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US market in the months ahead

V. Anantha-Nageswaran

ON MAY 15, the US Federal Reserve cut the Federal Funds rate by 50 basis points to 4.0 per cent, and fretted a good deal about the state of capital spending in the US. This reflected not only the collective concerns of the members of the Federal Open Mar ket Committee but more particularly that of the chairman, Mr Alan Greenspan. Despite his occasional notes of caution, he had more or less sided with the proponents of the `New Economy' extolling the virtues of technology investment, `just-in-time' and re al-time inventory management, and productivity gains. He had concluded, on many occasions, that these technology investments and productivity gains have extended the productive frontier of the economy and enabled actual growth to lie close to this enhanc ed potential.

Hence, any break in this virtuous circle would not only undermine the economy's ability to maintain its recent output and employment gains, but also the chairman's personal reputation. Therefore, there is a great deal of anxiety about the health of capit al spending in the economy.

In his recent speech on May 24 before the Economic Club of New York, the chairman pointed to considerable uncertainties both to the timing and magnitude of recovery. He sounded reasonably confident about the end of the inventory liquidation phase but was less so, with respect to the rebound in investment spending. He concluded on a positive note (or, a hopeful note?) that aggressive rate cuts would underpin the structural improvements seen in recent years and boost investment spending, if not to previou sly elevated levels, but at least to more reasonable levels. How realistic is his hope?

Concerns over investment spending

That the anxiety over capital spending was behind the rate cut in March and in the unscheduled rate cut in April is not surprising. The FOMC devoted considerable attention to this aspect:

``...Substantial downward adjustments to expected near-term business earnings had persisted, suggesting that firms saw investment as much less profitable than they had before and that cash flows would be constrained...As a consequence, a substantial volu me of planned investment was being postponed, if not cancelled. The capital stock had grown at an unsustainable pace for a time, so some downshifting in investment was inevitable...

``...and how large an adjustment in spending for business equipment might now be underway was still unclear, especially with regard to hi-tech industries...''

Investors, who look to a turning point in capital spending, for a revival of the fortunes in the technology sector might need more reassurance than this. That is, investors would like to see evidence of a turnaround in capacity utilisation in the technol ogy sectors that would suggest an improvement in the demand for technology output.

...Show up in capacity utilisation data

One would normally find this in the statistics for new orders for non-defence capital goods, excluding aircraft. Excluding aircraft and defence-related orders are logical since the former could occur at irregular intervals, distorting the statistics and the latter might not be representative of general economic activity.

Recently, however, the method of compiling this statistic has been revised and hence, some noise has crept into its information content. Nonetheless, it is worth noting that the above category of durable goods orders (non-defence capital...) fell more th an expected in April, indicating that a bottom for capital spending is not yet in sight.

Disaggregated data on capacity utilisation reinforce this (see chart). This is a consolidation of computers and office equipment, communication equipment and semi-conductors and related components. As of end-April, there is no bottom in sight. Capacity u tilisation has fallen well below the levels seen even during the last downturn in 1991-92.

Interestingly, in the semi-conductor sector, the peak capacity utilisation rate was in June 2000 at 99.9 per cent. Later, it started falling. Normally, one would have ignored the first and even possibly, the second downturn in July and August. But when i t fell for the third consecutive month in September too, investors would have been better advised to take note and exit their positions in semi-conductor and related stocks in end-October when this information would have been available. Thus, the statist ic has useful information content for investors. Interestingly, new orders for capital goods (non-defence ex-aircraft) also peaked in June 2000.

Asian economies in a precarious position

A digression on East Asia is in order here. Most of the North and South-East Asian nations depend, to a large extent, on the health of the US technology sector. The US share of global output could be 20 per cent but the US has the world's largest install ation of personal computers. East-Asian nations have benefited from feeding this boom in the US. Countries that were predominantly agrarian (for instance, Malaysia) had diversified but now find themselves in need of further diversification. Their exports consist principally of electronic components. Given the absence of a well-defined bottom in this respect in the US, one has to worry about the economic prospects for the region this year and at least for some months into the next.

This comes on top of rapidly deteriorating political environment in the region, principally in Indonesia. The situation could be described as only marginally better in other countries (for example, South Korea and Taiwan). The risk of East-Asia slipping inexorably into another crisis has increased. Now, all hopes ride on Japan dragging itself out of the bottom in the second half. If that fails to happen, one shudders to think of the short to medium-term outlook for Asian economies.

It is not gloomy, ex-tech...

Back on the US watch again. Are there sectors that have shown signs of bottoming? The answer is yes. They are related to transportation equipment, motor vehicles and parts, autos and light trucks. All of them bottomed out in January 2001 and have moved h igher in the last three months. Further, sectors related to energy have continued to roar ahead. Petroleum products, coal mining, oil and gas extraction and oil and gas well drilling all report capacity utilisation rates at or above 90 per cent and hence , there is bound to be continued margin protection for producers and operators in this sector. Investors considering energy-related stocks could still do so. After all, OPEC has ruled out any increase in production in its June meeting and unless, it rais es oil production early in fall, crude oil prices risk touching USD30 per barrel again later in the year (Source: Centre for Global Energy Studies UK, May 2001).

Let us come back to the question that was the focus of the piece. Given these diverging sectoral (mis)fortunes, what is the outlook for investors? After all, technology may have disproportionately hogged the limelight in the last several years but it is still only a small portion of the overall economy. Would it hold the rest of the economy and the stock market captive to its own problems?

If one looks at headline index readings, the answer would be `yes', but digging deeper, one finds there are stocks and sectors beginning to show steel and strength, and are rewarding investors who are trusting them with their money. The S&P 400 midcap in dex is up about seven per cent for the year. As mentioned earlier, energy sector stocks are performing well. However, outside of energy, the fortunes of the stock market could still reverse if consumer spending does not hold up. What are its prospects, t hen?

...But it depends on the consumer's staying power

That depends on employment gains (or minimal losses) and continued income growth. So far, there are no major causes for alarm on both counts. Even if the unemployment rate rises to five per cent, it would still be low by historical standards. Of course, the diminution of the wealth effect would hurt. Probably, not all segments are hurt equally. Again, one has to look at disaggregated information.

In an interesting paper and probably, the first disaggregated study of the wealth effect on consumption, the causes of the negative savings rate in the US seen in recent years, Messrs Dean Maki and Michael Palumbo (`Disentangling the wealth effect: A coh ort analysis of household savings in the 1990s', Board of Governors of the Federal Reserve Working Paper, April 2001) show that the entire consumption boom and the negative savings rate could be attributed to the highest income and education category of Americans who held the maximum percentage of wealth in corporate securities. A table from their paper reveals the whole picture.If the data in the table is true, then the capacity of this group to smoothen their consumption pattern could be deemed higher than the rest of the income groups. Moreover, they may have the staying power to wait patiently for stock market upturn and hence, the chances of creating a further panic-driven selling might be lower now.

Further, given high levels of institutional cash waiting to be invested, stocks (outside of TMT) could be unlikely to revisit lows seen early in the year.

Obviously, this prediction rides on the validity of the conclusions reached in the study and my own inference on the staying power of the top income and education groups in the country. If they are disappointed by the inability of the stock market to roa r ahead after five rate cuts, and thus, recoup their losses, then they might be prompted to reduce their exposure to financial assets back to the pre-1990s level. That would spell danger to the US capital market and the rest of the world. Admittedly, the base case of cautious optimism is a fragile one.