Outlook for the U.S. stock markets and interest rates
1999 Stock Outlook: Review and Update
Outlook for Ex-Soviet Equities
Outlook for Small- and Microcap Sectors
Outlook for Initial Public Offerings
Outlook for Global Stock Markets
Outlook for Global Stock Markets
The Dow has shown an incredible bounce-back, recovering more than 80% of its post-July losses. The S&P 500 index is basking in the glory of its best month since 1987, with gains of 8.3%. And global equities have enjoyed the same return to favor, with the stocks of the MSCI world index gaining 8.9% in October.
The emerging markets are joining the fun too. Shrugging off a series of economic disasters, the emerging markets jumped 4.7% in September and another 11.6% in October. In fact, for the first time since March, 1998, every global regional index posted profits simultaneously.
The great bear market of 1998 is dead! Long live the newly risen bull.
False dawn?
That's one side of the story -- but not the only one by a long chalk. Even if it appears that government policy makers have saved the world economy for the moment, serious questions remain as to the underlying fundamentals.
Does this recovery have legs? What happened to the global liquidity crisis? What about excess global manufacturing capacity?
Perhaps a more important question would be: Are central banks actually capable of sustaining this level of micromanagement without screwing up, and creating an even worse mess? It's like watching a fiscal limbo.
How low can they go?
Desperate to staunch the bleeding from the liquidity crises of September, the U.S. Federal Reserve, the Bank of England, and several European banks moved like synchronized dancers to reduce key lending rates.
These actions included the easing of monetary policy, with a half a percentage point decline in U.S. short rates, a three quarters of a percentage point reduction in UK rates and convergence within the euro-zone on the German level of 3.3%...
The lifeline of US$41bn provided to Brazil, US$37bn of which is to be available in the first year...
An enormous ¥
Not wanting to be left out, the Bank of Japan dropped short-term lending rates to a mere wisp: .25%. Soon they'll be paying folks to cart money away.
(Just out of curiosity, what is the value of a currency that you have to pay people to accept?)
Clearly, this recovery is not yet value based. The global returns to equities is not supported by any good news on the profits front. Corporate profits remain weak, just not quite as weak as originally predicted.
The price-earnings ratio on the S&P, at just under 29, is only fractionally below its (perhaps overly robust) all-time high. The big jump in spreads between riskier and safer bonds has also shrunk, if by far less: the spread between C-rated corporate bonds and treasuries is still around 12 percentage points, against 8 percentage points before Russia's mid-August default.
First the Asian Flu. Now: Discount Fever
No, this refrain of equity exuberance remains due solely to discount fever by federal banks. Is this exuberance justified? Can the central banks pull this miracle out their hats? Better hope the magicians don't slip up. The wrong magic word from Greenspan, and the whole trick will go awry.
Still, with the Dow Jones Industrial Average back around 9,000, you can't argue the success of Greenspan's manipulations to date. So far, he has done more than walk on water. With a few words and three small cuts in U.S. interest rates, he has quelled the storm and smoothed the troubled waves.
It is little wonder then that the Organization for Economic Cooperation and Development has rolled over for him, offering a guardedly optimistic analysis in its latest forecasts. It notes, in particular, that the policy actions recently taken should, at least, prevent further damage.
Hearing the Call
The global financial markets have not been alone in hearing the siren call of recovery. So has the OECD..
Its central forecast calls for world growth at 2.1% in 1999, and 2.9% in 2000. This includes 1999 growth of only 0.2% in Japan (kind of like when the weatherman calls for partly cloudy with a 40% chance of rain), but a heady 1.5% in the U.S. and 2.2% in the European Union (giving 1.7% in the OECD. region as a whole).
Economic growth outside the OECD was 5% in 1997; it is expected to fall to 1.7% this year, before recovering, modestly, to 2.5% in 1999 and 3.8% in 2000.
Anemic bull
This bull certainly isn't showing the strength of its predecessor. Most forecasters are hedging their bets for 1999 with sizable downward revisions from earlier predictions in March and April, with expectations for Japan falling by 1.1 percentage points for Japan and the U.S. and EU dropping 0.6 percentage points.
Behind the revisions lie the obvious problems that continue to plague the system: Japan's deepening recession, lower oil and commodity prices, the redirection of financial flows from riskier borrowers and despite all the good interest rate news, continuing declines in confidence.
Both the U.S. and EU economies have been significantly damaged by downward pressure on the profitability of manufacturers and increased market perceptions of risk.
They can't all be right
The U.S. current account deficit is forecast to rise to 3.1% of gross domestic product next year, up from 1.9% in 1997. But the OECD forecasts virtually no change in the external surplus of the EU, expected to be 1.3% of GDP in 1999 and 2000.
The likelihood of both coming true is slim. This incongruity will prove a potent source of conflict. We'll examine that conflict in more detail as we go over the EU's numbers for 1999.
Europe: Free Trade Zone or Socialist empire?
By now there can be no doubt as to the reality of the European Union's arrival. The time when naysayers would be taken seriously is long gone. In fact, by the time most of you read this, it will already be a fait accompli. However, the implications of that birth are nowhere near as certain.
At a moment when one would expect solidarity amongst the leaders of nations embarking on such a momentous undertaking, nothing could be further from the truth.
When Europe's new single currency arrives on January 4th, its parents will be the ones making all the noise. A boisterous crowd of neo-socialist national leaders, new German Chancellor Gerhard Schroeder not the least among them, are attempting to subvert the independence of Europe's central banks at the very moment when those banks are trying to create an atmosphere of trust in that very independence.
Hitting the panic button
They're pressing Europe's reluctant central bankers to reduce interest rates to spur economic growth at a time of international financial turmoil. The global crisis has slowed growth among nearly all of Europe's major trading partners, including the United States, and that retrenchment is lapping at the shores of continental Europe itself.
The outcome of the debate will determine the very nature of the new currency called the euro: whether it will be an instrument of sound policies and stable prices or interventionist social policy.
