in the kind of economic environment we expect.
Q: What are your thoughts on credit quality?
A: It would be a classic economic-slowdown event to have credit problems. I can't think of one business cycle where you've not had some sort of financial crisis linked to too much leverage in the system. Every major peak in interest rates, you have had a financial crisis in part related to debt. So I would expect to have some sort of crisis related to too much debt in the system. The question is, where is it going to be? And I don't know.
Q: Is it likely to occur on the commercial side? Or the consumer side?
A: I could guess, but that's a dangerous game. You've got Jamie Dimon of Bank One saying credit was his biggest worry for the industry and pointing to high-yield defaults. You've got high junk-bond yields, consumer-finance stocks have taken a hit. There are lots of yellow flags. In Europe, junk-bond yields are as high as ours.
Q: So cash is looking better and better.
A: I'm an economist, not a money manager. I'm sure there are some good values someplace out there, but I am afraid there is too much complacency and not enough recognition that things could be weaker longer than people think.
Q: Do you see any aberrations that would set this cycle apart?
A: This is turning into a classic slowdown in global economic activity, led by central-bank tightening and pushed further down by higher oil prices. The last three recessions were caused by central-bank tightenings and oil shocks and we've got them. Many people, myself included, have forgotten what a sustained slowdown looks like or feels like-it's been 10 years! That's why we're relying on these longer-term historical relationships.
Q: At what point are we at risk of depression?
A: Historically, the central bankers have done a nice job of cushioning financial markets, something they didn't do in the Depression. The Fed eased very aggressively in 1998, as did global central bankers. I do worry that the one country in the world that is most vulnerable to a depression -- maybe that's too strong a word, but certainly a severe recession -- is Japan. There, it looks as if you are at risk of seeing a triple dip. Growth there, as I've said, has been
export-oriented. There have been policy mistakes. Money-supply growth is low and slowing. In Japan, there is a very high correlation between swings in money supply and swings in the economy. Fiscal policy is restrictive. They are cutting government spending this year. They are still experiencing deflation. The banking system is still sick. They have other financial problems, such as the insurance industry. Of the G-7 countries, Japan is more vulnerable to a severe slowdown. Right now, the economic data look fine, but the stock market certainly smells something.
Q: Has the tightening been overdone?
A: The ECB overdid it. In hindsight, the last couple of moves related to supporting the euro will be viewed as a mistake. The Fed stopped tightening in May. We just can't point a finger at the Fed. |
