By
Scott B. MacDonald
Radical
Islamic terrorists strike at targets in Saudi Arabia,
Morocco and Israel, North Korea continues to bluster
with its finger close to a nuclear weapons trigger, Iran
is attempting to develop its own nuclear weapons program,
and Iraq remains unruly, with the rule of law still lacking
in the country’s major cities. The U.S. dollar
is falling, the Euro and Yen are going up, and one of
Japan’s major banks appeals for government assistance
to stave off a failure. Economic data from Japan indicates
that a double dip recession is an increasing possibility,
while trends in Europe point to the same direction. The
German economy is looking at unemployment creeping over
11%, while the French government must contend with fiscal
slippage, the pressing need to bring the pension and
benefits systems cost under control, and the strong hand
of unionized labor being manifest in a major national
strike. The stock market euphoria that was evident in
April and the early part of May, is increasingly fickle.
Although most investors really enjoyed the long-deserved
and distantly remembered “feel-good” sensation
of watching the Dow, NASDAQ and FTSE tick upwards, the
solid foundation for a sustained bull market – as
well as corporate health and increased capital spending
are still lacking.
As we have stated before the economic recovery is going to be gradual and
painful. In the United States, the recession is over, but the ability to
construct a strongly sustainable recovery remains a challenge. The consumer
is tired and the corporate sector still is not spending. Worse yet, unemployment
hovers around 6%, making it feel like as though the recession is still here
for many Americans. Adding to the sense of uncertainty, there is growing
concern about deflation, broadly defined as a reduction in the level of national
income and output, accompanied by falling prices. It has been partially caused
by excess capacity in industries from automobiles and telecommunications
equipment to banking and airlines. Another factor is the manufacturing machine
that China has become: China’s cheap labor and exports have forced
many other manufacturing countries to lower their prices to remain competitive.
While a little bit of deflation is not necessarily a bad thing as it can
balance past bouts of inflation (or hyperinflation in some parts of the world),
the fear is that the current type evident in Japan and Europe could make
things much worse in the United States. If the U.S. economy slips into a
new recession, the already struggling global economy will stagnate.
What must be done to put the global economy back on track? First and foremost,
the U.S. economy needs to maintain growth above 2% in 2003 and increase that
pace in 2004. For that to occur some form of tax reform/budget stimulus must
pass the U.S. Congress and be implemented, interest rates remain accommodative
(we expect one more cut in June), and capital spending resume (this may be
the toughest to occur).
Equally important, but in a medium term timeframe, Europe needs to regain
some degree of economic momentum. This implies a more accommodative stance
by the European Central Bank -- which has been more obsessed with inflation
-- a willingness to implement badly needed, yet unpopular, pension and benefit
reforms, which are necessary due to demographic and fiscal pressures. It
also requires greater leeway on the fiscal front as the current EU target
of a maximum allowance of a deficit of 3% of GDP is clearly not helping and
can in fact be argued as a contributory factor to growing deflationary pressures.
Germany, in particular, is vulnerable to deflation – it lacks an ability
to cut interest rates, push up fiscal spending and its banks are in a weak
condition.
Rounding out the picture, it is important that China continues to grow at
a rapid pace of above 6%. SARS has clearly put a crimp in China’s strong
GDP performance for 2003, but it could also result in some positives for
the Asian country in terms of improving the national health care system and
upgrading sanitation practices. This would certainly help to contain SARS
and reduce the potential outbreak of new diseases.
As for Japan, the problems remain – a troubled banking system, anemic
economic activity, a large and mounting national debt, and an embattled government
seeking to move ahead on reforms against entrenched opposition. We do not
see Japan imploding, but the economy will remain a challenge for the government
and a point of concern for the community of international policymakers. The
May government intervention in Resona Bank, which is a de facto nationalization
of the country’s fifth largest bank, does provide an opportunity for
the Koizumi administration to break the logjam in the terms of the banking
sector. It appears that Resona’s top management is to resign, providing
the government with an opportunity to appoint reformers. If this transpires,
Japan’s fortunes could begin to look up.
The bottom line on the global economy and stock markets is that we continue
to live in fear. There is a long shadow looming over the landscape – deflation.
It is a major factor in Japan, the world’s second largest economy,
and it is increasingly being mentioned as a point of concern in Germany and
the United States. The saving grace thus far has been that the U.S. economy
continues to grow – albeit far too slowly to remove the fear factor.
We still expect US real GDP growth of 2-2.4% for 2003, with a pick up to
3.0-3.3% in 2004. Key triggers going forward include the passage of a stimulus-oriented
budget in the US, interest rate cuts in Europe and the United States, and
some reduction in global excess capacity. However, if the proper measures
are not taken in the United States and Europe, deflationary measures on the
global economy will mount. The nervous market over-reaction to deflationary
fears will become a reality and we will then really be living in fear.
