World Equity Markets Signal Brisk Global Growth For 2000
John Lonski, Moody's senior economist in New York
A strong finish for equities worldwide suggests that confidence and liquidity are great enough to get the world economy off to a
strong start in 2000. Livelier expenditures globally imply rising inflation risks, increased credit demands and improved profitability.
Accordingly, the performance of central government bonds should suffer from higher interest rates.
Nevertheless, the possibly further overvaluation of equity shares enhances the prospective value of quality bonds to serve as portfolio
insurance. But before quality bonds benefit from a diminished preference for equities, interest rates may have to rise to levels at
which investors, in unison, will ask the agents of numerous internet and high technology companies to "show us the money".
Wealth cannot be created by faith alone. At some point in 2000, higher interest rates will remind investors of the importance of the
discount rate to equity valuation. At that seemingly inevitable point of inflection, a good number of stock prices will come crashing
down in a manner that could send investors rushing to the safe haven of quality bonds.
During the final three months of 1998, world equity markets were exceptionally clairvoyant regarding what they foretold about 1999's
global economy. During the final quarter of 1998, an unweighted average of 10 emerging-market equity indices advanced by 19%.
For the same final quarter of 1998, US stock prices gained 21%, German stocks increased by 12%, and Japanese shares rose by
3%. The steeper was a country's equity market advance during 1998's final quarter, the stronger would be its 1999 economy. The
81% rebound by Korea's major stock price index during the final three months of 1998 would prove to be an apt indicator not only of
blistering advance by Korea's 1999 GDP, but of a livelier than anticipated showing by emerging market economies in general.
The 63% average stock price advance since year-end 1998 of 10 emerging market countries included a steep 18% jump during
1999's final three months. Also, during 1999's final three months, major stock price indices posted advances of 17% in the US, of
8% in Japan, and of 33% in Germany. For all of 1999, stock prices recorded advances of 22% in the US and of 37% in both Japan
and Germany.
Moody's dollar-denominated equity mutual funds index for emerging market countries has advanced by a similar 65% for
1999-to-date. Mutual funds investing in the Pacific Rim's emerging market economies advanced by 75% since year-end 1998.
Notwithstanding a slower pace of Chinese economic growth, equity mutual funds specializing in Chinese shares appreciated by
59% in 1999. Reflecting expectations of an impending end to South America's many recessions, Moody's index of Latin American
mutual funds has returned 51% for 1999.
The global strength of equities in 1999 could be the forerunner of an especially strong year for the world economy. The 1999-to-date
home-currency denominated advances of 34% for European shares and of 49% for Japan's very broad stock price index supply
credit market participants with more than enough reason to be braced for higher interest rates through the first half of 2000.
Bond Yields May Rise Globally In 2000
Government bond yields should be rising throughout the industrialized world in 2000. Accompanying the slowing of the aggregate
economic growth of the major industrialized economies from 1996's 3.3% to 1998's 2.1% was a decline by the G6's average 10-year
government bond yield from 1996's 6% to 1998's 4.3%. In conjunction with a rise by major industrialized country economic growth
to 1999's 2.5%, the average 10-year government bond yield of the G6 countries rose to 4.5%.
The government bond yields of the G6 countries may be headed higher in the new year. Industrialized country economic growth
could approach 2.8% in 2000. Moreover, inflation risks should increase as global rates of resource utilization move higher.
Prospective peaks for 10-year government bond yields in 2000 are 6.7% for US Treasuries, 5.8% for European governments, and
2.2% of Japanese government bonds. These expectations add up to a 5.4% top for the G6's average 10-year government bond yield
in 2000, which would match 1997's annual average.
According to year-end 1999's stock buying frenzy, the US economy should start 2000 with vigor. After a possibly brief January
respite from a year-end spending spree, those indomitable American consumers will be back in force.
Both the realization and the expectation of bigger pay hikes should sustain household spending's brisk pace. The mild 3.7%
year-to-year increase by the average hourly wage for the quarter-ended November 1999 may be one of the most dubious economic
statistics extant. By 2000's second quarter, the yearly increase of the hourly wage should break above 4%. The US' unemployment
rate ought to be around 3.9% by mid-year and, later, end 2000 no higher than 4%.
