Thoughts from Martin Barnes of Montreal-based Bank Credit Analyst (from Barrons)
Monday, June 2, 2003
Deflation? Not Here
Dollar's slide is far from over, says forecaster, and don't fret over consumer debt, idle capacity
By SANDRA WARD
An Interview With Martin Barnes -- With so many crosscurrents sending conflicting signals, we turned to a longtime FOB -- friend of Barron's, that is -- for a better read on the course of the economy. As managing editor of the Montreal-based Bank Credit Analyst, a newsletter forecasting investment and business trends published by BCA Research, Barnes has distinguished himself for his probing and bold analysis and clear, yet contrary, thinking. He also has a nice way with words. While not exactly dour, the Scotsman is concerned about the dollar, less so about deflation.
Barron's: Are we at the end of the supercycle process you have often described?
Barnes: By no means. We thought we might have come to the end of it in the early 'Nineties. The government had pushed up the budget deficit, they were still fighting inflation and the dollar had been very weak and it looked as if there were no policy levers left to help. Then, of course, the stock market came to the rescue and we had the tremendous equity bubble, which breathed new life into the economy, allowed fiscal policy to get back into balance and allowed the corporate sector to restructure its debt. Once the bubble burst, the policy levers could be put to use again. We had budget surpluses and we could get the fiscal engine going again. There was lots of scope to put monetary liquidity into the system. The final trump card is the dollar. We had a huge run-up in the dollar during the bubble years and now there's the option to push the dollar down aggressively. All the policy levers are going flat out.
"The capacity-utilization rate is low, but that is just a measure of manufacturing. It is a short-term problem, and there is no evidence it is a structural problem."
Q: Isn't this a dangerous game with the dollar?
A: It is a dangerous game, absolutely. Currencies are notoriously volatile. You've got the risk of hedge funds making a one-way bet and really piling on. We've just seen George Soros come out and say he's shorting the dollar.
Q: A little late to the game.
A: Well, no, I don't think it is. People tend to look at the dollar in relation to the euro and maybe the Canadian dollar and it has moved a lot against those two currencies. But the Federal Reserve publishes a broader measure of the dollar, the real trade-weighted index, which includes a huge variety of currencies. By that measure, the dollar has fallen by less than 10%. If you go back to the previous dollar bear market of the 'Eighties, the dollar fell close to 40%.
Q: The crash of '87.
A: The dollar peaked in 1985 and kept falling into the early 'Nineties. The big decline was between 1985-88, a 30% decline, and it eroded further from there. Compared to that decline, this one has been fairly modest thus far. The problem is that China, the country with the biggest trade surplus, pegs its currency to the dollar. And Japan doesn't want to let its currency go up too much so it keeps pressure on the yen by buying dollars.
All the pressure on the dollar comes from the Euro and the Canadian dollar, and there is lots of potential for instability.
Q: The dollar never got to the levels it did in the 'Eighties, so why would you expect it to fall as far?
A: It did not rise as much this time around, but the current-account deficit is bigger now than it was back then and there is a less-favorable global economic backdrop. In the second half of the 1980s, foreign economies grew faster than the U.S., which helped the U.S. to export more and bring the trade deficit down. This time, the U.S. is continuing to grow faster than Europe and Japan, and the dollar has to shoulder the full burden of the current-account adjustment.
Perhaps the dollar will not decline as much as it did between 1985 and 1995, but it has not yet fallen enough. I expect the real trade-weighted dollar to drop by at least 20% before it hits bottom, so it is no more than half way through its adjustment.
However, it will not be a straight line down. The dollar looks quite oversold from a short-term perspective, so it could have a bit of a bounce in the near run.
Q: What's your outlook on business spending?
A: A lot of the excesses that occurred in areas beyond telecom have now been unwound, in my view. I don't subscribe to the view there is a huge overhang of excess capacity left over from the bubble.
Q: What do you point to when you say that?
