Looking In The Wrong Direction

It is the immediate danger that always seems the greatest. This is why (public opinion) always views as foolhardiness what is, in the end, the only safe option, and therefore the most prudent course of action. (Loosely translated from General Karl von Clausewitz)

In spite of what has seemed like a particularly difficult patch, US stock prices have essentially moved sideways, rather than down, since last summer.

In other words, after a severe bear market of nearly three years, stock prices have been “backing and filling”, or building a base, which is not unusual after significant declines.

The United Nations fiasco, the rift between presumed NATO allies, the build-up to the war in Iraq, and now the war itself - all have failed to reverse the stock market rebound that had been shaping up early last fall. Such resilience would seem to confirm that, although the most severe bear market since the 1930s had not brought valuations down to rock-bottom levels, stock prices had fallen enough to allow for a good cyclical rally. Our view remains that price-earnings ratios will continue to trend down for much of the coming decade, as inflation and interest rates recover, but that sharp stock market rallies are possible from current levels -- as happened in the mid-1930s, for example, in the midst of depression and on the way to World War II.

Even before the ramp up to the war in Iraq, the underlying statistics of the US economy, though somewhat erratic, had been better than the image painted by media reports. Now, everything we see and hear indicates that a number of spending plans, by both households and businesses, have merely been put on temporary hold. Meanwhile, there are powerful reserves of monetary and fiscal stimuli throughout the world’s economies.

Recent political and military developments have clearly had a short-term braking effect on the global economy. As spending and investing decisions have been temporarily delayed until the horizon cleared, statistics of economic activity for March and April (to be released between now and summer) are likely to look depressed. But this does not amount to a double dip.

Throughout much of Asia, government budgets are expansionary and, with ample foreign exchange reserves, there is also the potential for more stimulative monetary policies. This is important in two respects. First, the Pacific Rim now accounts for 13% of World GDP (about equal to Japan’s and 40 percent of the United States’) but, with a 6.6% growth rate, it has contributed close to a third of the increase in global GDP growth over the past year. Second, realizing that exports to the United States would likely weaken for a while, the region’s governments have aggressively moved to policies designed to promote domestic consumption. In addition, intra-regional trade has been expanding very fast, multiplying the benefits of domestic stimuli: China’s imports from Japan and the Pacific Rim recently have been running at a rate 2.3 times those from Europe and the United States.

In Japan, we must accept that there are very few potential sources of domestic growth. The consumer is essentially sated and fairly comfortable, if edgy about the future. Corporations are still trying to shed excess capacity and redundant assets, while moving production to China and actively working to strengthen their balance sheets.

Debt concerns have prevented more government spending, but the Central Bank has been pouring reserves into the banking system. Normally, this would amount to a powerful stimulus, but the banks are have not been using the new lending power that these injections of reserves theoretically allow. They have preferred instead to buy government bonds yielding almost nothing, in order to strengthen their balance sheets weakened by mounting write-offs of non-performing loans. The government has helped with infusions of capital into the large banks, while the Central Bank also has been buying assets from the banks’ balance sheets.

Three years ago, economists were warning that a stock market decline below 16,000 on the Nikkei index would throw the banks into insolvency. Since then, this danger mark has steadily declined: today, it reportedly stands at less than 6,000 whereas the Nikkei, though at a twenty-year low, remains above 8,000. There has been a stealth improvement in the health of the banking system, and we are closer to the point when banks may resume their traditional function of multiplying the high-powered money provided by the Central Bank, thus restoring some traction to Japanese monetary policy.

Meanwhile, as China aggressively equips its industry to supply not only its export markets, but also its booming domestic consumer market, exports of Japanese machinery and equipment to China have begun to boom. As a result, Japan’s foreign machinery orders recently were 33% ahead of those a year ago. Even capital expenditures have begun to rise, following the strong recovery in Japanese corporate profits since late 2001.

In Europe, too, spending by households and corporations has been very weak. There is money, but no one wants to spend it: even though money supply growth has been strong, private credit growth has further slowed down. To a large degree, this is due to well-publicized rigidities in the labor markets and other regulatory obstacles. But it also has been the result of inept economic policies. Hopefully, there are increasing signs that the governments of France and Germany have decided (amid strong opposition from vested interests) to attack some of these obstacles to growth. Even the European Commission is looking for excuses to relax the iron collar of the stability pact. Soon after the bombing of Iraq started, a senior EC official declared that the war qualified as an “exceptional circumstance” which could free France and Germany from the strict limits on budget deficits imposed on members of the Monetary Union. According to the New York Times, when asked how this could be so since these countries are not supplying either military or financial support for the war, the official answered that there would be “indirect costs of war”!

Meanwhile, the European Central Bank again failed, today, to cut interest rates. Presumably, they intend to send inspectors in the field to uncover proofs of recession. No doubt these proofs will be easier to find than Saddam Hussein’s weapons of mass destruction… In short, we believe that more stimulative fiscal and monetary policies in Europe lay around the corner.

Finally, in the United States, where monetary policy has been and is likely to remain expansionary, fiscal stimulus will continue to accrue for several years from the 2001 tax cuts, and will likely be augmented by further fiscal easing and special fiscal measures related to war and security. Certainly, it would be counter-intuitive to expect otherwise as we get closer to a presidential election year.

In summary, beyond the paralyzing uncertainties related to the early stages of the war, the world economy is set for a significant, policy-induced re-acceleration. The only fly in the ointment for this logical scenario does not lie in the Middle East, but in the Far East. The mysterious epidemic of pneumonia that has come out of southern China, if it gets much worse or lasts much longer, threatens to seriously disrupt the flow of people and goods in and out of a region that has become one of the important growth locomotives for the global economy. It is too early to panic, but I, for one, have postponed my usual spring visit to Asia.

Still, I have not sold my investments, which (since they are mostly in mutual funds of the Tocqueville family) are heavily geared to a global recovery in economic activity.

April 3, 2003
^©Tocqueville Asset Management L.P.

The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management. Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Any reference to past performance is not necessarily a guide to the future. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change.