After having recently peaked at the 7.9% of 1998's third quarter, the year-to-year increase of wages and salaries has since slowed
to the 6.6% of the quarter-ended November 1999. Rising levels of consumer confidence suggest that the annual growth rate of
aggregate wages and salaries may break towards 7% again.
Partly in response to an acceleration of employee compensation, the annual growth rate of wages and salaries -- an important
indicator of potential household spending -- should climb higher well into 2000. Perhaps, employee compensation has been slowed
by the profits slowdown of 1998 and by Y2K-related uncertainties. As corporate earnings recover and if safe passage into 2000 is
achieved, higher growth rates can be expected for both nonfarm payrolls growth and wages.
For all of 1999, the US' real consumer spending should advance by 5.3% annually, for its best such showing since 1984's 5.4%
surge and well above its 3.1% average annual increase of the 25-years ended 1998. The sustainability of 1999's consumer spending
boom has been brought into question by this year's slower 4% prospective annual increase by real disposable personal income.
Accordingly, real consumer spending might slow to a still above-average 3.5% annual increase in 2000.
After advancing by 4% annually in 1999, US real GDP's annual increase for 2000 may slow to a still impressive 3.6% in 2000. The
severity of 2000's expected slowing by economic activity will largely depend on the slope of the likely ascent by borrowing costs.
Of possibly greater importance to the US credit market will be the showing by the world economy. As demonstrated by
1999-to-date's 27% advance by Moody's dollar-denominated world equity mutual fund index, the outlook for expenditures growth
outside the US is decidedly upbeat.
By June 30th, the now 5.5% federal funds rate should have been raised to 6%. Also, by mid-year 2000, the now 5.33% three-month
Treasury bill rate should be up to 5.8%, while the recent 6.45% yield of the 30-year Treasury bond ought to have reached 6.8%.
At important turning points, bond yields have a tendency to overshoot in terms of what is warranted by economic conditions. Thus,
the 30-year Treasury yield could briefly break above 7% at some point during 2000's second-half. Only a shockingly steep climb by
bond yields might be capable of capping the unfinished rise in inflation risks following from a tighter labor market and a global
acceleration of expenditures.
One of the biggest dangers facing both the bond market and, in turn, the overall economy would the possibility of investor panic in
response to a series of greater-than-expected readings on core CPI inflation, particularly if domestic expenditures have largely
withstood higher borrowing costs. Most recognize that the anecdotal evidence regarding inflation has worsened. Slower US
economic growth may not be enough to prevent interest rates from rising if prices gain speed.
Fed Funds Rate Is Far From Onerous
The latest upswing by borrowing costs has not been steep enough to diminish consumer sentiment. The record shows that the
latest 5.5% federal funds is of no great burden when set against nominal GDP's 5.6% year-over-year increase for the 12-months
ended September 1999. Accompanying the US' economy's mostly splendid performance of the last five years have been the nearly
identical averages of 5.6% for nominal GDP's annual growth rate and of 5.4% for the federal funds rate.
The latest near equivalence between the federal funds rate and nominal GDP growth offers not the slightest hint of an onerous
monetary policy. By contrast, during the final 12 months of the 1983-1990 economic recovery, the federal funds rate averaged two
percentage points more than the concurrent annual increase of nominal GDP. Moreover, around the time of what is often cited as
the US' worst recession since the Great Depression, the federal funds rate topped the accompanying annual increase of nominal
GDP by a staggering 5.6 percentage points, on average. For 1980-1982, the spread between the federal funds rate and nominal
GDP growth was actually a bit greater than the latest federal funds rate-ouch!
Suppose nominal GDP grows by 5.6% annually in 2000. The record suggests that for monetary policy to be a major drag on US
economic activity, the federal funds rate would have to eventually be raised from its now 5.5% to, at least, 7%.
The latest upswing by bond yields may be sapping housing of its surprising vitality. During the 4-weeks ended December 24th, the
Mortgage Bankers Association's (MBA) index of mortgage applications for the purchase of a home fell by 6% from its average of the
contiguous 4 weeks while slipping by 1.2% year-over-year. In November, the MBA's barometer of the demand for housing was up by
10% from October 1999, while gaining 3.6% yearly.
