Saturation Dynamics anyone?
International Perspective - by Marshall Auerback
prudentbear.com
THE FED STARTS TO USE UP ITS BULLETS:
DOES A JAPAN-TYPE SCENARIO AWAIT?
February 6, 2001
"The confidence in equity markets is based on two premises. First, that
economic policy can sort out current economic difficulties. That may be
true. Second, that once the US economy recovers, it can continue
growing indefinitely, as it has in the past decade. That is not true.
Short-term success in averting a recession is most likely to be achieved
at the expense of long-term imbalances that cannot be sustained."
Financial Times editorial, Saturday, Feb. 3rd, 2001
Never can it be said that Alan Greenspan doesn't deliver what the
markets want. After virtually pre-announcing a rate cut two weeks ago
in his Congressional testimony, the Greenspan Fed cut its key rate by
an anticipated 0.5 per cent, and hinted at further cuts to come, given
that risks were still "weighted mainly toward conditions that may
generate economic weakness in the foreseeable future." Of course,
the FOMC was also keen to reassure the markets that all of its
incessant cheerleading over the past few years on behalf of the New
Economy was not a charade either. Despite the "rapid and forceful
response of monetary policy", which would imply a sharply
deteriorating economic backdrop, the Federal Reserve nevertheless
still insisted that "the longer-term advances in technology and
accompanying gains in productivity…exhibit few signs of abating and
these gains, along with the lower interest rates, should support
growth of the economy over time."
The Fed obviously has a delicate balancing act in respect of the
economic fallout that is emanating principally from the deterioration
in high tech. High tech is both the source of much of America's
current economic weakness, but it has long been the symbolic
standard-bearer for the New Economy and, indeed, the rationale for
the slew of inward investment that has occurred in America over the
past few years. Even Greenspan himself has implied on numerous
occasions that these industries were not supposed to be like any
other kind of "old economy" businesses prone to temporary cyclical
downturns. According to the Fed chairman, IT, the Internet revolution,
telecoms, etc., were all part of "the longer-term advances in
technology and accompanying gains in productivity" that have
permanently pushed American productivity to a new and higher
plateau, whilst simultaneously mitigating the traditional constraints of
the business cycle. Foreigners, consequently, bought into this myth.
How else to explain the seemingly endless willingness to recycle
their savings surpluses back into a country that increasingly
resembles an emerging market on the threshold of an IMF-led
bailout? To repudiate the seeming long-term benefits of all of this
high tech investment, therefore, would place the currency at
considerable risk, given that much of this inward investment, (which
has buttressed the dollar despite the economy's manifold
imbalances), came in on the hopes of reaping the full benefits of the
sky-high investment returns promised by the new economy.
But the capital expenditure excesses now apparent in high tech in
particular are coming increasingly to resemble a classic end-of-cycle
investment blow-off, common to many economies at the end of a long
boom. There is nothing particularly "new economy" in this at all. The
action of cutting 100 basis points off the Fed Funds rate in less than a
month appears to belie the Fed chairman's oft-stated belief in a new
era. Rather, it comes across as a panicked reaction to a typical, albeit
severe, cyclical "old economy" downturn.
………..
...(Not so as fed under AG has done greater than this Dec 19, 1991 it was
dropped a full percentage point, and that was not particularly regarded as
a panic move. )…………..
Capital expenditure,
particularly in the Internet infrastructure area, now appears to be in
sharp decline. It is falling from an unprecedented lofty peak. It is
being slowed down by the sheer burden of debt and the consequent
inability to service that debt as saturation dynamics take hold.
..... saturation dynamicsa great phrase……....
We have not seen anything like this in the US economy since the 1930s.
The most comparable post-war situation is the bubble economy of
Japan in the 1980s, during which a capital expenditure boom (also
fuelled primarily by debt) reached an unprecedented 25 per cent of
GDP at its peak (whereas during most of the post-war period, capital
expenditure as a percentage of GDP in Japan was about half this
level). Indeed, the Japan analogy is instructive in a further manner as
well: in the aftermath of such excesses, the unwinding generally
persists for a long time and proves surprisingly impervious to
repeated interest rate cuts. Is this what lies in store for the US
economy?
See 'The Ticking Debt Bomb' Robert Blecker; Economic Policy Institute
'Seven Unsustainable Processes' Wynne Godley
levy.org
'It Happened, but Not Again: A Miskian Analysis of Japan's Lost Decade'
Marc-Adre Pigeoon
levy.org working paper 303
policy note 2000/6
Despite high valuations, coupled with the prospects of substantially
lower corporate earnings, the market action since the beginning of
January suggests that investors have come no where near
capitulation just yet. There appear to be two simultaneously held, yet
mutually contradictory, beliefs that are currently animating market
participants. On the one hand, there is the view of Bear Stearns
investment strategist Elisabeth Mackay to the effect that "more of the
recent weakness has been related to confidence [which] the Fed
hopes to shore up." Mackay feels that whatever deterioration
sustained thus far in earnings is likely to be more than offset by
further cuts in interest rates, which in turn will engender renewed
confidence, and a bounce-back in growth by the second half of this
year, consequently justifying the continuation of what she terms, "the
stealth bull market" in the NASDAQ. And if worst comes to worse, we
still have another 500 basis points to play around with, coupled with
the prospects of ample fiscal stimulus from the new Bush tax cut
plan.