A: There are a lot of things and data you can point to. Mainly, if you look at the data on the capital stock, which the Federal Reserve publishes in its flow-of-funds report, the growth in the capital stock is the lowest it has been in the postwar period. The capital stock is the stock of equipment and software in the corporate sector. All the investment that is made over the years adds up to how much capital you have and whether it is machines or computers or whatever. Relative to gross domestic product, the capital stock is not particularly high by historical standards. The rate of return on capital has been rising recently and is still reasonably high by historical standards. The capacity-utilization rate is low, but that is just a measure of manufacturing and it is driven by the business cycle. It is a short-term problem, and there is no evidence it is a structural problem. The Fed has put a lot of resources into looking at this issue, too, and it couldn't come up with any clear evidence there was a big overhang of excess capital. Companies bought a lot of computers and information-technology equipment in the run-up to Y2K, but a lot of that stuff is obsolete now. It has depreciated. It needs to be replaced. The capital stock now turns over so fast that you have to keep investing just to keep in place. But, in fact, net investment as a percentage of gross domestic product -- investment minus depreciation -- is as low as it ever gets. So there has been a dramatic cutback in corporate capital spending, and that matters, that has an impact.
Q: And you think that's about to change?
A: The pieces are in place for capital spending to improve. There's been no investment for years. There is a good gap between return on capital and the cost of capital. The cost of capital is still very low. The fact that productivity growth stayed strong tells you there is a payoff to capital spending. But what is missing is confidence, and that is a big thing to be missing, of course.
Q: With all this worry about deflation, it's hard to have confidence.
A: If you were the proverbial man -- or lady -- from Mars and came and saw the current environment, you would see interest rates among the lowest they've been in the postwar period, and a very expansionary monetary policy. Money growth is strong. You would see the budget deficit up sharply. You would see the dollar collapsing. You would see we just had a spike in oil prices and commodity and gold prices are moving up. You would see a hot housing market. And you would likely say, 'My God, this is a pretty inflationary mix, very much like the conditions we had in the 'Seventies.' Those conditions suggest we're in an inflationary time not a deflationary time. The thing that is different, of course, is demand is weak. We do have excess capacity in the short run, so it is a tough environment for companies. But if you believe the economy is just facing a cyclical problem, not a structural problem, that will change. Isn't it interesting how you can have people worried about deflation and a housing bubble at the same time?
Q: Yet you're not terribly concerned about deflation?
A: I don't agonize over consumer debt the way some people do. I don't agonize over the idea there is a huge amount of structural excess capacity, because I don't think it is true. Asia is another thing. Not many people have noticed, but China's inflation rate has turned positive. Export prices out of Asia are positive in year-over-year terms. The big fall in the dollar -- and as I said I think it has a lot farther to fall -- is going to push up import prices. So even external deflationary forces are going to diminish. Still, deflation fears are going to be with us for a while because we have an output gap and that will keep downward pressure on prices in the months ahead. But by the middle of next year, deflation fears will be shifting to worries about inflation and concerns about the Fed raising rates.
Q: Tell that to the bond market.
A: In our view, there is a bit of a bubble in the bond market.
Q: Explain.
A: Deflation fears. Mortgage refinancing. Asian central banks buying Treasuries to try and keep their currencies down. All are powerful sources of demand at the moment. If another rate cut doesn't work, there's the idea that the Fed could start buying Treasuries. But from our point of view, the only rationale for buying Treasuries at current yields of 3.5% is if you really believe the economy is in deep trouble and that we are going into recession or there's a real deflation problem.
Q: What's your favorite asset class at this point?
A: Emerging markets offer the best value. It is a volatile and niche asset class, but the conditions are in place for emerging markets to do very well. They are cheaper than they have ever been. They've got a very positive liquidity environment. Other major markets are much trickier. Europe looks cheap, but the economics are terrible and the rise in the euro, which could increase a lot further in the next few years, is going to be deadly for European profits.
Q: Some people have started comparing Europe to Japan.
A: I would accept a comparison between Germany and Japan more readily than I would accept a comparison between the U.S. and Japan because of policy mistakes in the case of Japan and policy mistakes and a lack of flexibility in Europe. The U.S. has used every weapon available: it has eased fiscal policy, it has cut interest rates and it has let the dollar go. Europe has done nothing. It can't do any of these things. The European Central Bank could cut interest rates, but they've got a hairshirt approach of how they view the world. It looks tremendously complacent from our point of view, and it's an enormous policy mistake.