Mortgage applications from potential home buyers have yet to weaken by enough to brighten the outlook for bonds. When bond
yields last formed a major peak in late-1994, the index of mortgage applications for the purchase of a home was off by 18% yearly
in 1994's final quarter.
Industrial Metals Prices Call For Fed Funds Rate Hike
Moody's index of industrial metals prices has been a reliable indicator of changes in world industrial activity and of monetary policy's
direction. The steeper is the climb of the industrial metals price index, the livelier should be the global economy and the greater is
the likelihood of Fed tightening.
Since year-end 1998, the industrial metals price index has climbed higher by 32% for its strongest calendar-year performance since
advancing by 43% over the entirety of 1994. Both 1994 and 1999 were wretched years for Treasury bonds. During the 12-months
ended December, the 10-year Treasury yield would ascend by 204 basis points in 1994 and climb higher by 160 points in 1999.
Prior to 1999, the industrial metals price index had declined across each and every calendar year from 1995 through 1998.
Accompanying the 28% cumulative plunge by the industrial metals price index from year-end 1994 through year-end 1998 was an
astounding 316 basis points plunge by the 10-year Treasury yield from December 1994's 7.81% to December 1998's 4.65%.
If the industrial metals price index extends its climb during 2000's first quarter, the federal funds rate will probably return to 1995's
6% peak by mid-year. When the industrial metals price index rocketed higher in 1994, fed funds would ultimately be raised from 3%
to 6%.
Despite 1999's sizeable recovery, the industrial metals price index still falls about 2% short of its pre-Asian crisis mark.
Nevertheless, interest-sensitive investors need to worry about how 1999's charge by the industrial metals price index occurred in the
context of relatively low rates of manufacturing capacity utilization. As of December 1994, the US' rate of industrial capacity
utilization was at 84.2% compared to November 1999's 81%. Industrial commodity prices might be expected to grow briskly as long
as rates of industrial capacity utilization climb higher.
Private-Sector Debt Accelerates In Europe And The US
A recent consensus call has West European economic growth rising from 1999's 2% to 3% in 2000. Year-end 1999's annual
increase by Western Europe's nominal GDP is probably no greater than 4%. Favoring an acceleration by nominal GDP would be the
6% year-over-year increases by the Eurozone's M3 monetary aggregate for the quarter ended November 1999. In order to avert an
unwanted build-up of inflation risks, the European Central Bank (ECB) has designated 4.5% as being the reference value for the
annual growth rate of Euzone M3.
More than the now above-reference-value of M3's annual increase warns of an ECB rate hike during 2000's first quarter. In addition to
M3's rapid pace, the faster growth of Eurozone expenditures has also been suggested by November's 8.5% year-to-year advance for
the Eurozone's total amount of public- and private-sector debt outstanding.
A very wide gap separated November's 11% annual surge by the Eurozone's private-sector credit outstanding from public-sector
debt's concurrent 1.8% rise. Debt's rapid expansion ought to support lively spending. Also, private-sector debt's 11% annual
advance implies that West European liquidity is more than sufficient.
In both Western Europe and the US, private-sector debt has soared, while the US' public sector debt has contracted outright. For
the year ended October 1999, the US' outstanding nonfinancial sector debt was up by 6.8% yearly, wherein federal obligations fell
by 2.3% annually, while nonfederal indebtedness advanced by 9.5%. Among the US' nonfinancial borrowers, September's
year-to-year changes showed private-sector debt expanding by 10.1%, as total government debt dipped by 0.5%.
During the past three years, the much faster 8.7% average annual rate of growth for US private-sector debt compared to the 5.8%
average annual gain for nominal GDP has raised concerns regarding a possible diminution of US credit worth. The longer the
Eurozone's private-sector debt outstanding expands more rapidly than the region's business activity, the greater is the danger of an
enervating loss of credit worth. The US' debt repayment capacity would eventually suffer considerable erosion when during the 6
years ended 1989, private sector debt's 11.2% average annual advance sped past nominal GDP's 7.6% yearly pace.
The latest upsurge by Eurozone private-sector debt can be ascribed to a deepening of capital markets stemming from the adoption
of a common currency, the funding of mergers and acquisitions, an improved economic outlook, and what remain generally low
borrowing costs.