Even amongst those market participants (such as PIMCO's bond fund
manager, Bill Gross), who believe that we started a recession months
ago, there is still a pervasive sense that somehow the Fed can act in
time to save the consumer and underpin the market rally. According
to Gross: "Business confidence has plunged, capital investment is
slowing and production is contracting. Consumer confidence is
clearly in a downtrend. This indicator is key as consumers account for
as much as two-thirds of economic growth. Confidence needs to turn
back up for the economy to recover. We think the Fed will ease as
much as necessary to restore confidence. That means the Fed Funds
rate, which stands at 5.5% today, could be pushed down to 4% or
lower." Such is the pervasive belief in the Greenspan Put, so skewed
are market risk perceptions, that even the world's leading bond
market vigilantes eagerly lead the charge for easy money. Or perhaps
Mr. Gross is simply uncomfortably long a few too many of the
corporate bonds, whose risks he eloquently outlined last autumn.
Since the beginning of the year, the evidence of a deteriorating
backdrop in the US, particularly in manufacturing, has mounted.
President Bush's chief economic advisor, Lawrence Lindsey, has
commented that three-quarters of the US CEO's with whom he met at
the Austin summit on January 3rd thought the US was in recession in
the fourth quarter. Lindsey's comments appear to have been
bolstered by recent surveys of US CEO sentiment which show the
lowest readings since the recession of 1980. The recently reported
1.4% growth in GDP in Q42000 is consistent with a possible business
cycle peak at the end of the quarter. It is also important to bear in
mind that this figure is overstated by many of the statistical
amendments undertaken by the Federal Reserve's economists over
the past decade: these include the changes introduced by the Boskin
Commission during the mid-1990s, as well as the resort to hedonic
indexation, which has largely overstated productivity gains, in our
view. Using the same GDP accounting that was in use during the last
recession would show economic growth close to zero.
The Chicago purchasing managers survey, along with the recent
Philadelphia Fed index release, both point to weakness. This was also
confirmed by last Thursday's National Association of Purchasing
Management which, in the first major reading on the economy's
performance last month, said its index of manufacturing activity fell to
a weaker-than-anticipated 41.2 percent from a revised 44.3 percent in
December. Manufacturing activity has now showed its sixth
consecutive monthly decline. The index is now at its lowest level
since a 40.8 percent reading in March 1991. Export orders were also
down, implying further trade deterioration ahead and the new orders
measure was at its lowest level since 1981.
All of which does suggest hard times ahead for the manufacturing
sector, particularly high tech, which we have long termed the weak
link in the credit chain. But it is also true that on both the service side
and consumption, the readings are far more ambiguous, which makes
the Fed's rapid and forceful response somewhat harder to justify on
the face of it, and does leave Mr. Greenspan open yet again to the
charge of simply establishing a safety net for the stock market. While
much attention was paid to last week's sharp drop in consumer
confidence, it does not appear that this is translating into less
spending yet in January. Last Wednesday, the Bank of
Tokyo-Mitsubishi weekly retail sales report showed an increase of
sales from the previous week, with same stores sales 3.9% above
very strong sales from this time last year. Car sales were also strong
in January, particularly for up-market brands such as BMW and Lexus.
True, consumer sentiment measures are falling sharply; it is also the
case that such declines in the past have marked recessions in the
past. But it would be wrong to ignore the recent plunge in mortgage
rates, which implies that a further round of refinancing, concomitant
with rampant consumer borrowing, might be in the offing.
My question is can we go beyond 'saturation' and recover from the excess?
Like the myth of the drunk who drinks himself sober…..
It is puzzling that Fed policy makers appear so oblivious to this risk, but
then, again such compunctions never existed in 1998, so perhaps it
would be naïve of us to expect them now.
