Why Market Strength And Economic Growth Don't Always Line Up

Why Market Strength And Economic Growth Don't Always Line Up
WSJ, April 26, 2007
By GREG IP

The stock market has been a lousy barometer of the economy.

From the beginning of 2004 through the first quarter of 2006, economic growth averaged an impressive 3.4%. The Dow Jones Industrial Average rose just 6%. Since then, economic growth has slowed to a little more than 2%, yet the blue-chip index has leapt 18%, ending yesterday's session at a record 13089.89, the first time it has closed above 13000.

So, is the stock market providing reassurance? Or is it out of touch?

Economists differ. David Rosenberg, chief North American economist at Merrill Lynch & Co., thinks the market is misleadingly optimistic. He says there is a "disconnect between how the economy is doing and the way the equity market is doing." The U.S. economy has just completed four quarters of annualized growth below 3%, which, he says, has never happened in 60 years without being followed by recession. While he doesn't forecast one, he puts the risks higher than generally realized.

But Ed Hyman, chief economist at ISI Group, a New York investment dealer, says the market has it right. Just as in 1985 and 1995, the Federal Reserve has raised interest rates enough to slow the economy and bring inflation under control. That reassures investors that even higher rates won't be needed later that could tip the economy into recession.

Mr. Hyman expects economic growth to slow further -- to an annual rate of 1.5% in the last nine months of this year -- and the Fed to cut short-term interest rates by three-quarters of a percentage point. The boost to stocks from lower rates should more than offset the drag from weaker growth and profits, he says.

At present, the stock market isn't responding to recent profit growth. In fact, profit growth has fallen sharply, and the outlook is clouded by slowing U.S. productivity growth, high fuel prices and the specter of protectionism that could interrupt the pace of globalization, which has boosted U.S. companies' profits from overseas. Rather, the rally that began last summer has been principally driven by the Fed's decision to stop raising interest rates.

The stock market has long been regarded as a leading economic indicator, though it sometimes sends the wrong signals. It reflects the collective judgment of millions of investors on the prospects for corporate profits, which are highly sensitive to economic fluctuations. However, other things also affect stocks: interest rates, the flow of money into and out of shares and investors' appetite for risk. That is why experts often disagree on how to interpret the market.

Mr. Hyman of ISI says the popular view that a strong stock market requires a strong economy is "just totally wrong." Beginning in the early 1980s, he says, the Fed adopted the practice of raising rates ahead of anticipated inflation pressure, often early in an expansion.

Such "pre-emptive" tightenings slowed growth but prevented an outbreak of higher inflation. During the tightening phase, stocks struggled to advance, even though profits were usually growing, as investors fretted the Fed would go too far and tip the economy into recession. Once the central bank stopped raising rates, investors concluded that with inflation under control, a recession was unlikely, and stocks took off again.

The Fed didn't always succeed: Its tightenings were followed by recession in 1990 and in 2001. Still, Mr. Hyman points to the United Kingdom, Australia and Canada -- which have grown without interruption since the early 1990s -- as proof that long expansions are likely as long as inflation stays tame. "It appears we are still in the tame inflation mode," he says.

Merrill's Mr. Rosenberg, in contrast, says the 1980s and 1990s were the exception, and sees no special factors that will extend the current expansion the way tax cuts and Internet mania did in the two previous expansions.

The Conference Board's index of leading indicators has declined on a year-to-year basis for three consecutive months. That is in spite of the rise in the stock market, which is one of the index's components. Mr. Rosenberg says every time it has done that in the past five decades a recession followed, with one exception: 1967. Among the components of the index recently pointing to a risk of recession are capital-goods orders, building permits and the fact that short-term interest rates are higher than long-term rates.

There also are other signs that the economic expansion is showing its age. One that former Fed Chairman Alan Greenspan has called attention to is profit margins. On an economy-wide basis, they hit a record high in the third quarter of last year before narrowing slightly in the fourth period. Mr. Greenspan's view is that the 1980s and 1990s expansions were helped both by a decline in long-term interest rates as investors adjusted to a low-inflation world, and a surprise acceleration in productivity growth in the 1990s driven by information technology. Neither factor is at work now.

But Steven Wieting, an economist at Citigroup Inc., says stocks have persistently lagged behind the growth in profits since the end of 2001. He figures investors are anticipating economic growth over the long term of just 2% to 2.5%. That is below many economists' estimates that the U.S. economy can grow at about 3% a year on average over time.

"The market, from a long-term context, isn't expecting a great deal out of the U.S. economy," he says.

A stitch in time saves nine

A stitch in time saves nine
The Economist, Mar 22nd 2007

Chinese interest rates are still far too low

MOST central banks change interest rates by a quarter point here or a half point there. But the People's Bank of China (PBOC) is more particular. On March 18th, it raised its benchmark deposit and lending rates by precisely 0.27 percentage points, to 2.79% and 6.39% respectively.