Nothing spurs borrowing like the perceived cheapness of money. Benchmark European interest rates have climbed higher, but from
comparatively low levels. In 1999's final quarter, the ECB's key refinancing rate was lifted from a very low 2.5% to 3%. From 1999's
start to finish, the euro's three-month money market rate barely rose from 3.25% to 3.5%, while the 10-year German government
bond yield advanced from 3.9% to 5.3%. Neither of these short- and long-term benchmark interest rates for year-end 1999 differ
greatly from Germany's 1996-1998 averages of 3.4% for the three-month money rate and of 5.5% for the 10-year government bond
yield. In some important European economies the drop in borrowing costs has been breathtaking. Italy's 10-year government bond
yield has sunk from a 1996-1998 average of 7.05% to a recent 5.56%.
Notwithstanding still low borrowing costs and generally healthy levels of credit worth, Europe's interest-sensitive spending has yet to
soar in a manner comparable to what business and residential investment have attained in the US. Regarding corporate credit
worth, Western Europe has been the world's only major region where credit rating upgrades have consistently topped downgrades
during the past three years. Moreover, according to Moody's latest available ranking of bank financial strength ratings by country,
West European countries occupy 14 of the top 20 slots. By contrast, Japan is situated in 57th place among 75 countries, where
Russia occupies the lowest rung. Less onerous taxation could go far at giving effect to Europe's constructive combination of
relatively low borrowing costs and sufficient credit worth.
Overseas Investors Steer Away From US Governments
Like their American counterparts, foreign investment in the US has been directed away from US government securities and other
credit market instruments and towards earnings sensitive assets. During the past 15 years, foreign investor net purchases of US
government securities averaged 164% of foreign net purchases of US corporate bonds and stocks. However, for the year-ended
September 1999, the $140 billion net foreign investment in US governments was but 65% of the $216 billion net foreign purchase of
US corporate securities.
Foreigners increased their holdings of US corporate bonds by a record $147.2 billion during the 12-months ended September 1999,
which was up from 1998's $122.4 billion net purchase. During the five years ended 1997, foreign net investment in US corporate
bonds averaged $58.9 billion per year compared to average annual net investment of $23.3 billion in US corporate equities and of
$178.9 billion in US government securities. Notwithstanding a continuation of the US' monumental stock market rally, the $68.7
billion foreign net purchase of US stocks during the 12 months ended September 1999 was considerably less than the foreign net
buying of US corporate bonds. In 1998, the $43.8 billion foreign net investment in US stocks was under 1997's record $66.8 billion.
Foreign investors have generally not been a driving force behind the movement of US stock prices. As derived from Federal Reserve
flow of funds data, direct foreign ownership of US stocks approximates about 8.1% of the market value of US corporate equities. By
contrast, foreigners own a greater 18.9% of outstanding US corporate bonds, never mind the record 38.6% of outstanding US
Treasury securities now owned by overseas investors. If foreigners were to trim their massive holdings of US Treasuries, a resulting
upturn by Treasury yields could impinge on the performance of both US corporate bonds and equities. Stronger economies outside
the US should enhance the attractiveness of non-US assets and, thereby, possibly lessen foreign net investment in the US' financial
and real assets.
Foreign Direct Investment In The US Booms
Foreigners have shown a strong preference for the relative safety of credit market instruments. During the last 15 years foreign net
investment in US credit market instruments approximated 170% of the sum of foreign net purchases of US corporate equities plus
foreign direct investment. However, reflecting 1999's record breaking pace of foreign direct investment, foreign net investment in US
credit market instruments over the 12-months ended September 1999 has sagged to 64% of the sum of foreign net investment in
US stocks plus US real assets.
Foreign direct investment in the US was a record $342.3 billion for the year-ended September 1999. In 1998, foreign direct
investment in the US set a calendar year record of $193.4 billion. Underscoring the extraordinary support which the US now receives
from the inflow of foreign capital, foreign direct investment averaged a much smaller $71.6 billion annually during the five years ended
1997.
Offsetting the loss of US economic activity to the flat-to-lower performance by US exports during 1998-1999 has been 1999-to-date's
record-breaking annualized pace of foreign net investment in US credit market instruments, in corporate equities, and in real assets,
where the latter includes the acquisition of US companies.
