Scott B. MacDonald
Markets hate uncertainty. Unfortunately that is the one thing that is in
great abundance at the present time. Brutal and deadly attacks against
foreign oil workers in Saudi Arabia, ongoing conflict in Iraq, China’s
threatening behavior vis-à-vis Taiwan, North Korea’s
nuclear threat, and angst over interest rates in the United States
have opened a Pandora’s box of investor anguish. Even the U.S.
presidential election offers no comfort as opinion polls indicate
a close contest. Yet there are other, more positive signals – strong
corporate earnings, ratings upgrades, and robust economic growth
over the last two quarters. Malls are reporting a lot of foot traffic
as the intrepid consumer is still out buying goods from Wal-Mart.
Consequently, the U.S. stock market resembles a rollercoaster as
bulls and bears seek to push and pull investors along. Who is right?
Are we heading into another bull market period or is there another
lap in the multi-year bear market looming? We lean toward the later.
The bulls argue the U.S. economy has returned to a path of sustainable growth,
which in turn will help rectify the fiscal deficit and current account imbalance.
The worst is over as strong economic growth will translate into corporate
America going out and hiring. At last, the lagging indicator of unemployment
will fall – just in time for George W. Bush to win re-election. The
war against international terrorism will continue, but is likely to be controllable.
There is only a small likelihood that a major attack will occur in the mainland
United States – the struggle against the Axis of Evil and its allies
is to be found elsewhere.
While some of the above bull scenario is accurate (stronger and most likely
sustainable growth as well as an improved corporate performance), some of
it is overoptimistic. The bears do have some valid points. The U.S. economy
is carrying too much debt. According to Standard & Poor’ U.S. households
continue to set new debt records, with total debt (as of April 2004) at 113%
of after-tax income. The consumer at some point must step back and replenish
savings as the housing market is going to cool and employment generation
remains a gradual process. We have already seen some correction in the housing
market as the most recent data showed an 11.8% decline in new home sales
-- the largest drop in 10 years according to the U.S. Department of Commerce.
In addition, the fiscal deficit and current account imbalance are not going
away anytime soon. The latter could be greatly complicated by the trade policies
of both the Democrats and Republicans, as both appear equally keen to be
seen as the greater protectionist. Consequently, we have moderately strong
economic growth, but weak confidence; improving performance from the corporate
sector, but a slow approach to hiring; and a nation dependent on foreign
trade and capital flows, but lead by political parties preaching protectionism.
How does all of this play to the stock market? The short answer is not very
well. It sets an uncertain path in the weeks ahead. June 30 looms as a potential
swing date – the FOMC meets to decide on interest rates and the U.S.-led
coalition is scheduled to hand over sovereignty to an Iraqi government. Both
events are important. The market anticipates an increase in interest rates
to begin a new cycle. The Fed has claimed it will begin with a measured approach.
We believe it will increase rates by 25 bps in June, again in August (25
bps), and possibly once more before the year-end – if the economic
data supports such an action. There is a deep concern that if the Fed moves
too quickly as it did in 1994, it could slow growth. We do think the path
to raising rates and containing inflation must be carefully balanced with
the fragile condition of the consumer and the housing market. There is a
possibility if growth is slowed too much, these two parts of the economy
could plunge – and that would certainly send the market into a tailspin.
As for June 30 and Iraq, the Bush administration has invested a considerable
amount of its political capital into knocking out Saddam Hussein and replacing
his dictatorship with a democracy. The invasion of Iraq was also expected
to provide the American-led world order with longer-term benefits. By holding
Iraq, the Americans could bring Saudi Arabia, Iran and Syria under pressure
to make changes in their countries – along the lines of western democracies,
while also putting acute pressure on the state sponsors of anti-Israeli terrorist
Instead, the Bush administration underestimated the Iraqi resistance of the
former regime (and new Islamic Jihadists), has been embarrassed over the
alleged justification for the war (weapons of mass destruction which have
not been found), and is now seeking United Nations help in finding a way
out of the Iraqi mess. June 30, if all proceeds well, will begin to take
the monkey off the back of the Bush White House. If it is postponed or the
new interim government is unable to restore order (which is a distinct possibility),
the turnover could be problematic, adding to market uncertainty (not to mention
pressure on international oil prices).
Post-June 30, markets will still have to confront uncertainty around the
U.S. presidential elections, which we expect to be very close. We still regard
the contest as Bush’s to lose, considering that Senator Kerry has not
made a sufficient distinction between himself and the President in the minds
of many voters, the divided nature of the Democratic Party (between the liberal
and moderate wings which is hurting his ability to make a clear-cut message),
and the gradual improvement in the economy. The Green Party candidacy of
Ralph Nader could also hurt Kerry in a close election, much as it did Al
Gore in 2000.
Despite that, Kerry has a track record of being a strong campaign finisher – as
witnessed during the primary season in his performance against Howard Dean
-- and there remains a lot of things that can still go wrong for the Bush
presidency in terms of the economy and geopolitically.
We are in a multi-year bear market, which commenced in 2000. Considering
the relatively fragile nature of market confidence, we think there is a strong
chance of another pronounced downward leg in the Dow before the end of the
summer. It could be precipitated by another major terrorist attack in the
United States, a string of bad economic data or a confluence of negative
factors on June 30 (a botched handover in Iraq and a sharp hike in interest
rates). It is going to be a long hot summer for the stock market and gold
is probably going to look better as the months move along. We should add
that although the short-term looks potentially rocky, we do not see the U.S.
economy falling back into a recession and the stock market toward the end
of the year could have some bounce as some of the current uncertainties diminish.