This is not the scenario the euro's founders had in mind seven years ago at Maastricht, when they agreed to unite in creating a new union and a new currency.
Then, the goals were to enhance growth and efficiency by creating an enormous free trade bloc to rival any in the world, eliminate exchange rate fluctuation, and join multiple economies into one stable unit by cutting spending and deficits and by bringing inflation and interest rates into line across the continent.
Seemed like a good idea at the time
The project seems to be working. By Jan. 4th, 1999, Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain will abandon their national currencies and adopt the euro for all transactions except cash.
If only it could stay that simple and straightforward. In reality, the nations of the euro have squabbled repeatedly and continuously with each other regarding the oversight, regulation and even the goal of the new currency.
The French, of course, are not satisfied with their place in the new order, and yearn for greater political influence over the European Central Bank, which is replacing national central banks and will govern the monetary course of the euro in the same fashion as the Federal Reserve governs that of the dollar. That means the ECB will establish short-term interest rates for the 11 countries in Euroland, as the group is called. (Why does that name bring Disney's ill-fated venture outside Paris to mind?).
Germans to the front
The Germans, the de facto leaders and economic powerhouse of the new union, fearing a dilution of their strong and stable currency, the mark, have favored a central bank as independent and stringent as their own Bundesbank.
To ensure a strong currency the Euro-nations agreed (under strong German pressure) that the participants would limit their budget deficits to no more than 3 percent of national economic output. And they agreed that all the countries would raise or cut their interest rates as necessary to bring them to the same level, a process called convergence.
Nations from Finland to Portugal slashed spending and inflation to qualify, frequently encountering loud outcries of pain on the home front. So far, the convergence process has survived the fall of the Italian government, twice -- last year and this -- and outlived French elections in 1997 which pitted the fascist fringe-candidate LePen against Jospin's Socialist-led alliance with the Communists. Talk about your rock and a hard place.
The king pin falls
Over the years, as governments changed, one incoming leftist leader after another fell into (reluctant) lockstep with the austerity of Euroland -- until German dissatisfaction with Helmut Kohl's handling of German reunification peaked last fall with the election of Schroeder and removed the linchpin of that solidarity.
Quickly, European attitudes swung from conservative sanity to interventionist frenzy. While Schroeder and his team support the single currency, they wasted no time in calling on the Bundesbank (which holds Germany's monetary reins through December) and the ECB to cut interest rates to stimulate growth and create new jobs.
New German Finance Minister Oskar Lafontaine began clamoring for lower rates even before he was named to his post.
The new team also has questioned whether the Euro nations should have to adhere to the strict limits on budget deficits established by his predecessor, or fall for temptation like Clinton and Greenspan in the U.S. and slave monetary policy to the political objectives of the moment.
Once it was clear that the German resistance to bank manipulation had caved in, others joined the chorus. No need to be shy now. At meetings in late October in Austria, leaders of several of the 15 European Union countries spoke in favor of lower interest rates and government programs to stimulate their respective economies.
(Meanwhile, German businesses -- already buckling under the heavy tax burden and drowning in a sea of red tape -- have been ogling countries with less restrictive conditions of doing businesses. Look at recent acquisitions, such as Daimler-Benz AG's purchase of Chrysler and Deutsche Bank's merger with Banker's Trust, not so much as economic expansionism...but rather as a prelude to economic emigration!)
Line in the sand
The ECB responded quickly and firmly: It's not going to happen. If anything, the European pressure has hardened the resolve of Wim Duisenberg, governor of the central bank, to hold the line against this form of clumsy manipulation. Recently he informed reporters: It's normal for the political side to give suggestions or opinions on where political authorities would like rates to be. But it would be abnormal if those suggestions were listened to.
Other European central bankers, in particular Jean-Claude Trichet of France, Duisenberg's heir apparent at the ECB, have echoed his insistence on holding the line against interventionism.
They say there are no adequate reasons to lower rates in Europe, and one damn good reason not to. French and German short-term rates, which at 3.3 percent have been selected to serve as the baseline for the euro, are already more than 1 percentage point lower than in the United States. And while European economic growth is slowing, it's still higher than the numbers coming out of Washington D.C.
Reaching for the golden ring
Meanwhile, other euro nations are trying desperately to cut rates to bring them into line in time for the euro's debut in January. If German rates fall down any further, the gold ring on this merry-go-round just gets harder to reach for such higher-rate nations as Ireland, Spain, Portugal and Italy.
Interest rate convergence in Europe, which is absolutely necessary by January 1st, is still far from being achieved, warned Bundesbank central council member Klaus-Dieter Kuenbacher recently on German radio. So in this context it would be absolutely impossible for us to change our monetary policy.
Many analysts believe this quarrel will have little negative effect on the euro's debut. They point out that the United States has had lively monetary policy debates between political leaders and the Fed. Moreover, the argument goes, the ECB is a young institution and the euro a new currency. It deserves a shakeout period.
This whole debate would have happened even without the election of Schroeder, said Thierry de Montbrial, head of the French Institute for International Relations in Paris. Each institution has to find its place. And the question of lower interest rates is one that deserves to be debated.
Looking for solutions
At the same time, the economic ground is shifting. Profits are falling at many European corporations, due in large part to the world economic and financial crisis.
Two of Euroland's neighbors, Britain and Sweden, reduced interest rates this week. Growth in Euroland next year is forecast at just over 2 percent by analysts, nearly a full point lower than expected just a few months ago. Business confidence is down in France, Germany, Italy and elsewhere.
A stronger-than-expected euro would mean exports to the United States and elsewhere cost more in local currencies, reducing their sales.
Will they blame the euro?
Many analysts believe a healthy economy is needed to maintain public support for the new currency. Unemployment exceeds 11.5 percent in both France and Germany, the biggest economies in the euro.