The very strong foreign demand for the US' financial securities and real assets helps to explain why one dollar exchange rate index
managed to eke out a 0.1% gain for 1999-to-date, notwithstanding the US' record current account deficit. Such a feat will be more
difficult to sustain in 2000 if foreign economic prospects continue to improve.
Consumers Courageous
The second highest reading even for consumer confidence during December 1999 reflected a tight labor market, rising US wages, a
richly valued equity market, and a global firming of economic activity. If only by boosting the willingness to spend, the much better
than expected performance by 1999's US economy was linked to the surprisingly improved showing of the world economy.
December's very steep reading for the Conference Board's version of consumer sentiment only enhanced the odds favoring a
February 2nd hiking of the federal funds rate, particularly since stock prices again moved sharply higher.
The equity market's speculative bubble might very well be burst by an interest rate spike. Borrowing costs are likely to be driven
higher until they are burdensome enough to materially worsen corporate earnings prospects.
The more corporate borrowers sense that bond yields have climbed up to inappropriately high levels, the more corporations will avoid
fixed-rate bonds and instead, turn to variable-rate money market funds when tapping the debt market.
Consumers last swelled with as much measured confidence in 1968, or when the Conference Board index climbed up from 1967's
135 to 136.1. From 1967 to 1968, the annual rates of change rose from 3% to 5.7% for real consumer spending, from -3.1% to
13.6% for real residential investment, from 7.2% to 10% for wage and salary income, and from 3% to 3.2% for nonfarm payrolls. The
unemployment rate fell from 1967's 3.8% to 3.6% in 1968.
From 1998 to 1999, the average consumer confidence index climbed up from 131.7 to 135.1, as the annual increase of real
consumer spending rose from 1998's 4.9% to 1999's 5.3% and the unemployment rate fell from 4.5% to 4.2%. Nevertheless, the
annual increase of nonfarm payrolls slowed from 1998's 2.6% to 1999's 2.2%, while the annual growth rate of wages and salaries
sagged from 1998's 7.6% to 1999's 6.9%.
Upbeat Consumers Signal A Tighter Labor Market
The very tight labor market implicit to a very high level of consumer confidence warns of an acceleration of wage and salary income
which might eventually drive the 30-year Treasury yield back above 7% for the first time since April 1997. Worth remembering would
be how the S&P 500 stock price index formed a peak in November 1968, which would not be revisited until 3.5 years later.
To the degree high equity prices feed confidence, robust household expenditures will push bond yields higher. Both price inflation
and bond yields moved higher following consumer confidence's advances of the late-1960s.
In December 1999, a record 51.5% of the respondents to the Conference Board's consumer confidence survey described jobs as
being plentiful. The 11.8% describing jobs as being "hard to get" was barely above July 1999's record low of 11.5%. December's
39.7 percentage points separating those sensing an abundance of jobs less those holding to a dearth of employment opportunities
was of an unprecedented width.
A further tightening of the labor market at an already low rate of unemployment can only quicken the growth of earned income. More
upside surprises for household expenditures would worsen the plight of Treasury bonds. By contrast, corporate bonds should benefit
somewhat from developments which enhance cash flow.
Moody's long-term, investment-grade industrial company bond yield climbed up from the 6.62% of year-end 1998 to a recent 7.78%.
However, the yield spread over Treasuries for this long-term, investment-grade yield narrowed from year-end 1998's 153 basis points
to a recent 133 points. Also, a speculative-grade bond yield spread over Treasuries has been trimmed from the 526 basis points of
year-end 1998 to a recent 444 points.
Japan Mends Slowly
Following back-to-back monthly setbacks of a cumulative 3.3%, Japan's industrial output more than recovered with a 3.8% monthly
advance in November. After plunging by as much as 8.6% year-to-year in 1998's third quarter, Japan's industrial production has
since rebounded to the 3.3% yearly gain of the quarter-ended November 1999. Japan's industrial activity has entered into its
steepest upswing since 1996, or when Japan's real GDP expanded by 3.5% annually.
Boding well for manufacturing near-term was November's 10.7% year-to-year drop by Japan's inventory-to-sales ratio, which reflects
the refreshingly divergent paths taken by manufacturers' shipments -- up by 6.5% year-to-year -- and by inventories -- off by 7.1%
year-to-year.