It is possible, however, that this borrowing represents, not a further
manifestation of unalloyed euphoric expectations, but rather
something more akin to the distressed corporate borrowing that
often accompanies the tail end of a business cycle; a household
sector equivalent of Hy Minsky's "Ponzi-type financing". In this type
of scenario, if real interest rates rise sharply, personal income simply
cannot meet interest charges on a high level of debt. Therefore,
when real interest rates rise, for the most part they must be "Ponzi
financed" - i.e., heightened nervousness on the part of the consumer
leads to more aggressive borrowing against home equity, in effect,
trying to build a "liquidity" safety net through further borrowing. Of
course, such propagation of financial fragility is clearly not a
sustainable phenomenon and there is an increasing possibility that
the deterioration in corporate cash flows, particularly in the massively
leveraged Internet infrastructure will ultimately impinge on this credit
mechanism and brings the process to an end for the consumer, if this
indeed is the explanation for the consumer's apparently puzzling
behaviour in the face of increased layoffs.
In any case, the Fed's decision to cut rates by 100 basis points in less
than a month is not the measured response of a central bank that is
acting under belief that we are merely in the midst of a short-term,
albeit severe, inventory led correction, particularly if we are to take at
face value the section of the Fed statement that "the longer-term
advances in technology and accompanying gains in
productivity…exhibit few signs of abating and these gains, along with
the lower interest rates, should support growth of the economy over
time." But if this statement were true, consider the ultimate
implications of sustaining such growth. According to the latest
research from Goldman Sachs, even if a recession is averted, the
longer term structural problems remain: "The private sector financial
deficit in this forecast would remain at about 6 per cent of GDP over
the next 2 years. Furthermore, the current account deficit would
remain at close to 4.5 per cent of GDP." In other words, the very
imbalances that continue to push us very close to the economic
abyss do not go away.
Three out of four of the indices the National Bureau of Economic
Research uses to identify cycle peaks have now gone into decline.
The fourth ---employment---is a lagging indicator and gave a
somewhat ambiguous reading last Friday. Service sector employment
remained strong, particularly in the volatile construction and public
sector components. But December's job growth was revised down
sharply and employment growth in manufacturing was abysmal, with a
net loss of manufacturing jobs of 65,000, coupled with an overall
increase in the unemployment rate from 4 to 4.2%.
Externally, the environment is not nearly as benign as was the case in
1998, during which the East Asian economies and Japan were
showing signs of recovery from the toll of the emerging markets'
crisis, whilst Europe was growing reasonably robustly. This time
around global growth appears to be slowing at the margin, which
obviously does not bode well for US exports and the current account.
Slow growth abroad creates the risk that the shocks which emanated
from America in the fourth quarter have now begun to exact a toll on
the global economy, which in turn creates a negative feedback loop
domestically, thereby exacerbating the current prevailing weakness.
Last week, we cited increasingly ominous signs of dramatically
slowing growth in the economies of Taiwan, Korea, and Singapore.
More recently, Thailand's economy has shown signs of faltering:
December exports were at their lowest level in over a year. We have
commented on the underlying fragility of these economies due to
prevailing high levels of debt. We suspect that the adverse impact of
the weakness in US high tech on these tech export dependent
economies are just beginning to hit fully because of contract and
trade related lags.
This more cautious assessment also fits with signals sent last week
by policy makers in the euro-zone's three largest economies -
Germany, France, and Italy. Hans Eichel, Germany's finance minister,
said last Wednesday that he expected German growth this year to be
at the lower end of a range between 2.625 per cent and 2.875 per
cent, rather than at the upper end, as previously forecast. On the
same day, one of Italy's leading research institutes, the ISEA,
downgraded its forecast for Italian GDP to 2.4 per cent from 2.6 per
cent. On Friday, France's finance minister, said French growth might
be 2.8 per cent, rather than the 3 per cent previously foreseen. It is
also noteworthy that consumer confidence measures in all three
countries have been conspicuously sluggish despite last year's
aggregate growth in Euroland being the best in years at 3.45 per cent.
It is therefore hard to be sanguine about the world outlook. Market
professionals appear to be out of touch with reality, convinced that
investing is simply game playing, featuring the use of technical charts
in a manner in which a fortune-teller might use tarot cards. Therefore,
despite the disastrous high tech news, they have run these stocks up
on the theory that Greenspan will bring the tech boom back again
soon.
This seems highly unlikely. Capital spending orders in the fourth
quarter GDP report of last year shows an outright 4.7% rate of decline
in nominal spending on computers and software in that quarter.
Typical of the changed environment is PMC Sierra, an Internet
infrastructure component supplier companies such as Cisco. Its sales
growth has gone from 153% year-over-year to an expected 30%
decline quarter-to-quarter in Q1 2001. It sells to all the largest
companies in Internet capital spending. It says eight out of the largest
ten now have declining sales. This is a company trading on a P/E ratio
of 200 times earnings and used its last pre-announcement to indicate
that this was not simply a "company specific" problem.