If the new currency debuts just as layoffs begin on the continent, the uninformed masses may be inclined to blame their trouble on the easiest target.
And all the new neosocialist governments (especially Schroeder) badly need economic growth to create the tax revenues necessary to pay for their campaign promises. All the more reason, in their view, to reduce interest rates.
In Schroeder's framework, lower rates are central to get to more growth and employment, after all he has promised, Thomas Mayer of Goldman Sachs & Co. said. This is not just la la la, as the French say. This is serious.
So where will all this contention leave Europe in 1999? Let's look at the numbers.
Strong...for the moment
Germany's fundamental numbers remain the strongest in Europe. Growth trends should continue. In essence, the game is theirs to lose.
Germany's strength lies primarily in the fact that it is still a productive economy, and its quality products have well-established markets. Secondly, their conservative fiscal policies have served them well to date.
For them, the new unified market will bring in real profits from genuine sales and real capital from the new unified exchanges, not cheap loans and a credit bubble.
We predict a solid, reliable 15% in German equities by years end and GNP growth of 1.5-2%. All Schroeder has to do is resist the temptation to monkey with a good thing.
Study in contrasts
France remains a study in contrasts, barely able to navigate between monarchist fascists and frothing communists. LePen has been banned from politics -- for a year -- while railroad conductors are striking for more hours and more new hires. (How can one tell? The last time we were in Paris, there were no conductors to be found anywhere on the system.)
Experts in the industrial sector are predicting 5.5% growth in 1999, a figure that may be overly optimistic. The pressure on Jospin to solve this shortfall via central bank manipulation remains the fly in the ointment. We don't think he can do it.
His coalition owes too much to labor. He'll spend it before he earns it. Look for equities growth to be modest, 5-8% at best, and for GNP to come in at a measly 1%.
Struggling to keep up
In Italy, the policy gains of recent years seem to be slipping away. The aim of recent annual budgets has been to rein in over-swollen public finances, reduce a horrific deficit, and control the debt to ensure that Italy qualified for economic and monetary union.
Now that Italy has a lock on EU membership, discipline is slipping. The main concern of policy makers is to boost the sluggish rate of growth, which is now by far the lowest of the 11 countries entering the single currency.
The low growth rate will bring reduced tax receipts next year and an uncomfortably modest drop in unemployment. But the poor growth figure is a bigger worry all by itself.
Marching out of step
There are fears that Italy is now out of step with the rest of the euro-zone, where growth in 1998 has averaged 2.7%. This discrepancy is making it even harder for the European Central Bank to devise a monetary policy that fits Italy as well as the rest of the Euro 11.
So why has the Italian economy stalled like this, and what does that bode for 1999? The poor performance this year is due to several halfcocked schemes coming home to roost.
The government has finally phased out a truly awful idea introduced in 1997, in which people were given a strong incentive to trade in their old cars for new ones. The scheme ensured that the economy did not go into recession last year, when the last big tax squeeze was on. But its removal has had a depressing effect on the economy in 1998.
Keeping business in suspense
The Bank of Italy is keeping its main interest rates 1.7 percentage points higher than those in Germany despite the certainty of convergence this year (great news for Italian bonds, but murder on borrowers).
With yet another political crisis threatening the passage of this year's budget, governor Antonio Fazio believes in further protection for the lira. His policy is delaying investment decisions by Italian companies.
Finally, there is the ever-present specter of the Asian and Russian market crises. Italy is a particularly big exporter of textiles to these markets and has been stung badly by currency devaluations and bank defaults in these arenas.
These are merely short-term concerns, however. Italy still has huge unresolved structural problems: the high tax burden required to reduce the ratio of debt to gross domestic product over the next few years, Italy's famously inefficient public administration which continues to drag at company bottom lines, and a labor market in which it is nearly impossible to lay off workers during periods of retrenchment.
For 1999, we predict an early spike in equities as a result of Euro-excitement, and then a marked decline as reality sets in. Net result: 1% GNP gain, and only a 5% gain in equities.
Britain: Hoping for a soft landing
The U.K. has made a U-turn so fast that most onlookers are suffering from whiplash. As recently as June, the Bank of England was raising interest rates and complaining of overheating. Now the word in the halls is of an approaching slowdown and cutting interest rates.
In the minutes of its October meeting, the Bank's monetary policy committee spoke of a sea change in the international outlook, and promptly voted to cut domestic interest rates for the first time in more than two years.
The committee claimed it was referring to the effects of the Russian debt default. We think they had the turnaround in the domestic numbers in mind when they noted that the committee recognizes that recent financial turbulence has introduced new downside risks to the outlook for output in the industrial countries as a whole.
Saying the R-Word
Even before the recent global turmoil the economy seemed likely to become sluggish next year. Now, according to analysts at J.P. Morgan investment bank, it is almost certain that the economy will tip over into recession. Manufacturing surveys have already moved to recession-like levels.
Bank of England governor Eddie George attempted to put the best face on the turnaround. He described the approaching falloff in growth as a necessary slowdown rather than a more serious recession. In his dreams!
The most recent data from the Confederation of British Industry supports a contraction in manufacturing output of between 5 and 10 per cent next year. The CBI's survey has been one of the most reliable in recent years. Moreover, the decline in economic activity has been broadly based across the whole economy and regions, not just the sectors exposed to overseas trade.
Our forecast for Great Britain: A decline of up to -10% GNP and a downward correction of up to -50% in stocks. Bail out now, or be prepared to hold on for at least two years.
Russia: Life amongst the ashes?
To international investors, Russia has been gone overnight from the opportunity of a lifetime to a bowl of sour cabbage soup.
Having frantically bid up Russian shares in 1996 and 1997 on the promise of future economic growth, investors watched the whole pyramid scheme come crashing to the ground this year.
According to Fitch IBCA, the international rating agency, as much as US$100bn of capital may have been vanished into the maw of Russia's financial market collapse and the government's effective default on its domestic debt market. And it's not ever yet! Like a rock in a pond, the fatal effects of this crash are still finding their way around the global financial system.
