Global Economic Review


Here is a review of what the economy has in store for 2003 provided by Thomas Fischer at Jyske Bank.

"Is the US heading for another recession and is the dollar on its knees?"Well, the old recession (i.e. the one that started in March 2001) has actually not come to an end - at least not according to the experts. It is true, though, that after a period of accelerating growth this past spring the momentum has dropped quite considerably. And the situation is in fact similar to that of 2001. The industrial sector is showing signs of weakness, whereas consumer spending is once again the single most important factor when it comes to keeping the economy going. The economy will slide back into recession if consumer spending is not maintained until the manufacturing gets back on track or if the problems of the manufacturing industry finally get the better of the consumers. I expect consumers to overcome the problems and break the spell. But there is still a considerable risk that consumers will eventually give in."What is actually happening in the manufacturing industry? "Optimism in the manufacturing industry is wearing thin due to declining equity prices, higher oil prices, fierce competition and weaker-than-expected demand. Due to the decline in equity prices, corporate sector funding costs have increased  a problem to most companies, as they are heavily in debt. Admittedly, US government bond yields have dropped, but investors demand a higher risk premium to invest in corporate than government bonds. Many companies, therefore, pay a high rate of interests despite the fact that the Fed has lowered its official rate. Due to the still fierce competition, only very few companies have been able to raise prices and in that way improve profits. Therefore, focus has been on other ways of increasing profits, such as increasingly efficient inventory management. As a result, inventories have been reduced to the lowest level ever compared to sales. At the time of writing, companies only have inventories covering 1.32 month's sales -considerably below normal levels. Even if corporate sector profits increase as a result, the economy still faces a number of problems."When companies sell goods, these will normally have to be produced. This leads to a rise in both the level of employment and investments - factors that will boost the economy. But when companies cut into inventories to meet demand, they can cut back on production. Again, this means that they do not have to hire as many people or invest as much as they would normally have done. Consequently, industrial production has been low over the past three months, i.e. the economy has not yet been stimulated in the way it has grown accustomed to. But this being said, the reduction of inventories may also lay the foundation of a major upswing. If demand continues to increase, the manufacturing industry will build up inventories again. Production must exceed demand - and hence the industrial production will get going."Will US consumers manage to keep the economy afloat?Of course, US consumers have felt the adverse effects of declining equity prices, the events of 9/11 and declining employment, but we have also seen a number of positive trends. Property values have increased, they have seen decent tax breaks, they have been offered the opportunity to refinance their mortgages to get lower monthly payments as well as cash by increasing the limit of the loans. Until this autumn, they had also seen very decent real wage increases as a result of only moderate inflation and an insignificant reduction in the rate of wage increases. The increase in real wages has declined recently, but it will not doubt continue to stimulate consumer spending. Furthermore, chances are that the US tax payer will see additional tax breaks. After the mid-term elections at which the Republicans experienced widespread victory, President Bush has been given better possibilities of introducing further tax reforms."To what extent is the US government and the Fed able to stimulate growth? "Tax breaks are still on the agenda, but even if the public deficit is relatively large, the government and the Fed still prefer to stimulate the economy rather than saving up. Finally, public spending may be increased, but considering the deficit, there are limits to how much they will be able to stimulate the economy. With respect to the monetary policy, a rate of interest close to 0% poses certain restrictions. And the Fed is quite close to that level at 1.25%. However, there are a number of other monetary policy instruments such as buying government and corporate bonds in the market in an attempt to push down the rate of interest even further. Moreover, they can buy foreign bonds and thus weaken the USD. So although the Fed and the government may be running out of ammunition in its war against the low business activity, the enemy can still be defeated. Yet, further tax breaks and lower interest rates entail a certain risk. The public deficit may increase to such an extent that consumers become increasingly cautious for fear of future tax increases. The Fed may end up in a situation where an interest rate cut will not have the desired stimulating effect on the economy.The US dollar down on its knees"The value of the US dollar has plunged since early December. But most market participants are no doubt surprised that the plunge has taken on such huge proportions. I admit that the speed and persistence of the depreciation took me by surprise. The slide has been quite significant - in particular in terms of the euro. What are the driving forces behind the downfall of the US dollar, and for how long have these forces been in play?"As 2002 progressed it became increasingly obvious that the solution to the problems of the US economy would not be as simple as many had hoped at the beginning of the year. The bursting equity market bubble still leaves a trail of blood in the world economy. Not as bloody, however, as expected. Thanks exclusively to Alan Greenspan  the renowned chairman of the US Federal Reserve Board. By pursuing a very aggressive monetary policy, he has turned almost every conceivable valve in order to keep the economy alive. So far, he has only barely managed to sustain US consumer spending. The corporate sector is still marking time. The improved accounting results published so far have for the most part only been achieved through cutbacks and improved production methods. A fact reflected in the still high rate of unemployment. Real growth and optimism are still unfamiliar phrases in terms of the US economy. And with a de facto US Fed Funds rate of only 1.25%, Greenspan's possibilities of blowing more hot air into the US consumer bubble are almost exhausted. The economic imbalance is more serious than ever. The debt of the US consumer is in sharp contrast to the level of savings, and corporate sector capacity utilisation is still alarmingly low. It is difficult to imagine how the US consumers and the corporate sector can avoid having to pay the bill after several years of excesses. The time of reckoning is getting close. It becomes increasingly difficult to finance the still rising balance of payments deficit, and the more-than-expansive fiscal policy pursued by the Bush administration makes the budget deficit grow. All in all not something which will encourage international investors to fork out. Soon, there will only be one left to pay the bill! From a macro-economic point of view, it is therefore no wonder that the US dollar has depreciated. Trust is a key concept to any investor. A kind of trust which the current state of the US economy does not inspire."

You can get further details from Thomas Fischer at fischer@jyskebank.dk

Until next message, good investing!

Gary


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