 September 2001 Capital Ideas
The way we see it, most of today's problems can be traced back to the usual suspect for a recession, a monetary policy blunder. This particular one was the Fed's untimely interest rate increases of 2000. While the intent was righteous -- prick the speculative bubble in the equity markets -- what they did instead was behead the economy. Sure the dot-coms were priced absurdly, but it was only a matter of time before investors would realize the emperor had no clothes. Unfortunately what the Fed and many others failed to realize was that the dot-coms didn't act in isolation. When you burst their bubble you also hit Cisco and Sun Microsystems who were selling them equipment, Citigroup and JP Morgan Chase who were financing them, Convergys who was providing fulfillment, and Federal Express and UPS who were delivering their products. Like everything in the current economy, what affects one part affects all. Turn Off the FedSo when the Fed acted to slow the speculative financial markets, they reduced liquidity for all sectors of the economy, not just the dot-coms. This came at a time when the cycle was peaking and the economy would naturally begin to slow. Now we're paying the price.So where do we go from here? Unfortunately it's been becoming painfully clear that what the Fed broke, they can't fix. After a rapid succession of cuts, the Fed Funds rate is 3% lower than it was at the beginning of the year, yet the economy and financial markets are well below their January 1 starting points. It's obviously a lot easier to screw up the economy than it is to fix it. At the start of the year, many believed quick and decisive action by the Fed would head off any serious economic slowdown. The Fed's moves in January and February -- including the surprise ½% cut in the first week of the year -- raised everyone's hopes and sent the equity market off in a false fit of euphoria.
But nine months and 300 basis points later, things have only gotten worse. First quarter corporate earnings were bad, but second and third quarter reports were even worse. The economy shows continuing signs of slowing (or at least no signs of picking up) while the Fed keeps cutting rates. For anyone except the totally blind, the obvious conclusion is that the Fed can't fix the problem. In fact, the best thing they could do at this point is nothing. Several meetings without action or dire words about the state of the economy would be the best gift they could possibly offer. It doesn't take a rocket scientist to see why. First, no action would send the signal that the Fed doesn't see a need for additional cuts. If they, the seers of the economy, don't see further deterioration, why should we as mere mortals? Investors would take no action as a positive sign. And why not? They haven't seen previous cuts as a positive sign. Aside from the first one or two moves, the markets haven't reacted well to subsequent cuts. Clearly investors feel that if the Fed's concerned, they should be, too. If no action implies the Fed is more sanguine, investors will react accordingly. Finally, no action would serve to bring participants back into the financial markets. During the current easing cycle like all others before it, many market participants have moved to the sidelines. Put yourself in their place: If your company needed to borrow money for a new project, would you rush out to secure financing when the Fed is just starting to ease or would you wait to see how low they could go? Unless the project needed immediate attention, you'd be foolish to rush in before you had some assurance you'd get the best rate. Don't you think others in the same situation are doing the same thing? Of course they are, and as long as the Fed continues to signal further cuts may be in the offing, projects are pushed out further into the future and capital spending remains constrained.
By moving to a neutral stance, the Fed would signal the worst is over and the easing cycle is too. Not only would this indicate the beginning of the economic turn, it would also suggest the time is right to reenter the capital markets. That's a better jump-start for the economy than another ¼% cut. Hands Across the WaterOf course the Fed may not be able to keep easing aggressively if the dollar continues to weaken abroad. Throughout the 90s, the strong dollar kept inflation at bay while the U.S. economy went through a prolonged expansion.This was accomplished on two fronts. First, a strong dollar keeps the cost of imports low, putting pressure on domestic producers to hold the line on their prices. Price increases domestically would simply send U.S. demand overseas. In the 90s, U.S. companies grew earnings by increasing efficiency rather than by simply raising prices. Productivity was the beneficiary.
A second benefit of a strong dollar is increased demand in the domestic financial markets. A strong currency makes financial markets more attractive not only at home but abroad as well. When foreign investors repatriate their profits, returns are enhanced when moving from a strong currency to a weaker one. The strong dollar attracted record levels of foreign investment to the U.S. financial markets throughout the 90s. On the other hand, multinational companies -- those that count on a lot of their sales overseas (like Coca-Cola or Procter & Gamble) -- are hurt when they translate sales in a weaker currency back into dollars. It's no wonder these companies have been whining to the Bush administration about the ill effects of the strong dollar. The downside of a weaker dollar is the effect on capital flows in the U.S. That's a fancy way of saying that foreigners wouldn't want to keep investing in the U.S. if our currency fell in value. If they did, they'd run into the same problem our multinational companies are experiencing now when they convert gains back into their domestic currency. The U.S. needs foreign investment since the country continues to run a massive trade deficit. Since this debt is owed to foreign countries, we need a steady supply of their currencies for repayment. As long as our financial markets offer interest rates higher than those in other countries, there's no problem attracting foreign investment. But if the dollar weakens, all bets are off. Those who favor it argue that a weaker dollar would make U.S. products more competitive abroad. There's no question they're right, but what's the real cost of this benefit? Not all domestic companies export their goods and services, so the benefit of a weaker dollar would only apply to specific industries. On the other hand, the increased potential for inflation would affect us all. If the dollar continues to weaken, don't look to the inflation fearing Fed for any additional cuts.
Sound the BuzzerAnyway, a country can't export its way out of recession. Look no further than Japan for proof. For the past decade Japan has suffered severe disinflation leaving the economy dead in the water. The central bank has maintained interest rates right around 0% yet the country continues to languish. Not a model to follow.Instead, domestic capital spending holds the key. Throughout the current slowdown, the consumer has continued spending. Arguably, this is what kept the economy from recession. But the consumer can't alone sustain the economy. The expansion of the 90s was fueled by corporate capital spending as businesses geared up for the "New Economy" and in preparation for Y2K. As the decade closed, capital spending hit a crescendo. Once Y2K passed uneventfully, capital spending fell and the stocks peaked in March 2000. Looking back, we should have seen this coming. According to Baseline's statistics for the past 15 years, as a 3-month leading indicator capital spending has a .85 correlation with the S&P 500 index. This correlation rises to .95 over the past 10 years. In other words, current trends in capital spending are a good indicator of trends in the stock market three months hence. When capital spending peaked in December 2000, it was a prediction that stocks would peak in March 2001. Throughout 2000 and into 2001, capital spending trended downward and so has the stock market. Not only does this make statistical sense, it also stands to reason. If businesses are not spending to expand capacity and improve efficiency, they must not be seeing a demand for their products. That's precisely the situation we've had for the past 18 months as companies have struggled to work through bloated inventories. Rate cuts and monetary policy can only go so far. As long as demand remains tepid and businesses are overstocked, the economy won't move forward. No one rings a bell when the economy hits bottom, but capital spending at least sets off a buzzer. When CFOs become more comfortable with economic conditions -- perhaps when the Fed stops lowering rates -- a resumption in capital spending will signal the turn. Three months later, stocks will look a lot better. Despite falling in the first two quarters of 2001, many economists predict capital spending will turn up in the current quarter. If so, this could still be a merry Christmas for stock investors. Search this site! Just enter you key word or words:
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S THE THIRD QUARTER DRAWS TO A CLOSE the stock market is languishing as the economy sputters and the dollar weakens. All of this is the effect of a basic tenet of elementary economics: capital flows. Or perhaps more precisely in this case, lack of capital flows.
Source: Baseline
Source: Baseline