Bankers, stockbrokers, prime ministers (and Presidents?) are still being sacked by the score. In Moscow, the mood is gray bordering on black. The consensus among economists is that the government will continue to try and print its way out of this crisis, papering over its gaping budget deficit, spurring further inflation and bankrupting its own citizens.
In this environment, there's no way the International Monetary Fund can release any further funding. Not until the government clarifies how it can put its public finances in order.
But which government will it be?
Which government that will be is also uncertain. Yeltsin is working from a bed in a sanitarium, leaving (former KGB thug) Primakov free rein in the capital. With which he's done...what? After months of dithering and delay, he's ready to release a plan that still looks like far too little and way too late.
Things should get very interesting when Russia faces parliamentary and presidential elections within the next 20 months.
There is a feeling that you may have seen the worst in most emerging markets, but that increased optimism has not yet spilled over into Russia, says Par Mellstrom, head of research at Brunswick Warburg, the Moscow-based investment bank. The market is still in the mood to expect bad news.
There have, however, been some faint stirrings of life. In nominal terms, Russian shares have already bounced 55% from their trough in October (although the trading volumes have been too thin to call this a solid trend).
Light at the end of the tunnel?
Even pessimists like Mellstrom agree that twelve months ago, no one thought it was possible to reform and restructure the banking sector. Nobody thought it was possible to reduce the power of the oligarchs. Nobody thought you could get the Duma to agree to a tough budget for 1999 -- especially in an election year. Yet all those things are happening now.
Perhaps John-Paul Smith, Russia strategist at Morgan Stanley Dean Witter, describes the problem best: It is very difficult to go out and advise people to buy. You have still got a very bad news flow from the market. Once stung, eh, John-Paul?
Where does that put Russia for 1999? For most investors, it's still below radar. But for the experienced Russia hand with good connections on the ground, perhaps an opportunity to begin grazing for sweet buys in companies with locks on key sectors, preferably companies with income in dollars (or Ecus) and costs in the ever diminishing ruble.
It seems that something is stirring in the long Russian night. For instance, if Primakov can sweet-talk the Duma and pass some genuinely productive laws, like tax and production sharing agreement legislation for the oil industry, than perhaps there's hope yet for Russia.
(For our outlook on Taipan's individual Russian stock picks, click here.)
Which very naturally brings us to where the recent economic plague began -- and perhaps where it will end: Asia.
The Asian Miracle, Part Two:
Ah, the Asian Miracle. Will we ever get tired of hearing that? Perhaps, but can we afford not to listen? That describes the crux of the Asian dilemma.
For more than a decade, Asian stocks were the economic wunderkinder, Asia the emerging market of choice, thanks to a combination of rapid growth, low inflation, stable politics and financial reform. Instead of headaches and heartaches, they represented most investors with the best opportunities for extended double- and triple-digit growth.
Heck, they were going to teach the world how to do it right. Copies of The Art of War littered the desks and nightstands of executives around the world.
The do-no-wrong reputation of the region ensured that the disillusionment that followed the Thai baht devaluation in 1997, and the subsequent financial turmoil in Asia, would be a crushing blow. Most investors swore that once burned, they would never return.
Hair of the dog that bit them
And yet, those same investors are sniffing around again (at least the ones that aren't bankrupt or in jail). And who can really blame them? Just look at the figures.
The Indonesian market was up 64% in dollar terms in October this year, Bangkok 60%, Manila 48%, Singapore 40% and Hong Kong 32%. While those rebounds reclaimed only a small fraction of the hideous losses many endured, they are the sort of gains that few investors can afford to ignore.
Where's the beef?
But many onlookers want no part of it, claiming it's just a trading rally, rather than the return of long-term money into to the market.
After all, they didn't bite during the first quarter of the year, when southeast Asian markets jumped more than 80%, and more foolish investors assumed that, with IMF rescue packages in place, the Asian Tigers would enjoy the kind of V-shaped recovery enjoyed by Mexico in the mid-1990s.
And they're not going for it this time either. After severe recessions in most countries this year, the mean forecast for Hong Kong and Indonesia, according to Consensus Economics, is for a 2.8% drop in gross domestic product next year; for Malaysia, a 0.5% decline; and for Thailand, 0.5%. Singapore and South Korea are expected to show marginal rises.
Figures like these would be hard enough to swallow for the U.S. or Europe, markets used to 2-2.5% trend growth; they're even harder to take in southeast Asia, where 6-8% annual growth was the recent norm.
As if that wasn't hard enough
The slowdown in the developed world is making life even harder for Asian economies. The best hopes for Asia has always been an export-led recovery. But it takes two to tango. Who's going to buy all the inventory already stacked in warehouses and on docks around the Pacific Rim -- let alone buy enough to put factory workers back in the saddle?
Not Japan. They're offering 0.25% just to get industry off the blocks. And certainly not a retrenching Europe, where growth forecasts for 1999 are being rapidly scaled back.
Speaking of scale, the scale of the financial restructuring needed across the region (of which the six-month debt moratorium announced by Thai Oil was only a foretaste) remains enormous.
According to ING Barings, the Thai corporate sector has a debt-to-equity ratio of 168% and Korea 185%. It estimates that least 217 major Asian players have serious solvency problems.
But wait, it gets better: the majority of Asian banks have negative book values. Where on earth is the capital to come from to fill these holes? Stocks? Bonds? The lottery?
Who's going to pick up the check?
Spreads on emerging market bonds have come down a bit from the panic levels recorded earlier, but so far there has been virtually no issuance from Asian corporates or banks. Equity investors are far more eager to liquidate existing positions than to snap up new issues, and the region has so far shown a reluctance to sell businesses outright to foreign corporates. So far, the best bet might be that lottery ticket from the 7-11.
