Column

BAD NEWS HIDING THE GOOD

The headlines are scary, but the economic fundamentals are sound

DONALD COXE June 7 2004
Column

BAD NEWS HIDING THE GOOD

The headlines are scary, but the economic fundamentals are sound

DONALD COXE June 7 2004

BAD NEWS HIDING THE GOOD

Column

The headlines are scary, but the economic fundamentals are sound

DONALD COXE

INVESTORS AND SAILORS both have to put up with patches of bad weather. For sailors, it’s either the absence of wind or too much of it. For investors, it’s the bad news equivalent of sustained rain, with intervals of thunderstorms and hurricanes. That, unfortunately, has been the investing climate this spring.

The Middle East news has been worse than usual these days, with more suicide bombers and new obstacles for the road map to Israeli-Palestinian peace. In Iraq, the news keeps getting worse, with revelations of misdeeds in what used to be Saddam Hussein’s torture chambers. We learned that a few American soldiers and jailers had engaged in a wide range of abuses of Iraqi prisoners. Incredibly, they photographed themselves in The Iraqi Horror Picture Show, a folly that recalls Talleyrand’s words, “It was worse than a crime, it was a blunder.”

WHEN the U.S. Federal Reserve finally gets around to raising its rate, the markets should have got themselves in shape for less liquid times

Bad news from neighbouring Saudi Arabia upset world markets as terrorists attacked one of that nation’s oil facilities. Oil prices leapt to US$40 a barrel. Suggestions that the biggest OPEC producer (8.5 million barrels a day) could be put out of action if jihadists pulled off a 9/11-style superstrike triggered talk of a global depression caused by US$100 oil.

Moving further east, the Indian elections, which forecasters had predicted as a massive endorsement of the economic reforms of prime minister Atal Bihari Vajpayee and his Hindu nationalists, instead brought back the Congress Party with the backing of the Communists. That pairing had given India 45 years of socialist stagnation during which India became off-limits for global investors. Five years of liberalization had generated amazing growth that had led investment banker Goldman Sachs to predict that India was on track to eventually overtake China as Asia’s biggest economic success story. That forecast now is on hold.

As for China, investors fear bad news in the regime’s attempts to rein in the overinvestment that comes from years of endless good news. Stocks with “China” in their name and shares of steeland metal-producing companies worldwide have slumped as investors tried to decide whether China would merely slow down, or would crash, as it had in 1994.

Tokyo had been the best-performing major stock market this year, as the Japanese economy roused from its long torpor. Japan’s economic growth in the first quarter was the strongest in the G7, based largely on booming exports to China. Then came an unfolding story of leading politicians confessing to not contributing to the nation’s pension plan, an underfunded monstrosity, in the land with the worst demographic outlook in the industrial world. Stock prices fell sharply, because Prime Minister Junichiro Koizumi’s government, the closest thing to a reform administration Japan has seen since the Second World War, faces an election in July and voters are infuriated that cabinet ministers, including Koizumi, had not made their pension contributions. The only “good” news was that the supposedly clean opposition politicians admitted that they, too, had no yen for the plan.

Meanwhile, back in the shell-shocked U.S., the most closely watched economic statistic, the monthly nonfarm payroll report, on May 7 showed a spectacular number, with 288,000 new jobs, 100,000 above the most optimistic estimates. Good news for the markets, right? Wrong. Bond and stock markets plunged in heavy trading. That nearly 300,000 new jobs were created was obviously bad news for bondholders, who prosper when the economy is weak, inflation is low and the Fed is keeping interest rates down to promote economic recovery. But why was the evidence of a strong economy bad for stocks? The easy answer is that there’s no longer any doubt that the Fed will be boosting interest rates, and that’s problematic for stocks. Even if Federal Reserve Board chairman Alan Greenspan doubled the federal funds rate, it would still be a skinny two per cent, one of the lowest levels in four decades.

The threat of rising rates has sent one pack of speculators, the carry trade, running for cover. The carry trade borrows at low short-term rates and buys longer-term bonds, stocks, foreign assets and commodities. One group in that crowd, the Wall Street bond dealers, is US$790 billion in debt to the Fed, and that money is invested in longer-term bonds. But hedge funds and other fast-money operators have borrowed unknown billions at those irresistibly low rates to buy riskier assets, and they’re rushing to pay down their debts before money supplies get tight. In so doing, they’re hammering prices of financial assets around the world. That giant sucking sound is painful to the ears of genuine investors as they watch asset prices slump.

The good news is that all that selling of bonds and unwinding of debt is driving up interest rates, which means frightened speculators are doing the Fed’s job for it. When the Fed finally gets around to raising its rate, the markets should have got themselves in shape for less liquid times.

Of course, if the bad news continues to stream out of the Mideast and Asia, then stocks will not get a big bounce. Right now, that’s the prevailing view. Take heart, the consensus is usually wrong. HI

Chicago-based Donald Coxe is Global Portfolio Strategist, BMO Financial Group. dcoxe@macleans.ca