Such fine calibrations may date back to the use of the abacus, and to an old Chinese convention that assumes a 360-day year for the purpose of reckoning interest payments. To make it simpler to calculate daily rates, lenders set annual rates that could be easily divided by 360. In practice this meant they had to be “divisible by nine” (because anything is easily divided by 40).

Even without an abacus, it is easy to show that Chinese interest rates are still surprisingly low. Despite the recent increase, the world's fastest-growing economy pays savers one of the world's lowest rates of interest. The ceiling of 2.79% on 12-month deposits barely compensates them for consumer-price inflation, which rose to 2.7% in February. Some economists reckon inflation could hit 3% in March, implying that the real rate of interest is probably still negative (see left-hand chart).

The rates paid by borrowers are higher, but not by much. The central bank's benchmark lending rate is above inflation in corporate-goods prices, now running at 4.5%. Even so, it looks far too low. In theory, a country's equilibrium interest rate should equal its marginal return on capital. In developed economies this is often taken to mean that interest rates should be roughly the same as the trend rate of GDP growth (a proxy for the return on capital). But China's nominal growth rate and its return on capital are both in double digits, well above the bank lending rate (see right-hand chart).

This is not to say that China's interest rates should be as high as 13% or so, in line with its nominal growth. Many other Asian emerging economies also have interest rates well below their growth rates, thanks largely to high levels of domestic saving. But, according to Jiming Ha, the chief economist at China International Capital Corporation, nowhere is the gap between the pace of growth and the rate of interest as wide as it is in China.

Mind your Ps and Qs

Central bankers can conduct monetary policy by changing either the price of money, ie, interest rates, or its quantity. In developed economies they favour interest rates. In China rate changes are less common: the latest move was only the fourth in three years, a period during which America's Federal Reserve has raised rates 17 times. China has relied more on quantitative measures, such as direct controls on lending and changes in the amount of reserves that banks must hold at the central bank. The PBOC's reserve-requirement ratio has been raised five times since July 2006.

One reason for this approach is that the economy has traditionally not been very sensitive to interest rates. Higher borrowing costs deter private-sector companies, but do not discourage inefficient state-owned enterprises, because they are less bothered about their return on capital. In such circumstances, direct controls on credit may have been a more effective way to curb overinvestment.

But leaving rates so low has its costs. Firms may borrow too much to invest in projects with low returns, thereby exposing banks to dangerous risks. Cheap loans encourage an overdependence on bank lending and hinder the development of capital markets. At the moment the most worrying distortion is that the low return on bank deposits is fuelling asset-price bubbles as households seek higher returns by buying shares and property. After plunging by 9% on February 27th, the Shanghai stockmarket has since rebounded past its previous high.

Higher reserve requirements have also lost their bite. In theory, if banks are required to hold more money on deposit with the central bank, this should increase the cost of their funds and so lead them to push up their interest rates. But banks' deposits at the PBOC are already much larger than the required ratio, so an increase does little to constrain their ability to lend.

China's monetary policy is also constrained by its rigid exchange-rate regime. Thanks to its widening trade surplus and strong inward investment, the country has experienced heavy inflows of foreign exchange, which swell domestic liquidity. The central bank has been reluctant to raise rates for fear this would attract more “hot money” from abroad. To regain control over its monetary policy, China needs a more flexible exchange rate.

A new IMF working paper* by Bernard Laurens and Rodolfo Maino argues that interest rates need to play a much bigger role in China's monetary policy. If the PBOC adopted a short-term money-market rate as its operational target, its policy would be more effective and the allocation of capital would be more efficient. The PBOC should scrap its controls on lending and deposit rates. It should also reduce banks' excess reserves to give them an incentive to borrow from each other in the interbank market, thereby enhancing the importance of money-market rates.

More controversially, the authors argue that the PBOC must be given full discretion to change interest rates. At present the State Council must approve all adjustments. The Chinese government is unlikely to grant the central bank such powers in the near future. Nonetheless, the PBOC should use all of its existing powers of persuasion to argue more strongly for higher interest rates now.

Even when free of political meddling, central banking is fraught with uncertainty. Monetary policymakers have to rely on good luck as well as sound judgment. That may be another reason why Chinese interest rates are divisible by nine: it is seen as an auspicious number. The Forbidden City in Beijing, for example, has 9,999 rooms. Unfortunately China's loose monetary policy is leaving rather too many hostages to fortune.

What Spending Slowdown?

What Spending Slowdown?
BusinessWeek, APRIL 23, 2007
By Michael Mandel

Forget those antiquated government statistics. U.S. corporate investment is booming—just take a look overseas

When is a slowdown not a slowdown? On the face of it, the government's statistics tell a very convincing story about cautious companies and weak business investment. For example, so far in 2007 new orders for nondefense capital goods, such as computers, trucks, and machinery, are barely higher than they were a year ago, an omen, perhaps, of tough times ahead for corporate profits.

