Over the last two weeks, this column has focused on the risks for the global economy and markets, arising out of the early signs of trouble in the US housing sector. We will stick to that theme for some more time.
As the curtains came down on the first quarter of the new year, global equity markets held up reasonably well. Some would attribute it to quarter-end window dressing. We would know if it was the case from the behaviour of the markets in the new quarter. However, market behaviour is reasonable, given the absence of clear signs of the risk of a US recession.
Leading indicators—as the name suggests—give advance warnings of economic contraction or expansion, about two to three quarters ahead. They comprise 10 economic and financial variables that have historically been helpful in gauging the future direction of the US economy. The index of leading indicators has now fallen for two consecutive months in January and February. The precipitous decline in this index in the last several months indicates a rapid loss of momentum in the US economy. Second, orders for durable goods—these are signs of long-term capital spending in the economy—have been disappointing lately. Data for February was no exception. An index of home builders’ confidence declined sharply in March. One of the home builders who was optimistic for 2007 two months ago said last week that he was not sure at all how 2007 would turn out to be.
In contrast to these ominous signals, the index of confidence of purchasing managers in the Chicago region leapt up in March. This index was topical in times when manufacturing dominated the US economy and when the mid-west region, with its concentration of automobile sector was the bellwether of the US economy. Both have lost their relevance considerably. Yet, investors focus closely on the Chicago purchasing managers’ index and the national purchasing managers’ index that follows a couple of days later. New orders placed by purchasing managers climbed steeply. The other encouraging indicator was personal income and spending growth in February. US households earned more and spent more than economists had anticipated.
What do we make of it all? That it is too early to signal an end to the US economic expansion. Yet, while backward-looking indicators have been solid, forward-looking ones show signs of turning down. Hence, it would be safe to say that, at present, the indications are that the US would witness several quarters of below-trend growth, with the risk of tipping over into a full-fledged recession.
However, equities have already received an unambiguous warning signal. A comprehensive measure of US corporate profits declined for the first time this cycle, in the last quarter of 2006. That should not have been a surprise. As the US federal funds rate rose from 1% to 5.25% between 2004 and 2006, nominal GDP growth slowed.
Corporate profits peak in short order. Therefore, US stock markets that appeared reasonably valued when measured against peak corporate earnings would be pricier when earnings are adjusted for economic cycles. Additionally, the Federal Reserve appears to be in no hurry to bring down the federal funds rate since inflation is proving to be a lot stickier at high levels than they had anticipated, as is the case in India. The combination of fading growth in profits and high interest rate is a big hurdle for fully valued equity markets to climb.
If US equities decline under the combined weight of a slowing growth momentum and corporate profits, then equities around the world would follow suit, regardless of how well their own economies are doing. Asia, in particular, would suffer more. In recent years, Asian markets have seen their correlation to the US increase. Moreover, the sensitivity of Asian equities to any up or down move in US equities has gone up. Asia over reacts these days.
In addition to this financial integration, the Outlook 2007 report recently released by the Asian Development Bank has nailed the myth that Asian economies could grow independent of the global economic cycle and that of the US, in particular. It is not the case. If anything, this dependence has increased after the Asian economic crisis of 1997-98. Therefore, Asian economies and equity markets should brace for less cheerful times in the coming months.
In India, with the Reserve Bank of India abandoning the “dual mandate” in favour of a single-minded focus on price stability, the repercussions on the overvalued equities and real-estate markets would be felt more acutely. Making money would be a lot harder in 2007. However, preserving gains made in the last four years should not be that difficult. All that it requires is for investors not to be inebriated by their own exuberance.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer (Singapore) Ltd. These are his personal views and do not represent those of his employer. Comments are welcome at firstname.lastname@example.org