At least the risks of biting on the Asian Miracle hook are getting smaller with each lurch of the cycle. As ING Barings points out, valuations are more moderate this time round. Only China and Malaysia have historic price-earnings ratios above those prevailing in the first quarter of 1998. In terms of price-to-book (or asset) ratios, only China is above its 1998 first-quarter high.
But valuation measures matter little when confidence in the region (and in the quality of the earnings and assets on which the valuations are based) is totally trashed. Most investors are unlikely to rise to the bait this time.
Japan: Time to fish or cut bait
Speaking of bait, the Japanese government's newest economic stimulus package received exactly the kind of reception from markets and analysts one would expect from a pile of dead fish.
The Japanese cabinet agreed to implement a package worth ¥24,000bn (£117.9bn) in new spending and tax cuts, or more than 4 per cent of gross domestic product. It will include at least ¥17,000bn of pump-priming measures such as public spending and at least ¥6,000bn of additional corporate and income tax cuts, over the next year. (It also contains the outright daffy ¥700bn scheme to give "shopping vouchers" to out-of-work consumers.)
This leaves the planned package even bigger than the ¥18,000bn draft package, floated last week. Taichi Sakaiya, head of the Economic Planning Agency, said: Given such a huge, bold package the economy cannot fail.
New Rust Belt
Of course, the labor market slowdown is only a reflection of the damage done to industrial production over the past year. Industrial output shrank 8 per cent year on year in October, according to Japan's ministry of international trade.
The production cuts -- particularly by steel manufacturers and car makers -- have forced companies to reduce overtime, which represents a critical part of worker salaries. Overtime fell 15 per cent year on year in October, according to labor ministry statistics.
Looks like a classic vicious cycle that the Japanese government's stimulus packages would be unlikely to arrest, according to Jeffrey Young, economist at Salomon Smith Barney in Tokyo.
Spiraling down
Japan is stuck in a deflationary spiral, where consumers, expecting price cuts in the future, postpone purchases and thereby damp down demand even further. Retail sales have collapsed in the past year (mind you, an increase in the consumption tax from 3 to 5 per cent in April 1997 didn't help at all). This decline accelerated in September (-3.8%) and October (-5.5%) year on year.
These trends are likely to continue until the government can convince ordinary Japanese consumers, terrified of losing their meal tickets, that it's safe to break open the piggy banks and spend their yen again.
The government's growth projections are far too optimistic. This attempt to end Japan's worst recession since the 1950s will add only 1 or 1.5% to the bottom line in 1999. Not enough to end the Japanese Recession, and nowhere near enough to interest us in investing there.
China: Promises and reality
When Zhu Rongji took over as China's prime minister in March, he promised a brave combination of economic growth and sweeping change. His proposals were well thought out and far reaching, but his task was daunting. However, many analysts were prepared to give him the benefit of the doubt.
But, though his government swiftly began cutting interest rates and easing credit, the Chinese economy has yet too respond with in any great way. As for the much-vaunted reforms, there are growing indications that some -- perhaps most -- may be delayed or even reversed.
Zhu and his cadre have insisted that China will achieve 8% economic growth in 1998 (already a low target by Chinese standards). Now it doesn't look like that will happen. In the first six months the economy barely managed an official 7% (and the credibility of local statistics is becoming dubious at best).
No turning back
Zhu has no choice but to keep plugging along. The prime minister has given China's state-owned enterprises three years to clean up their act.
Most are to be cut loose from mother China's apron strings, and those that remain will no longer be expected to provide housing, schooling and health care. Zhu is relying on massive economic growth to create jobs, and thus absorb the millions being laid off. China's leaders are concerned at the social chaos that mass unemployment could bring (not to mention the possibility of losing their jobs).
When they fall short (and they will), they will probably pin the blame for the slowdown on Asia's financial mess. China's exports to Japan, South Korea and Southeast Asia have collapsed. But those to Europe and the United States have held up. This will be a dangerous place to pin their hopes, as these markets are experiencing their own reversals.
China has also found new markets. For instance, exports to Australia have surged this year by over 20%. In all, exports in the first half of the year grew by 7.6%, compared with the same period in 1997: a declining trend in growth, but still healthy in the circumstances.
That Great Wall comes in handy sometimes
China is somewhat protected from the Asian turmoil by a fire wall around their currency (and boy, is Mohamed Mahatir jealous). That means any economic sluggishness must be blamed on failures of domestic demand. Zhu's mistake is that he has misjudged the effectiveness of his own reforms on the Chinese economy.
He placed great hope in the creation of a new private housing market to revive domestic demand. Great. Now instead of spending money at the marketplace, everyone's saving for a house.
Also -- much like the Japanese workers -- the Chinese are getting used to the new idea that they could lose their jobs at any moment. Buying a new color tv falls kind of low on your list in these circumstances.
Meanwhile, state banks that have been told to clean up their rotten balance sheets have not been willing to lend on anything less than terms attractive to them. All of these influences are deflationary. Retail prices are now falling like a rock at an annual rate of 3%.
With hope for growth slipping away, Zhu's reforms are teetering on the brink. On July 10th the government issued a notice critical of the blind privatization of small and medium-sized enterprises. The government is concerned that the sale of such enterprises is often accompanied by cronyism and corruption -- though perhaps not as much as, say, in Russia.
In fact, Zhu's boldest measures are being put on ice. Housing reform was meant to start from July 1st. Not going to happen: rent increases will not begin before the end of the year.
The health-care reform Zhu promised at his first prime-ministerial press conference in March? It hasn't been mentioned since. The promise to cut the central-government bureaucracy by half? It's vanished from the papers and government speeches. The major bank reforms: now officially delayed by up to a year.
Think big
They will be delayed a lot longer if growth does not pick up. China is resorting to the sort of infrastructure projects made famous during the great push forward in the hope that they will provide the much-needed shot in the arm.
The projects reflect the traditional imperial/Maoist obsessions with flood control, irrigation and grain production (certainly flood control ought to be popular in light of this summer's repeated disasters).
