Bermuda: LOM Weekly Perspectives

Last Updated: 12 December 2001

Bullishness, tempered with a touch of fear

The bulls are running on Wall Street, despite occasional pauses for refreshment, and the bears are furtively covering their short positions. The proximate cause for the spurt in stock indices last week was the NAPM report on non-manufacturing businesses. Market participants usually ignore this report, but the nice jump in the index was a sufficient excuse for investors to give vent to their positive sentiments. Also, there was some winking and nodding from a couple of top tech executives, which cheered receptive minds. However, the employment numbers, on Friday, were lousy and dampened the partying mood. Still, there is sufficient momentum in the market to carry it forward for a while and, of course, technology stocks are leading the rally. Never mind that the valuations are wacky, but fund managers don’t want to be left out and need to do some window-dressing at year-end. Most of all, they don’t want to be caught holding a lot of low-yielding cash in their portfolios. So the mood is generally bullish, but this does not preclude moments of doubt, and even fear.

The tech upswing over the past two months has also been reflected on many Asian markets, which have risen nicely – but so have European indices. In fact, there is now a very strong correlation among equity markets. High correlation is bad for diversification purposes but confirms the consensus view of a synchronised global recovery. Foreign buying rather than local purchasers, who have yet to plunge back into the markets, has been a major factor in pushing up prices in Asia. Meanwhile, it does not appear that U.S. investors are being attracted to European markets, which have nevertheless shown healthy increases on the back of domestic interest. Once again, fear of being left behind in a bull run has overcome caution. The only major index that has had only a grudging rise from its lows in September is, of course, the Nikkei 225.

Waiting for the next crisis in Japan

As we all know, Japan has been wallowing in sub-standard growth for the best part of a decade, punctuated by periods of recession. There have been many false starts for investors who thought that the stock market had finally hit bottom, only to be surprised by new downward move. The current situation is quite dim, with deflationary forces squeezing profit margins and adding to the bad loan totals of the already burdened banks. Meanwhile, the authorities are having a tough time working out effective policy solutions. Prime Minister Koizumi has been a disappointment, showing more style than substance. Efforts at restructuring have been half-hearted. Some of the more enlightened leaders are aware that the Kieratsu system of tight conglomerates may have become passé in a world that favours creativity and flexibility, as well as accountability to shareholders. It was very effective for many decades but has really outlived its usefulness. Things are changing on the organisational front, but rather slowly.

There is another issue that is of even greater importance in effecting structural change. Observers have always noticed the dichotomy in the Japanese economy between an efficient and innovative exporting sector and the thoroughly inefficient sectors of distribution, agriculture and construction. These sectors are protected and subsidised. Any thoroughgoing attempt at structural change will result in considerable pain for workers and businesses, and will have political costs for the party in power. It is a tough nut to crack. In all societies, those benefiting from privilege, monopoly, protection and subsidies will fight like hell to maintain the status quo. The problem is that Japan has yet to experience desperate crisis conditions that will force a competitive solution despite heavy political costs. At that point the prospect for the economy and for equities will improve dramatically. We need to keep a close eye on Japan for a possible turning point.

Bond market blues

Bond investors have had a pretty awful time in the past two months, experiencing the sort of abnormal volatility that has rattled even professional players. The upward spikes in Treasury yields have retraced a bit of their climb, but they are not coming back to their lows. Essentially, the bond market has rejected the deflation story. It correctly believes that inflation will be lower in the short term because of relatively weak activity, but that eventually it is going to be heading higher. The government’s fiscal measures will inevitably increase the budget deficit, which will not be easy to reduce. It is well known that spending programme increases and tax cuts are politically difficult to reverse. A rising deficit would mean more competition with the private sector for funds and upward pressure on borrowing rates. So it is a fair assessment that Treasury yields have broadly bottomed. Many corporations borrowed heavily earlier this year on fairly attractive terms, locking-in low rates. It has also been noticed that the government, by dropping the issuance of the 30-year bond, may be increasing its eventual financing costs, as interest rates rise on shorter-term debt.

Somewhat better prospects for the first quarter

The bounce in the stock market has undoubtedly helped to boost consumer confidence. Other positive factors are the rapid progress of the war in Afghanistan and low oil prices. The big negative factor is, without question, the poor state of the job market. Meanwhile, the edging up of interest rates may begin to reduce the prospects for mortgage refinancing. It still remains true that, on the whole, household balance sheets are not too healthy and are in need of repair. The massive monetary easing by the Fed since January has helped in preventing the occurrence of a deep recession. The normal process in a market economy is for a deep recession to cleanse the system of its excesses and allow a sharp rebound in activity after balance sheets have been repaired, assets destroyed and re-valued. A deep recession causes a lot of pain and authorities try to prevent it from happening, or try to make it shallow. But there is a cost involved, in that when the process of adjustment is truncated the subsequent recovery carries with it a set of unresolved problems that still need to find a solution and may act to sap the vigour of the recovery. In consequence, it is possible that consumers may yet have the wherewithal to maintain their spending in the first quarter of next year. As well, declining inventories may force firms to ratchet up production. This may result in a more robust outcome in Q1 2002 than is currently expected. However, it does not mean that this is a prelude to substantially stronger growth in subsequent quarters. Essentially, the economy may have been given time by the Fed to readjust over a longer period.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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