Japan's acceleration of shipments and shrinkage of inventories has occurred despite November's 2.8% annual decline by total retail
sales, marking the category's 32nd consecutive annual retreat.
Housing starts, however, have been firming in response to Japan's still very low borrowing costs and in spite of soft residential
property prices. After incurring deep annual setbacks of 15.6% in 1997 and of 13.6% in 1998, Japanese housing starts managed to
eke out a 1.6% annual gain through the first 11 months of 1999.
For the quarter-ended November, housing starts grew by 5.9% yearly, but shrank by 15% annualized from the quarter-ended August
1999. A rise by home sales led US household expenditures out of the 1990-1991 recession. Perhaps a similar sequence of events
now unfolds in Japan.
Japan's unemployment rate dipped from the 4.6% of September-October 1999 to the 4.5% of November. Japan's jobless rate set a
record post World War II high of 4.9% during June-July 1999. November's unemployment rate was up marginally from November
1998's 4.4%. Following 21 straight year-to-year declines, Japanese employment was unchanged from a year ago in November.
Japan's precarious labor market situation just might be stabilizing according to the third consecutive monthly rise by the number of
job offers per job seeker. Although November's 49 job offers per 100 job seeker was up from the record low of 46 per 100 of
May-August 1999, the ratio of job offers per job seeker remained well under its 0.69:1 average of 1993-1997, never mind the 1.23:1
of 1988-1992. The comparative dearth of job offers per job seeker preserves the risk of another upturn by Japan's unemployment
rate.
The tankan survey of 1999's final quarter showed that the net percentage of Japanese businesses sensing a surplus of employable
people was at 18%, which was under both the 20% of the previous quarter and its 29% peak of 1998's final quarter. When the
annual average of this indicator of surplus labor last fell from 1996's 20% to 1997's 13%, Japan's unemployment rate for 1997
remained at 1996's 3.4%.
Accompanying the rise by the index of surplus labor to 1998's average of 23% was a jump by Japan's unemployment rate to 4.1%.
Notwithstanding how the index of surplus labor dipped to 21%, on average, in 1999, the jobless rate still climbed up to 4.7% through
the first 11 months of 1999. Nevertheless, if the index of surplus labor continues to decline, Japan's unemployment rate has
probably peaked for this very difficult cycle.
Japan's CPI sank by 1.2% yearly in November, while the country's core CPI dipped by a shallower 0.2% yearly. A stronger yen
exchange rate has abetted Japan's price deflation. Price deflation in Japan should not have been a great surprise given how steep
Japan's product price levels have been relative to product prices in the US. Even after deflation, Japanese product prices remain well
above levels found in the US.
A Sluggish Japan Helped To Curb Inflation In The 1990s
Few dare to predict that Japan's economy will grow by more than a lackluster 1.5% in 2000. If Japanese expenditures growth
delivers an upside surprise, the prices of internationally traded goods should be greater than otherwise. In turn, bond yields might be
somewhat higher globally. The US was able to enjoy declining inflation amid robust expenditures partly because of a profound
slowing of Japan's average annual rate of real GDP growth from the stunning 13.5% of the 1970s to the still awesome 6.1% of the
1980s and, most recently, to the slack and disinflationary 2.2% of the 1990s.
Among the world's economies in 1999, few staged a comeback as remarkable as Korea's reversal of fortune. After averaging 8.2%
growth during 1994-1996, Korea's real GDP would slow to a 5% annual increase in 1997 and then contract outright by 5.8%
annually amid 1998's crisis atmosphere. Korea's government recently estimated that economic activity should advance by 10.2%
annually in 1999.
The lively rebounds posted by most East Asian emerging market economies helps to explain the recent upturn by industrial
commodity price inflation. For the quarter-ended November, the 25% average annual increase for Korean industrial production still
fell short of the 28% average annual advance for Korean factory shipments. A consequent 4.8% annual decline by November
inventories implies that Korean manufacturing activity should not slow abruptly.
The Chinese government recently announced that the country's real GDP growth should dip from 1998's 7.8% to 7.1% in 1999.
Moreover, 1999's prospective annual increase by China's real GDP fell considerably short of its 11% average of the five years ended
1999. Nevertheless, a recovery by Chinese exports would ultimately stave off a widely anticipated devaluation of the Chinese yuan.
-------------------
John Lonski, chief economist |