There are ambitious plans to improve the rural power supply, to build railways, roads and housing. To help pay for all this, the finance ministry is preparing to tap over 100 billion yuan (US$12 billion) from the huge pool of savings sitting in the state banks. The ministry will use traditional Chinese strong-arm tactics to compel the banks to buy special issues of treasury bonds.
Once such cash is put to work, says Xiang Huaicheng, Zhu's new finance minister, it will take just three or four months for the economy to hit the 8% growth target. If he is wrong, Zhu's government might even start to look like a lame duck.
We don't think China will achieve these ambitious targets. Growth will be in the 5-6% range. But this will still make China superior to Europe in growth. Stay tuned to this market. It can't afford to fail.
Hong Kong: Falling into a hole
The Hong Kong government -- often glorified as the last bastion of free trade -- started buying blue chips on the market to fend off speculative currency attacks, in effect nationalizing major industries. (And I thought their translation of movie titles was bad...like Batman and Robin's rendition into "Don your rubber codpiece and come into my cave, pretty boy"...)
Hong Kong is in the throes of its worst recession in recorded history. Recent figures released show a 7% plummet in GDP for the third quarter of 1998 year on year. The government is forecasting a full-year drop in GDP of 5%, and these numbers only confirm private-sector forecasts.
So why hasn't the stock market, Hong Kong's traditional barometer of confidence heard the bad news yet? The benchmark Hang Seng Index gained several hundred points in a week in which Hong Kong revealed four historic lows: retail sales, inflation, exports and GDP.
Hong Kong's incredible fall in GDP in the third quarter was the result of plunging consumer and government spending and disastrous exports. Naturally, consumer sentiment fell following the currency attack launched by speculators in August, which in turn led to extreme volatility in the financial markets.
Prices shriveled in Hong Kong's legendarily bloated property market, and the number of transactions shrank as well. Buyers forfeited deposits or resold at a loss rather than risk continued exposure to even bigger losses.
While forecasting a full-year shrinkage of 5 per cent, the government said this could be worse if consumer spending dropped further because of the threat of increasing unemployment, or if exports underperformed.
Hong Kong is in the hole for the long haul. We are calling for recessions for the next two years: a 3% fall next year and 2% in 2000.
Taiwan: Immune to the flu
In the 1980s the world marveled at Japan's economy; now it pities the nation for keeping its discredited model for so long. Perhaps someday, analysts will shake their heads and sigh about the errors of Taiwan's ways.
But not this year, and not in 1999 either. So far it has either been remarkably lucky or remarkably wise in avoiding the pitfalls that have beset its Asian neighbors.
It's done so with a healthy dose of paranoia in combination with pure Chinese business smarts. These qualities show up in lots of ways, from conservative government policies to prudent corporate financial management. But there are also some more prosaic reasons why it dodged the bullet this time.
For starters, Taiwan is benefiting from trading mostly with either America or China rather than the rest of flu-infected Asia. Between them, those two countries account for more than half of Taiwan's exports, and neither has so far been pulled into recession by the crisis.
Anything that could go right...
Even where Taiwan was exposed, it was largely as an investor, not as an exporter counting on the local markets. Taiwanese companies have set up factories in Malaysia, Thailand, Vietnam and even Indonesia to take advantage of dirt cheap labor there. When those currencies were devalued, it made that labor cheaper still. They came out of the charnel house smelling like a rose.
Taiwan is also lucky that its business cycle happened to be out of phase with the rest of the region. It has seen mad property inflation and stock market booms, just like Thailand, Hong Kong and the rest, but that was in the late 1980s and early 1990s.
In 1989, for instance, Taiwan's stock market had the world's second largest turnover, behind New York but ahead of London and Tokyo. An estimated quarter of the adult population (many of them housewives, stock clerks and farmers: stock listings were color-coded so that even the illiterate could join in) was playing the market.
Of course, Taiwan has not been immune to business cycles altogether. There have been several corrective crashes, the most recent one caused by a crisis of confidence when China conducted military exercises and missile tests in the Taiwan straits in 1995 and 1996.
So when the regional crisis hit last year, Taiwan's stock and property markets were already more than 30% down from their peaks. There was simply less of a bubble to burst.
Luck may explain why Taiwan was not a big juicy target for currency vampires (read as honest international traders) in the early days of the crisis, but there are sounder reasons that account for its resistance to the contagion that later struck the rest of the region.
Like a rock
Taiwan's fundamentals remain rock solid. Its foreign-exchange reserves stand at US$84 billion, exceeded only by China and Japan. Its foreign debts are less than US$250m (smaller than some American cities). GDP growth this year is likely to be around 4-5% (down a point or so, but a world apart from its Asian counterparts, and much better than Europe), and it's sporting a hefty trade surplus.
Now, if only it didn't need to spend so much of its budget on F16s and other arms to keep China at bay. Indeed, the only significant black marks are its chronic budget deficits and its relatively high national debt (about 20% of GDP).
Likewise, the corruption, nepotism, egomaniacal infrastructure building and overcapacity that (eventually) offended the international bankers in countries such as Indonesia and Thailand were simply not such big issues in Taiwan. Because of its rapid transition to democracy and the emergence of a strong opposition, the KMT is far less corrupt than it was just a decade ago.
Not all Asian debt is a bad thing
The same conservative tendencies have also spared Taiwan the sort of banking meltdown that most other Asian countries are now suffering. A high level of bad debt is a regional affliction that can turn a few bank failures into a chain reaction.
But at the start of the Asian crisis, Taiwan's non-performing loans accounted for just 1.5% of total assets, compared with Thailand's 30%. Even in the darkest days of this year, peak levels reached only 7.5% in Taiwan, half the official figures in Japan and less than anywhere else in Asia.
