THE SKEPTICAL INVESTORTM

Issue No. 18 April 1999

Posted 30.IV.1999

CONTENTS

INTRODUCTION

The first quarter of calendar 1999 saw confidence return to financial markets around the world. Most key stock market indices realized gains, some substantial, and the major indices in the USA and the UK have even gone on to all-time record highs. The junk bond market too, which collapsed after the Russian default last August, started to show signs of life, whilst the market for high grade bonds, which had benefited from the same financial chaos - the yield on the US 30-year Treasury fell to its lowest ever last year - suffered a fairly nasty bear market as yields rose off their lows.

This happened despite that fact that the fundamentals almost everywhere remain weak, and may even be deteriorating. So what is going on?

First it can be said that much of the move was initially nothing more than a reaction - a bounce back from temporarily extreme levels. With memories of the sequential series of financial upheavals in Asia still fresh, there were widespread expectations that something similar or worse was going to occur following the events in Russia and Latin America. But then, when nothing much further did happen, fears of a global slump receded and markets bounced back. Such a response is a perfectly normal short-term technical response which, by itself, does not in anyway demonstrate a new trend leading to economic growth and recovery. That indeed is how I interpreted it in the last Issue (when I suggested that the Toronto Stock Exchange Index might be a better surrogate for North America than Wall Street).

But it has subsequently become increasingly evident that financial markets have moved well beyond this technical rebound and are now reflecting a widespread belief that the international financial crisis is waning and a recovery is underway.

"The financial crisis that engulfed most of the world's emerging market economies . . . 'Seems to be over.', Michel Camdessus, the managing director of the International Monetary Fund, said yesterday." (Financial Times, 26 April 1999).

The stock markets of Japan and South Korea for example must be anticipating this, but most telling is the reappearance of demand for high-yield debt. We are seeing not only the recovery of the US and European junk bond markets but also renewed interest in the debt of emerging economies: an unmistakable sign of the perception that risk is fast disappearing there.

This is the most difficult global marketplace to call since The Skeptical InvestorTM was launched in June 1997. Regular readers will know that it has been possible to predict the evolution of the crisis with a great deal of success for almost two years now, but this is the first time that I can seriously entertain the possibility that we may have seen the bottom. This is not because the financial weaknesses that caused the problem in the first place have gone away - they have not - but they were there for a long time before 1997 too. Given enough believers that it is all over, there can be a return first of confidence, and then of business investment and consumer demand. The day of reckoning can be put off again.

But will it? As usual, the best I can do is to begin with the facts and see where they lead.

DEBT AND CREDIT

The root cause of the crisis is financial: the economic effects that we have seen are only the consequences. It is the result of too much debt. Debt that cannot, ultimately, all be paid off. (Economists prefer to talk about "excess credit" which sounds better than "too much debt" I suppose.)

Astonishingly, this underlying problem is getting worse. Admittedly there are positive signs in, for example, Thailand where the banks' ratio of non-performing loans has improved, but that is not what you see when you look at the big picture. According to top credit rating agency Standard and Poor's, as reported by the Financial Times on April 20th " More and more of the world's financial systems are weakening in the face of excessive credit growth and falling asset prices . . . Credit quality is deteriorating in 24 of 611 countries monitored since its last report on financial system stress in October."

ECONOMIES

1. ASIA

The Asian Development Bank forecasts 4.4% growth across developing Asia in 1999. In Japan, the Ministry of Finance forecasts a return to growth (0.5%p.a.) during the current fiscal year. But the track record of formal economic forecasting is dismal. I find both forecasts dubious.

In JAPAN, the stock market is rising. The Nikkei Dow Index has recovered from below 13000 last year to above 17000.

But there is no convincing evidence yet that the economy is starting to turn around. The most recent fiscal quarter saw a further decline in GDP,the fifth consecutive quarter of contraction.

There is one item of economic news which might turn out to be presaging the first glimmer of recovery: a small increase in domestic demand. Domestic demand growth is the essential requirement for economic recovery because Japan cannot rely on an export-led recovery during the present global slowdown, and this is thus a crucial number to watch.Unfortunately the observed blip may be nothing more than that - a blip -because it is a normal phenomenon during a long recession for a period of increased demand from consumers who have put off essential purchases for as long as they can: we must await the emergence of a trend before putting any weight on these data.

If domestic demand fails to pick up and fades again, then the outlook for the economy is bleak indeed. This is because the government has already used up its options. Let me explain. The focus of Japanese strategy has been to engineer a recovery by attempting to stimulate domestic demand by massive programmes of deficit spending (make-work projects, tax cuts, etc.) and through interest rate cuts. It is difficult to visualise any more being done along these lines. The existing massive budget deficit is already unsustainable over time and any further increase risks (with justification) panicking the markets. Interest rates are already almost at zero. This pessimistic view appears to be supported at least in part by the usually inscrutable deputy governor of the Bank of Japan, Yutaka Yamaguchi, who, in a rare recent interview was quoted as saying that with interest rates almost at zero " . . . there is a limit to what (more) monetary policy can do." Little more than a truism perhaps, but that fact that he felt the need to make the point is significant.

These fiscal and monetary measures are mostly classic Keynesian. I have argued vigorously and consistently that both reason and the lessons of history make a nonsense of this Keynesian economic theory. Therefore I do not expect to see a sustained recovery of economic demand immediately ahead.

