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U.S.
Markets – Is the Paradigm Changing?
By
Scott B. MacDonald
The backdrop to the U.S. stock and corporate bond markets is currently
defined by relatively good fundamentals. The earnings season is
generally positive, ratings trends are allowing for more upgrades
than downgrades, economic data is supportive that growth will continue,
and new issuance in both debt and equity remains limited. Yet,
change is in the air – there is a growing likelihood that
interest rates are going up in 2004. In the short-term this is
likely to be bad for markets as there is a degree of uncertainty
as to what higher rates will mean. The passage to a higher interest
rate regime will clearly bring more spread volatility for bonds
and make the Dow trend sideways, probably with a negative bias.
And casting a long shadow over this less-than-settled environment
is the impact of China – which has already shown some signs
that its dynamic growth has begun to stall.
First, the good news. About a half of the S&P 500 companies have reported
earnings and almost three quarters of them beat consensus expectations.
Mind you, comparisons to last year make this quarter look very strong.
Companies such as Boeing, Ford, General Motors, JP Morgan Chase and Wyeth
easily beat expectations. Accounting upsets as occurred with Nortel are
the exception, not the rule. What shines through the current earnings season
is that stronger economic growth is being translated into higher revenues
and profits. Companies are also beginning to show greater pricing traction – something
that has been missing for the last two years. This was evident in earnings
from pulp and paper companies such as Abitibi and MeadWestVaco.
This newfound pricing traction also represents the beginnings of new inflationary
pressures. Added with higher commodity prices, such as oil, natural gas
and various metals, the case could be made that inflationary pressures
are already starting to build. Fed Chairman Alan Greenspan stated before
the U.S. Congress that deflation was no longer an issue and that: “The
federal funds rate must rise at some point to prevent pressures on price
inflation from eventually emerging.” This implies that at some point
the Fed will raise rates. This also implies a healthier economy, which
is able to sustain a higher cost of money. Considering that U.S. real GDP
growth is likely to be 4% for 2004, the inflation story is gaining ground
within policy circles. The period of low rates and cheap money is over.
The next move will be to raise rates. This is a logical progression.
While
higher interest rates may be a positive development
over the long-term, the initial period of change
can have a negative impact on markets. Concerns over
a change in direction on the interest rate front
have already rippled through REITs (with analyst
calling April’s sell-off in REIT equity names “carnage”)
and Emerging Markets (with Brazilian bonds being
particularly hard hit). In 1994, rate increases caused
a much higher degree of spread volatility. Consequently,
we acknowledge that credit fundamentals are better,
but that the short-term looks choppy as the market
digests the implications of higher rates.
It is important to clarify two things about the looming change in the U.S.
interest rate regime. First, any increase in interest rates is likely to
be gradual – with one, possibly two actions in 2004. Second, the
place where the Fed now has rates is at the lowest level since 1958. Even
with an increase of 25 or 50 bps in 2004 (possibly in August), the environment
is still low on a historical basis. The Fed must be careful in raising
interest rates for the very simple reason that by moving too quickly, it
can choke off growth.
And there are reasons for caution - consumer demand and housing are set
to decline. In contrast to Corporate America, the U.S. consumer has not
reduced debt. Continued spending has come from the positive impact of tax
cuts and lower interest rates. Now, the impact of the tax cuts is diminishing
and interest rates are expected to go up. At the same time, higher interest
rates are casting a shadow over the housing market. The days of cheap money
are coming to an end. What all of this means is that economic growth and
employment generation will, in part, be balanced by slower consumer demand
and housing. The Fed can begin the next phase of monetary policy with a
view to keep inflation under control, though much will depend on job creation.
It should be added that without job creation, the scenario could become
dire.
Look for interest rates to go up in 2004, but
at a gradual pace, which could still be marked by considerable
volatility as the market over-reacts. At some point,
good earnings and economic growth will eventually trump
interest rates. It is the passage from low rates to higher
rates that remains the challenge. Until then, our advice
is to reduce exposure and sell into any rallies.
While interest rates have emerged as a dominant theme for U.S. corporate
and stock markets, the worry about China is not far behind. In recent years
massive amounts of foreign direct investment have poured into the country
and portfolio investors have not been far behind. First quarter growth
was a sizzling 9.7%, by far the fastest of any major economy. After two
decades of sweeping industrialization, China’s economy has outstripped
many domestic resources and led to a massive surge in commodity imports.
The concern about China is that the economic miracle has the potential
to rapidly deteriorate into an economic nightmare, which will ripple outward
through the rest of Asia and the global economy in the form of an international
commodity bust. Reality is likely to be a little more boring – China’s
growth will slow, not crater; international commodities will see less demand
from China, but the market is not likely to see a brutal price collapse
(though the fate of individual companies will vary).
China’s role in the global economy has changed drastically over the
past 20 years. GDP growth has been at an average pace of 9% and the country
is witnessing the expansion of a new middle class that is beginning to
buy imported consumer goods. At the same time, China’s share of world
trade has risen from less than one percent to almost 6%. Consequently,
China is now one of the largest economies in the world and Asia’s
second biggest behind Japan. It is also the world’s fourth largest
trading nation.
China’s growth spurt is not without problems. Much of its banking
system lacks a professional credit culture, is politicized and carries
a substantial bad loan burden. Transportation bottlenecks undermine efficient
industrial development and raises costs. The country’s fast growth
is rapidly outstripping natural resources such as oil, natural gas, iron
and copper. China used to have enough oil for its own needs; and the Asian
giant’s major oil companies are now competing for critical energy
sources throughout Asia, the Middle East and Africa. Local governments
have built up large debts, but there is little transparency about the extent
of the problem. In addition, the country faces shortages of water, while
there has been considerable environmental damage.
The Chinese government is concerned that the pace of growth must be slowed
to a more manageable 6-7% range. The danger is that government efforts
to slow the economy overshoot, causing a severe downturn in growth and
imports. The ripple effects would be considerable, especially if growth
falls under 5%, opening the door to social turmoil as rising expectations
are not met. Instead of a government-guided soft landing for the Chinese
economy, the situation could be one of a hard landing, with multiple negative
consequences for the global economy. A major economic crash in China would
not only pull the rest of Asia down, it would ripple into the U.S. corporate
bond market – at least that is what many investors are worried about.
Although we have concerns over China, we do not think that it will collapse.
What is most likely is that the government will increasingly apply pressure
on the banks to limit further credit. Raising interest rates is a likely
policy action. At the same time, a more concerted effort will be made to
sell off bad loans into the market and clean up the major four government-owned
banks. This implies that China will have to provide greater transparency
and disclosure, which is likely to make many investors more cautious about
buying local assets (as well they should be). Although the authorities
are tightening credit in 2004, the slowdown in real GDP growth is likely
to be more evident in 2005. We see China going through a “recessionary
period”, with GDP growth slowing to the 6-8% range and industrial
expansion cooling from 20% levels to levels closer to 10%. China’s
slower pace of growth will have a negative impact on global commodity markets,
but it will not be massively disruptive (due in part to still rising levels
of demand from India) – a pause in what is likely to be a multi-year
commodities bull market.
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