To prevent leakage of precious hard currency, the government early on introduced strict capital controls to prevent Taiwanese companies from taking on cheap foreign-currency loans for speculative projects. Capital is like blood. If you use too much of it, it will cost you your life, says Chiang Pin-kung, head of the government's Council for Economic Planning and Development.
For anything but the biggest companies, this meant that bank loans were simply unavailable. Instead, smaller firms turned to friends and family, and to the so-called kerb market, meaning anything from loan sharks to community lending associations that auctioned off loans to the highest bidder.
In either case, the price was steep (often three times the official interest rate, which was itself higher than the regional average), so companies borrowed as little as they could and paid it back quickly.
The legacy of this credit shortage is that Taiwan's firms have one of the lowest debt-to-equity ratios in Asia: about 30% for listed Taiwan as a whole, compared with more than 400% for Indonesia.
So far, Taiwan is doing everything right. We are calling for solid and safe growth here in 1999.
Malaysia: Wrong way to recovery
It has been months since Malaysia shocked world financial markets by slapping strict controls on capital flowing in and out of the country. And as much as it grieves us to admit it, the move is paying off in spades -- at least in the short term.
Instead of backfiring as proponents of economic globalization predicted (and many at the IMF and U.S. Treasury not-so-secretly hoped), the controls are saving Malaysia from being buried by the Asian crisis.
Interest rates are down to 7%. Banks are suddenly starting to do business. The stock market is looking up. There's confidence in home-buying now, too. Suddenly people are queuing to buy houses.
New legs or a cheap crutch
The burning question for Malaysia whether this miraculous recovery is based on real returning health, or is just a short-term charlatans trick. Call us pessimists, but We're betting that Malaysia will sorely rue the day when Prime Minister Mahathir Mohamad threw out the money changers in a fit of pique. (hey, we don't much like them either, but they're a necessary evil).
Malaysia, which had thrived over most of the past decade by welcoming foreign investment, has been among the countries hardest hit during the past year-and-a-half by the sudden withdrawal of speculators and other investors from the region's stock and currency markets.
Mahathir has established himself as a leader among the critics of unfettered global markets and the IMF's orthodox economic prescriptions. The IMF and the Clinton administration will do almost anything to discourage other countries from following Mahatir's lead in imposing controls, arguing that doing so would destroy their chances to attract new investment and achieve a lasting recovery.
House of cards
The danger is Mahathir will look good for six or nine months, and then, just as the whole thing starts falling apart, people in the region will be saying, Mahathir's approach works, and the IMF's doesn't,' said Robert Manning, an Asia specialist at the Council on Foreign Relations.
The controls have enabled Malaysia to adopt a stimulative economic policy -- including tax cuts and sharply lower interest rates -- without worrying that traders would jump on the ringgit like wolves on sheep. That's because under the controls, it's illegal to withdraw money from Malaysia in less than one year. What's more, the government has fixed the exchange rate at 3.8 ringgit per dollar and prohibited the holding of ringgit overseas.
Freed from the external discipline of the currency market, there are no limits on the excesses the Malaysian government can get away with. Along with the low-interest-rate policy, the authorities have ordered banks to expand lending by 8% a year and eased the rules on reporting bad loans.
Capital controls might have been positive if Malaysia used the opportunity to buy time for itself to restructure the banks, or restructure the corporations. But at this point, you can't say with confidence that this window of opportunity is doing them any good.
All of these draconian measures may boil down to simple electioneering. Mahathir is desperately trying to pump up the economy until next year's scheduled elections, when he must contend with his popular former deputy, our old friend Anwar Ibrahim. (That is, of course, if Ibrahim -- who favors more conventional economic policies -- is not in jail on trumped up corruption and sex charges.)
Most onlookers are skeptical that demand is actually rising at all. In Kuala Lumpur's colorful Indian and Chinese shopping districts, interviews with retailers suggest that the government's new policy certainly isn't spurring spending across the board.
Moreover, while Malaysia's interest rates have fallen and its stock market has risen over the past 2 1/2 months, the figures aren't as impressive as in neighboring countries that are following IMF prescriptions -- notably Thailand, where rates are even lower and stocks have risen further.
Where will they be a six months to a year from now, when people can take their money out of the country? The economy will be like a balloon popping. Our recommendation: stand clear.
Indonesia: Out with the old, in with...what?
Struggling to recover from the devastation caused by the Asian financial crisis, Indonesia's government is moving to root out the crony capitalism that flourished here for decades -- with a vengeance that's making a lot of cooler heads increasingly nervous.
The word of the day is the vaguely Maoist-sounding People's Economy, a government plan to end the economic dominance of the large conglomerates run by tycoons who enjoyed close ties to former president Suharto and his family.
Instead of conglomerates, the government of President B.J. Habibie is aiming at building an economic system based more on in cooperatives and small and medium-sized businesses.
In Indonesia, 1% of the population has controlled 60% of the gross domestic product, and that is not a healthy economic structure," said Adi Sasono, the cooperatives minister and one of the government's most influential figures. "Now the idea is to promote even playing fields. What we have to avoid is where the big players control everything. Sounds like nationalization to us.
A rose is a rose
The new approach was approved in broad terms at a special session of the 1,000-member People's Consultative Assembly earlier this month. But while it may sound like a refreshing shift from an era characterized by corruption and collusion, it is stirring considerable concern that Indonesia may be simply replacing one rotten, discredited system with another.
Even if the effort was honest, it would still be frightening. But it's not. The initiative is shot through with ethnic politics. Most of the largest conglomerates are run by members of Indonesia's ethnic Chinese minority, whose entrepreneurial talents played a crucial role in the country's rapid growth over most of the past three decades.
The government steadfastly denies that ethnic groups are being singled out. Don't believe them. Habibie, who took over in May after mass protests forced Suharto to quit, owes to much to Muslim-controlled businesses, and is trampling over ethnic Chinese interests to reinforce his own political standing.