The dotcoms themselves are dying. Disney closed GO.com because
firms are abandoning advertising on the Net. Amazon, the premier
e-tailor, projects only a 20% growth in revenues this year after
previously forecasting growth in excess of 40 per cent. This is a
company that has always been notoriously optimistic. The layoff of 13
per cent of their work force, however, would tend to belie even the
more cautious 20 per cent figure. With a loss of $4 a share last year,
they clearly generate their revenues only by giving their products
away. In an interview last week, their founder and chairman, Jeff
Bezos, mentioned in passing that it appeared that consumers were
getting bored with Internet shopping. We have also alluded to this
trend in the past; the Internet appears to be going the way of the
hula-hoop. Even more curious for a company with such a supposedly
sunny outlook, Bezos also asked his recently laid off employees to
sign a 15-page "non-disparagement" agreement, which leaves one to
ponder what exactly the company has to hide. There is no question
that the plunge in fourth quarter sales growth to just 11 per cent was
not what the market wanted it hear: it was "startlingly slow" in the
words of Internet perma-bull, Henry Blodget. Similarly, Mark Rowen of
Prudential Securities has calculated that Amazon's books, music and
video business could be worth just $4 a share (compared to the
current price of around $18). He noted that the company's core
businesses were rapidly approaching saturation and that the market
"appears to be placing a significant value on Amazon's newer
businesses. We believe this premium is unwarranted at this time."
The ratio of capital spending to GDP has been higher and for longer
than anytime in the post war history of the US economy. The strength
was in Internet infrastructure. Such capital spending was way above
the levels dictated by its economic determinants like the capacity
utilization rate. It has been financed by debt. The revenues to
validate this spending on this debt are simply not materializing. This
is clearly not a problem which is going to go away quickly through the
magic elixir of further rapid interest rate cuts. Like our colleague,
Doug Noland, "we certainly don't see the technology industry
quagmire ameliorated by more 'easy money'. Instead, the great and
now punctured technology bubble will be a case study for decades to
come as to the negative financial and economic consequences of
reckless money, credit, and speculative excess. Amazingly, however,
there is still barely recognition that things ran so terribly amok. There
appears no appreciation as to the extent of damage inflicted by an
unprecedented flood of speculative capital into this sector. If the
lending and speculative juices do get flowing again and $100's of
billion of additional dollars fall into the black hole of the
'telecommunications arms race', the consequence will be only an
extension of this historic period of gross resource misallocation and
precarious Financial Fragility.
Fred Hickey reports that in the telecom area, there are hundreds of
competitive local exchange carriers (CLECs), many of which are
publicly quoted and now filing for bankruptcy, leaving billions in debt.
These collapses have had a domino effect on the entire high tech
industry. To quote Hickey: "The Internet companies are defaulting on
the ISPs, the ISPs are defaulting on the CLECs, and the CLECs have
started to default on telecom equipment providers." These are not
problems that get resolved through the elixir of lower interest rates,
as the immediate history of Japan clearly illustrates. When you're
bankrupt, cost of capital doesn't enter into the equation.
The Japan scenario must surely be the nightmare scenario that
secretly exorcises the Fed: a situation in which the saturation
dynamics in high tech industries have become so deeply entrenched
that the companies themselves prove impervious to improvement
despite "the rapid and forceful response of monetary policy". Unlike
the events of the 1930s, this is not lost in the sands of time, but very
much a comparatively recent event well within the experience and
recollection of a number of investment professionals. Yet curiously,
no Wall Street strategist has yet drawn the ominous linkage. We, on
the other hand, believe that the comparison is highly germane.
Despite repeated cuts in interest rates, Japan's economy has proved
curiously unresponsive even 10 years after the puncturing of its
bubble. Whenever Japan is discussed it is always in the context of
ineffective policy response after the fact: we get constant carping
about the nation's "clueless", incompetent bureaucrats, those same
bureaucrats who were once venerated for their long-term insights
and planning throughout the post war period. We suspect a similar
downgrade in the respective historic reputations of Messrs.
Greenspan, Rubin and Summers lurks at some point in the future.
Internet infrastructure stocks still sell at very high valuations, which
is not what one would expect if we were genuinely at the trough of a
bear market cycle. Given the collapse in their sales trend these
valuations are unsupportable, despite the fact that many have already
fallen sharply. Professional investors reflexively bid high tech stocks
up in January. The public has experienced losses in high tech for the
first time in more than a decade. They respond to price. If the price
action of last week in the NASDAQ goes on much further, we would
expect to see a scared public begin to sell their high priced Internet
infrastructure stocks to the professionals (who presumably will
persist in the mistaken belief that the Fed can still turn this mess
around). But when that change in psychology finally turns the
momentum game down, the professionals will be forced to sell. This
next time down losses will be so deep the public will probably start to
redeem its mutual funds. Once this begins, the process will feed on
itself. Two or three hundred points on Fed funds won't changes from
apprehension to panic. Perhaps at that point, market professional
might begin to ponder more closely the experience of the Japanese. |
