New Age Economy or Stock Market Bubble?
New-age economy or
stockmarket bubble?
By Gerry van Wyngen
Two utterly convincing and opposing explanations are given for the buoyant world stockmarkets and the thriving US economy that is acting as locomotive for the rest of the world. Which is right is of vital importance.
The new paradigm explanation sees continuing economic prosperity as new technology creates more growth and increasing productivity. This is an economic heaven on earth.
The stockmarket bubble explanation sees stockmarkets worldwide crashing in a scenario at best like that of Japan post-1989, and at worst, evoking memories of 1929.
Computer-related products touch every part of our lives. And it is only a small part of the beginning. Binary codes and the development of digital technology have opened a new world which did not show up in statistics at first.
Economists looked in vain for the promised efficiencies and increases in productivity computers were supposed to bring. Then in the 1990s, it started in a big way. This time, there seems to be no end.
Better computers, more efficient software, new applications, revolutionary new communication, the "grunt" for new space technology, navigation through GPS, it just goes on. We do not yet know the boundaries, and the internet is just one of many that has captured the imagination of users and investors.
For economists, continuing development means better and cheaper goods and services that translate into increased growth, productivity and low inflation.
While not unprecedented, the world has not seen anything like this since the early 1900s. Then, the introduction of electricity, the telephone and the internal combustion engine drove growth well into the second half of the 20th century. It was not until the second half of the century that sophistications such as electric typewriters, steam irons, electric jugs, stereo, tape recorders, TV and similar items began to appear.
There is no reason to think the "new paradigm" is markedly dissimilar, or why it will not continue to deliver more prosperity over the coming decades.
But, the similarities go further! The beginning of this century that brought the burst of scientific and commercial enterprise also brought a blind unreasoning confidence that the price of traded equity shares of the new companies would always go up. And for many years they did.
Unfortunately, the real economy and the financial economy are not the same. The latter hopes, anticipates, fears and despairs (possibly within a cycle of 25 per cent or even 50 per cent) at the same time as the real economy alters course by 2 per cent or 3 per cent. In 1929, share investors learned they had confused real assets and real earnings with financial assets and earnings.
The connection between the real and financial economy is strong, and was particularly so in 1929. The gold standard was more powerful than the central banks that served it. There was no mechanism for massive national or transnational granting of credit for institutions that were caught illiquid but not insolvent. So the stockmarket crash became the Depression, which in turn precipitated another crash.
In 1999, many sharemarkets are as overvalued as the US was in 1929, and some most notably the US are more. Investors have bought not for value, or earnings, but because they have seen prices go up, and they do not want to miss out. And that, like any pyramid scheme, is a recipe for a crash.
There are some basic economic and business principles that apply to this situation. First, price-earnings ratios averaging over 30 (as for the S&P500) are reasonable only if the percentage increase in profitability in future years is in double-digit figures. Investment bank Goldman Sachs, which went public recently, projects profits in 2000 to fall. Many other institutions agree.
Second, interest rate falls may offset decreases in profitability, when looking at stockmarket valuation. But the US Federal Reserve Bank is on a declared tightening bias, and most observers expect a 25 points increase in the federal funds rate at the end of June, with the possibility of more to come later.
Third, and most important, large public companies rarely manage continued increases in profitability of over 10 per cent annually compound for long periods of time. The reason is competition. If there is a profitable niche in the market other entrants will keep coming in until profit margins fall sufficiently to deter newcomers.
All this points to a stockmarket bubble, of 1929 proportions. So what is going to happen?
For clues, look at the US economy. Growth is going gang-busters. Analysts keep revising up their GDP forecasts, with estimates beginning with 4 per cent starting to appear. By any measure, this is above the long-term capacity of the economy, and the question is when, rather than if, the Federal Reserve Bank will apply a touch of brake.
How that growth has been financed is alarming. Simply, it is by a run-down in household savings that is unprecedented. Dissaving is approaching 5 per cent.
Investors are happy to do this because they have seen the paper value of their mutual fund investments appreciate as share prices increase. And their theory is, they can always reverse their dissaving by cashing in their mutual fund investments. But can they? The sharemarket went up only because collective investment drove prices up, that is, there were more buyers than sellers. What happens when the average investor wants to be savings neutral or savings positive?
In fact, the US has been on a huge spending binge, also unprecedented. Last year, this resulted in a current account deficit of $US233 billion ($353 billion) while this year, it will exceed $US300 billion.