IMF to the rescue
So far the IMF has been wielding its $43 billion rescue effort like club, and has managed to beat back some of the more outrageous schemes to steal property from Chinese conglomerates. But the government has countered with a move to require conglomerates involved in lumber and plantations to transfer 20% of their assets to cooperatives, and it has ended their special distribution rights in markets such major Indonesian staples as cooking oil.
We're are skeptical that investor confidence has truly begun to revive. We're particularly dubious about official claims that the rupiah's strength is based on a return of private capital rather than the government spending its international aid dollars to buy rupiah.
Evidence abounds that people with money in Indonesia would bail out given the slightest opportunity to do so profitably. The political outlook is shaky and the new economic policies are demagogic at best, and corrupt, racist hysteria at worst. Again: Stand clear.
Thailand: Seeing the light
This is where it all began -- the whole Asian flu deal -- and this is where it will probably end. As you talk to businessmen and investors here, the sense of panic is gone.
Now the picture is getting clearer. People don't think the banking system will collapse beneath them. Confidence is beginning to return.
More than a year after Thailand devalued its currency, igniting the Asian economic crisis that eventually swept through global markets, many of Thailand's vital signs are beginning to show improvement. The currency has strengthened. Interest rates have fallen. Some Thai exports are flourishing. Tourism is booming. New factories are opening.
Bargain shoppers' paradise
More importantly, every incoming plane is carrying foreign investors back into Thailand, boosting room rates at top Bangkok hotels. Foreign investors have gone on a $6.7 billion bottom-feeding frenzy, snapping up bargains like steel mills, securities companies and entire supermarket chains.
One reason is that the Thai government has become increasingly sure-footed, mapping out ambitious reform plans and staying largely on course despite strong, entrenched opposition.
The Thai government has tried to eliminate the weakest part of the banking sector. It closed more than two-thirds of Thailand's finance companies and nationalized several ailing banks. Surviving banks benefited as depositors fled to stronger institutions. The government has also earmarked $8 billion for bank restructuring.
General Motors Corp. is recruiting aggressively for its massive new Thai car assembly plant, scheduled to open in two years, and BMW AG has declared its intention to build there as well. The facility, which eventually would employ 500 people, is intended to serve as BMW's Asian hub, to produce vehicles for export to the rest of the region.
Rubber-glove king
Meanwhile, American and European companies that make rubber gloves cited Thailand's political stability as the reason they are moving from Indonesia to consolidate operations here. More than 20 new rubber glove factories are slated to open in Thailand, which will create thousands of jobs in rural areas and make Thailand the world's largest manufacturer and exporter of rubber gloves. (One has to wonder what all those rubber gloves are for. Aging baby boomers, maybe? Just turn your head and cough...)
A marked slowdown in the United States, Thailand's biggest export market, could send the economy tumbling all over again. But while Thai companies and jobs continue to disappear, new ones are beginning to surface, helped by the foreign capital boom, a few robust export sectors and a healthy surge in tourism.
The Thai economy is expected to shrink by more than 7% in 1998, but we predict that the contraction will halt during the winter. Look for the bottom during the first quarter of 1999 and then begin to swing up as much as 6% by years end.
Global Investing in 1999
So where does all this leave the global investor in 1999? Leave aside, for the moment, the "millennium" bug, that timely prophecy. Four other dangers now menace the forecast:
First, most emerging markets will continue to perform poorly. The recently announced Brazilian package will probably fail: all such attempts to hold exchange rate pegs are a gamble.
The Chinese slowdown will reverse (though not with any great conviction),while most of the debt-burdened Asian crisis countries will experience another year of decline. You can count on some fool in South East Asia to tout Mahatir's restrictive policies as the holy grail, and attempt to install exchange controls, involuntary write downs of foreign debt, or both, sending another shock through credit markets.
The Japanese economy will continue its downward slide. Loans to Asian emerging markets amounted to 133% of the (exaggerated) capital of Japanese banks in 1997, while exports to Asia were 4.5% of GDP. The banking recapitalisation will also fail, either because banks do not take the money or because they then lend less. The succession of fiscal packages will also fail to restore buoyancy to demand, while the yen appreciation is bound to harm exports.
The U.S. equity market will go into reverse, particularly if the Federal Reserve became more worried about inflation or, more plausibly, investors began (at last) to re-adjust their expectations of future earnings growth. With US household savings negative, stock market weakness could lead to a turnaround in consumption. Instead of rising faster than disposable incomes, it would then grow more slowly. Lower stock market prices will also affect US corporate investment.
Credit will continue to be severely rationed to riskier borrowers. Risk spreads are still large. Furthermore, there is some evidence of tightening credit standards among banks, at least in the US. It is often forgotten that European banks are also highly exposed to emerging markets, with total loans outstanding equal to 91% of their aggregate capital in 1997.
When these risks were all to come together, there will be further declines in oil and commodity prices. There would also, quite possibly, be a decline in the dollar and the yen against the euro, as the Federal Reserve loosened and the Japanese were driven to wholesale monetisation.
What would be the outcome? Look for U.S. growth next year could be minus 0.4% with unchanged real interest rates. Japan's economy would shrink by more than 2% for the second year in succession. As for the EU, its economy would expand by less than 1%.
We see stagnation in the OECD next year and sluggish recovery thereafter. The U.S. and E.U. are poised between stagnation and modest growth, while Japan is balanced between stagnation and continued decline.
Big financial crises come when investors have long seen only golden opportunities - the more prolonged that period, the more spectacular the crash. This is among the most significant lessons from Asia's woes. This was a region of sustained high growth, sound fiscal and monetary policies and stable exchange rates. Investors largely forgot about risk. Was Tokyo's land worth more than the entire US? Quite right, concluded investors, in a fast-growing and land-short economy.
Global investors face two dangers: the more immediate is that they do not sustain confidence. The more distant is that they do. For what might then prevent the Dow from marching to 15,000? The Nikkei was, after all, once at 39,000.