I have also argued that the only cure for a deflationary recession such as Japan's is an economic clean sweep. The deadwood and bad debts must be cleared out. That means corporate failures, bankruptcies, unemployment, the disappearance of unsound financial institutions, and large-scale repudiation of debt - in short, a hard landing with a lot of pain.

It is ironic that just at the time that the rest of the world starts to think that Asia is in recovery, there are signs that an appreciation that a hard landing may be the reality are appearing in Japan itself. In the same newspaper article that quoted Yamaguchi, the Financial Times reported that " In recent weeks some bureaucrats appear to have finally accepted that Japan cannot stave off restructuring with magic wands. Instead, they mutter, it would be better to have a hard landing and use the shock to push through structural change."(7th April 1999)

So, what about SOUTH KOREA? A major economy, and one that with the best performing stock market last year ought to be the one nation where we can find justification in the fundamentals for equity valuations. The government there has taken rather more credible action to clean up the mess in the financial services sector, action that was clearly necessary. Necessary, but not sufficient though because the rest of the economy remains weak. Few corporations and chaebol have done any significant cost cutting and restructuring and, accordingly, many professional equity analysts believe that current valuations are out of line with the fundamentals.

THAILAND was of course as everyone knows the first country to go into crisis. Whilst the dynamics have changed and it cannot be expected that what happens there will continue to trigger similar events elsewhere, it can offer us a nice illustrative example of what may or can happen.

In the October 1997 Issue I talked about Thailand's bailout agreement with the International Monetary Fund and whether they would stick to the conditions they had accepted. My conclusion was "Theywon't." It took a long time. But they didn't. Last year Thailand abandoned the agreed high interest rate policy, and began to dilute other measures. All pretence of following the original terms was abandoned when on 30th March this year (1999), Thailand announced a Bt130 billion package of government spending and tax cuts. I expect these policies to work as well as similar methods have worked in Japan. Such policies do not promise a quick end to the crisis.

2. EUROPE

The major EURO-ZONE economies (Germany, which accounts for 33% of the euro-zone GDP, France - 22% - , and Italy - 18%) show weak or declining growth. There is even some price deflation in Germany: inflation is almost non-existent in the region as a whole (0.8%). Unemployment stands at 10.5%.

" . . . growth has collapsed. Domestic demand is sickly. Across much of the European economy, business confidence and investment are terribly weak." (Financial Times, 10th April 1999).

On 8th April, despite the weakness of the euro, the European Central Bank reduced the euro interest rate by an unexpectedly large 50 b.p. to 2.5% from 3.0%. Statements made at the time by officials made it clear that this action was taken because of weakening economic conditions in an effort to stimulate growth. Interestingly it was also made clear that lower rates, by themselves, will not boost growth. I wholeheartedly agree! In view of the fact that the other necessary conditions are not present, the outlook for the economy is not rosy.

EASTERN EUROPE (including RUSSIA) is in worse shape. Regional GDP fell by 11.3% last year, and is forecast to continue to shrink in 1999.

"The Russian economic crisis is having a more serious effect on conditions in the former Communist bloc than was expected when the upheaval began last summer." (European Bank for Reconstruction and Development Report.)

The UNITED KINGDOM is performing much better than any other major European economy. Expectations here are for, at worst, a short mild recession, and business confidence actually rose sharply in 1Q99. GDP grew at 0.7% p.a. in the same quarter. The UK however is mirroring the US in most ways - a strong currency, an overvalued stock market, even to the extent of also having a deteriorating trade balance of payments - and for our purposes is best viewed analytically lumped in with the United States. In the global economic picture the UK economy is a satellite of the US economy.

3. UNITED STATES.

America continues its astounding vigorous non-inflationary economic growth. GDP grew at 6.1% p.a. in 4Q98. This was in the face of a global slowdown.

But the US stock market bubble remains, and is getting worse. According to IBES International, the S&P 500 ended February overvalued by 25%. The only previous time that it reached such a level was during the two months leading up to the 1987 crash. And the market is getting more narrowly based: as the DJIA went through 10,000 only one third of the stocks listed on the NYSE were trading above their 200-day moving average. I believe that there is no precedent for a major stock market to broaden out again once it has narrowed until there has been a significant fall in the leading stocks.

I continue to firmly believe that there is no New Era. The US market is a bubble that threatens the entire US - and the world - economy.

CONCLUSIONS.

The recovery in global financial markets is not supported by either the economic or the financial fundamentals. Nor is there much evidence, except for the special cases of the USA and the UK, that it is accompanied by a recovery in business confidence. It has so far been essentially only a recovery in investor confidence. Hence the underpinnings remain fragile, and markets and economies everywhere remain vulnerable to any new financial shock.

Were it not for the situation on Wall Street, I might now be leaning towards a scenario of recovery in business confidence and investment,with the ultimately inevitable "Great Reckoning" put off to some future time. But the Wall Street Sword of Damocles hangs there: and the rest of the world remains too vulnerable to withstand a market crash in America.

My favoured scenario now is that the last act of the unfolding drama will be exactly this - a Wall Street crash. Followed by the obvious effects on the rest of the world.

But, and this is important for anyone thinking about shorting the market to remember, there is no way to tell how long all this can go on before that happens.

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