There's only one problem. Corporate America is still spending big time, just increasingly outside the U.S. A BusinessWeek analysis of financial reports from more than 1,000 large and midsize U.S.-based companies shows that global capital expenditures in the fourth quarter of 2006 were actually up 18.1% over the previous year, a number that includes nonresidential construction as well as info-tech equipment and machinery. The comparable growth for domestic business investment, which is all the government reports each quarter: only 8.9%, without adjusting for inflation.

So far in 2007, U.S. corporations seem to be keeping up the global spending pace. Alcoa Inc. (AA ), which reported first-quarter earnings on Apr. 10, boosted capital spending by 32% over a year earlier, in part to fund the construction of the company's new smelter in Iceland, as well as investment projects in the U.S., Brazil, Russia, and China. And Boise (Idaho)-based Micron Technology Inc. (MU ) spent almost $1 billion more in the first quarter of 2007 than it did a year earlier: The semiconductor maker developed new plants in China and Singapore and expanded capacity at existing facilities in Virginia and Utah.

Welcome to the global economy, Mr. Statistician. Government measures were well-suited for the 1950s and 1960s, an era when U.S. companies mainly invested at home, and imports and exports were a relatively small portion of the economy. Even as corporations stepped out into the world, most of them still did the bulk of their capital spending at home. So government investment numbers remained an accurate gauge of corporate health.

Today, however, virtually every major company is trying to reduce costs and get closer to fast-growing markets by spreading manufacturing operations and research facilities around the world. As a result, a U.S.-centric view of capital spending, says Steven R. Appleton, CEO of Micron, is "almost meaningless."

SHIFTING FORTUNES

Still, it's hard to wrap your mind around the implications of a world where U.S.-based companies make more and more of their investments overseas. Whether they are going abroad to chase customers or to seek out the skilled workers they need, American companies no longer depend on capital spending at home. "I don't have to hire one more person in the U.S.," says Appleton. "I don't have to invest one more dollar here--and we'll be just fine."

Appleton's sentiment is particularly striking, since Micron invested 100% of its capital spending domestically as recently as the late 1990s. But plenty of other companies are making the shift abroad as well.

For example, 3M (MMM ) expects to spend about $1.5 billion in cap-ex in 2007, up about 25% over last year. Out of 18 new plants or major expansions in the works, only seven are in the U.S. Four are brand-new facilities in China, with others in India, Korea, Poland, and elsewhere.

Or take Commercial Metals Co., (CMC ) an $8 billion steel company based in Irving, Tex. In 2003 it bought a steel mill in Poland, where it makes wire rod and other products to sell in Eastern Europe, one of the hottest construction markets in the world. This fiscal year, says William B. Larson, chief financial officer, Commercial Metals will double its capital spending in Poland, helping drive a 49% increase in global capital spending in the company's second fiscal quarter, which ended in February. What's more, the company is currently bidding on two mills in Croatia and looking for more investments in Vietnam.

REALIGNMENT

In some cases, expansion overseas can coexist with increased investment at home. In 2006, Sealed Air Corp. (SEE ), a $4 billion maker of Bubble Wrap and other packaging products, based in Elmwood Park, N.J., boosted capital spending by 73%, in part to fund projects in Brazil, Russia, and China. The goal, says CEO William V. Hickey, was to "align global production capabilities with growth." At the same time, however, the company's North American investment more than doubled.

What does all this mean? In part, the gap between the corporate and the government numbers may reflect differences in the sorts of companies being counted. The government estimate for capital spending covers all businesses, down to the corner grocery store. It also includes investment in the U.S. by foreign companies, such as Toyota, which can be big spenders. Moreover, the corporate numbers are subject to the vagaries of financial accounting, which tend to make government statisticians a bit leery of them.

But there's a bigger point here. In the past there was a close link between the location of capital investment and jobs. When a company built a factory, that was where the jobs were going to be. In today's global economy, though, the link is not so clear. An expensive data center in Oregon, say, costing hundreds of millions of dollars, can support workers in India. An investment in database software in Texas can run a supply chain that starts in Taiwan. And new freight planes bought in the U.S. by companies such as FedEx Corp. (FDX ) can help speed high-value exports from China.

It's not even clear there's a close connection between the amount that companies spend in the U.S. and the health of the country's capital-goods makers. Twenty-five years ago, virtually all the equipment and machinery used by domestic businesses were made in the U.S. In 1980 imports accounted for only 17% of domestic business spending on equipment and machinery, outside of trucks and cars.

Today imports equal 66% of U.S. capital spending on non-motor-vehicle equipment and machinery. Even more mind-boggling, exports of capital goods from the country are just as big as the imports.

The bottom line: If a company is investing in the U.S., there's a good chance it's buying computers or some other piece of machinery made overseas. And if a piece of capital equipment, such as construction machinery, is made in a U.S. factory, there's a good chance it will end up being shipped abroad--perhaps even to help build a factory for a U.S.-based company that is expanding in another country.

If this all makes your head spin, you are not alone. The big divergence between domestic and global capital spending is a sign that the process of globalization has shifted into a new stage, and it's hard to know what's going to come next.

Mandel is chief economist for BusinessWeek