No more rabbits left in Alan Greenspan's hat
biz.scmp.com
Thursday, November 7, 2002
DAVID ROCHE
Global equity markets rallied this week on the expectation that the US Federal Reserve would decide to cut interest rates by at least a quarter of a percentage point. But would a wave of the interest-rate wand by that wizard Alan Greenspan do the trick for markets and the economy?
After all, this bear market has been characterised by the coincidence of falling Fed funds rates and equity markets. Why would another Fed cut be any different?
First, the problem is that the United States and the world have a liquidity trap as wide open as Jaws. The more cash there is, the more the American owners of that cash stuff it into banks that, in turn, buy US government bonds or lend more money on real estate. So any extra liquidity generated by a Fed rate cut would not do a lot to raise investment in equities or lift real demand in the economy (except indirectly through an almighty bubble in real estate).
Second, American consumers and homebuyers have bought as much as they can of the things that get more affordable when interest rates fall. How many houses can you own? And how many cars can you put in a two-car garage? So the marginal impact on domestic demand of cheaper rates would be small. Indeed, the impact on mortgage rates from current bargain basement levels would be negligible.
Third, the propensity to borrow more and save less by US households (and corporations) has been driven by rising asset prices and falling interest rates. Rising asset prices kept household wealth rising faster than debts. Falling interest rates made servicing the explosion of household debt affordable from a cash-flow perspective. But falling stock market prices over the past three years has meant that US household wealth (after deducting mortgages and other debt) has fallen nearly 20 per cent. Only rising house prices have avoided even bigger wealth losses for the average American family.
When the property bubble bursts, as it eventually will, then the hit to wealth will be considerable. That will force consumers to reduce their levels of debt, especially as asset price deflation will raise the real cost of debt by more than Fed chairman Mr Greenspan can reduce it with interest-rate cuts. America will stop spending.
The equity market bulls want to ignore these arguments against a sustained equity rally. They concentrate on valuation. Equities look cheap when compared to interest rates - both long and short. A further cut in interest rates would make equities look cheaper, goes the argument. This argument makes Mr Greenspan look like a slave of equity traders, and sure, equities may rally on a Fed cut.
But I'm cynical about the buy signals derived from comparing current dividend yields or price-earnings ratios with interest rates. These measures assume that income to the investor will grow in the future at the same rate as in the past.
This doesn't hold. Corporate return on capital and growth in dividends and profits in the future will be way lower than the average of the last 10-year bull market. Indeed, I find the S&P 500 Index more than 20 per cent overvalued when I plug a 6 per cent to 7 per cent growth rate in profits and dividends into my discounted cash-flow model and use the current long-term bond yield plus a 2.5 per cent risk premium to discount the proceeds.
The only way that Mr Greenspan can change chalk to cheese for the equity market is to reduce the long-term risk-free cost of capital or boost the economy's growth rate. The former task is beyond the power of any central banker. The latter task is also impossible in the long term and even in the short-term the response of the economy is pretty inelastic to another drop in the ocean of cheap liquidity.
The key need is for US corporations to start investing to replace an exhausted US consumer. But lower short-term interest rates would have little effect in lowering the cost of borrowing for the average US company. Indeed, the yield on corporate debt is at record highs compared with the yield on risk-free government bonds. Lenders do not want to give corporations money, except at very expensive rates, because they see little sign of profit recovery and fear default.
While that continues, all the extra liquidity in the world will not put the Humpty-Dumpty of the US economy together again.
Easy money is not the easy road to economic recovery and rising stock markets. When the reality of a weaker consumer, investment doldrums and poor earnings growth becomes clear to investors, the Fed rate cut will be revealed as no panacea.
David Roche is chief strategist with London-based Independent Strategy |