The German financial system is in pretty bad shape. They have very inflexible labor markets. To the extent that in a deflationary environment you want to be as flexible and adaptable and nimble as possible, Germany is dragging around a lot of anchors. Germany is at risk of deflation much more than the U.S.
Q: That still can't be very good for the U.S.
A: Japan has been in deflation for more than a decade, and it hasn't really affected the U.S. Now Europe looks grim also, and that will make it a lot harder for the U.S. To me, that is one of the big problems in the outlook at the moment and one thing that certainly does make me quite nervous: There is still too much reliance on the U.S. The U.S. grew faster than Europe and Japan in nine of the past 10 years -- 2001 was the only exception. The U.S. has a huge trade deficit, and it is time for the rest of the world to start doing better.
Let Europe and Japan take up the running and let the U.S. get its trade position into better balance. But that shows no sign of happening. If you look at the OECD [Organization for Economic Cooperation and Development] forecast and IMF [International Monetary Fund] forecast, they show the U.S. continuing to grow considerably faster than Europe and Japan into next year. But there is a big problem with this kind of imbalance. It puts all the pressure on the dollar to adjust and then we are back to where we were earlier on.
Letting the dollar fall is necessary and is part of the adjustment, but it runs risks because currency moves can get out of hand and it has the potential to create turmoil in the markets. The 1987 market crash was partly tied up with the weak dollar.
Q: So what are the odds of that happening again?
A: It is hard to say. It has been amazing how calm and benign markets have been with the dollar sliding. We've had this strange situation in which the dollar is going down and bond yields are going down and the stock market is holding up.
You wouldn't have thought those three things could continue like that indefinitely. What's allowed this to happen are the deflation fears and foreign central banks buying dollars, which is keeping yields down. But it begs the question: If people are so worried about deflation, why isn't the stock market collapsing? As Greenspan said in his testimony recently, markets aren't behaving as if they fully endorse the deflation story.
Q: It's been so long since we've experienced deflation, perhaps no one is around who knows how to behave accordingly.
A: Greenspan noted that all we can do is see what happened in Japan and read the history books for what happened in the 'Thirties. But, as I have said already, the only reason to think we are going into deflationary times is if you think the economy has got real structural problems that will prevent any response to the really significant stimulus that is in place.
I don't believe there are huge structural problems. There are certainly some problems. I don't want to sound complacent or as if I'm looking at the world through rose-tinted glasses. But maybe the danger becomes self-fulfilling. If companies continue to delay, delay, delay increasing capital spending, then we may just slide into deflation. The irrational exuberance of investors in the 'Nineties has been replaced by an irrational pessimism on the part of corporate executives.
Q: Martin, you said earlier you don't agonize about consumer debt levels. Why not?
A: People have been worried about consumer debt for 40 years. Yet the consumer debt-to-income ratio, which is now above 100%, has been rising through the whole postwar period. At any point in time you could have agonized that it is at a new peak. I guess there is a limit, a level at which it will cause a problem.
I don't know what that level is. I am not sure anybody does. And if you don't know what the level of debt is that may cause a problem, you just have to look for symptoms. You would expect to see rising bankruptcies, and we are, but there are other things beyond that. You would also expect to see rising loan-delinquency rates, and, in fact, they are falling. They are quite a bit lower than they were back in the early 'Nineties recession.
Q: Isn't much of the debt tied up in housing now?
A: Housing is a big part of this. People have refinanced mortgages and restructured loans and shifted to low-interest-rate loans, which makes sense. Mortgages represent more than 70% of household debt, and that is collateralized by the house. There has been a big rise in the home-ownership rate. If you are just looking at the debt-to-income ratio, it shows there has been a big rise in debt. But there is also an asset now -- the house -- on which they are making mortgage principal repayments every month. That means there is forced savings going on and maybe they are better off in a cash-flow sense. Prices are high relative to incomes, but at this level of interest rates, housing is very affordable.
Q: Thanks, Martin.
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