How is this possible? Through massive investment by foreigners, mainly into bonds and equities. The motives for this are interesting and relevant. Growth in Europe has been unexciting. In 1997, Germany's real GDP increased 1.8 per cent, in 1998 2.3 per cent, and this year it will likely be around 1.5 per cent. The equivalent US figures are 3.9 per cent, 3.9 per cent and 4.2-4.3 per cent.
Guess what. Yes, European money poured into US bonds and equities. In 1995 investment in bonds was $US10.5 billion, in 1996 it increased to $US47.5 billion, in 1997 to $49.6 billion, before falling to $US11.7 billion in 1998. Now look at the equities: 1995 $US6 billion, 1996 $US8 billion, 1997 $US38.9 billion, 1998 $US55.4 billion. Scary?
Japan's growth was even more miserable. 1997 was 1.4 per cent, 1998 minus 2.8 per cent, 1999, say 1.0-1.5 per cent.
And the capital flows reflect that. In 1995, investment in US bonds totalled $US18 billion, and equities $US1.5 billion. In 1996 bonds were $US48.8 billion, equities $US6.4 billion. 1997 was $US28.1 billion and $US6.4 billion. 1998 $US19.7 billion and $0.3 billion. (All these figures courtesy of ABN AMRO, collated from US Treasury statistics).
So foreigners have been holding up the US securities markets. Not only Europeans and Japanese, but also Asian countries other than Japan. The question is what happens when the non-US economies start to recover, and investment is more profitable at home? Korea, Thailand, Singapore, the Philippines, and Malaysia have reversed to strong positive growth. Japan has come off the bottom. Even Europe is making an unspectacular recovery.
A major key in all this has been currency parities. The weak Japanese yen has contributed to a tentative rebound from negative growth. The weakening of the euro will also help Europe, and there are indications of this from European manufacturers.
The course of investment capital flows, and their timing, will determine the end of the stockmarket bubble and the strength of the US dollar. While the tremors in Wall Street may cause foreigners to reposition their investment portfolios, in turn precipitating a rush out as we saw in Asia less than two years ago, events back home may be even more important.
In the case of Japan, if bond (JGB) yields were to increase to 3 per cent as they almost certainly will over the next year or two the whole platform for international investment, including bonds and equities, changes. Low Japanese interest rates, directly (through the so-called yen carry) and indirectly, have enabled interest rates in the US and Europe to fall below what otherwise would have been possible.
Whether higher JGB would attract Japanese investment immediately, or suspend it until interest rates settle at a level perceived to be sustainable, is unknown. Ultimately, it would call money back.
This will in any case be backed by the monumental bond sales that will hit the Japanese market in future years. In 1998, new bond sales totalled 34 trillion yen ($43 trillion), and 1999 will be similar. However, many previously issued bonds are beginning to mature, and will also have to be rolled over.
Higher domestic demand, either corporate or household could also precipitate a slowing or even reversal of US investment. Europe could also surprise on the upside. Apart from the effect of the lower euro, some of Europe's basket-case trade partners are starting to look decidedly healthier.
There is a possibility that the US may cause its own stockmarket sell-off. No doubt fuelled by anticipation of an interest rate rise, Fidelity Investments' flagship equity fund Magellan has been busy increasing cash to 7.3 per cent of portfolio. That is still low. However, Magellan is a traditionally aggressive investor that has at times reduced cash to as low as 4 per cent. Also interesting is that Magellan, the largest mutual fund in the US, dropped assets from $US93.4 billion in April to $US91.4 billion in May.
If you accept that a sharemarket crash is inevitable, there is the question of how bad. The most comforting answer is that it will not be like 1929. For while valuations are more stretched, the disastrous gold linkage has gone and safety mechanisms are superior. The possibility of a compounding decline like post 1929 is highly unlikely.
We received a taste of this during the Asian crisis, where some financial institutions were found to be hopelessly stretched and counterparties of those institutions came under suspicion. The Japanese Ministry of Finance's Dr Eisuke Sakakibara quotes US Treasury secretary Larry Summers as saying at the time "the world is collapsing".
Only it did not. The financial system underwent a stress test. For a short time the outcome was in doubt. But now, like a vaccination, the system is stronger for it. The flow on from a stockmarket fall will be more severe than in 1987 because US consumers will be forced to cut back, and GDP will fall sharply. Beyond that, the impact may be as curtailed as was the Asian debacle. So, is the new age economy a new paradigm or a stockmarket bubble? Both.
afr.com.au
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