Slowing world economy poses risk to stocks

With the world economy showing clear signs of deceleration, the risk that world stock markets may be peaking soon is rising.

Economic indicators reported by several countries over the past few weeks continue to show signs of slowing growth.

In the United States, the Commerce Department reported on 24 November that durable goods orders fell 0.4 percent in October. Although the University of Michigan reported on the same day that its consumer confidence index for November rose to 92.8 from 91.7 in October, a survey by ACNielsen showed that 28 percent of consumers say they have no extra money to spend.

At least third quarter growth in the US managed to hold up, chugging along at an annual rate of 3.7 percent against 3.3 percent in the second quarter. Other countries have not been so fortunate. The biggest Asian economy, Japan's, grew at an annualised rate of just 0.3 percent in the third quarter from the previous quarter, down from the 1.1 percent rate in the second quarter.

Many other Asian economies are experiencing similar slowdowns. Taiwan's economic growth slowed to 5.3 percent year-on-year in the third quarter from 7.9 percent in the second quarter. In South Korea, GDP growth eased to 4.6 percent year-on-year in the third quarter from 5.5 percent in the second; on a seasonally-adjusted quarter-on-quarter basis, growth in the third quarter was just 0.6 percent. Hong Kong's GDP rose 7.2 percent year-on-year in the third quarter after having risen 12.1 percent in the second; on a seasonally-adjusted quarter-on-quarter basis, third quarter GDP was up 1.9 percent, down from 2.6 percent growth in the second quarter.

Probably worst of all was Singapore, whose third quarter GDP was up 7.5 percent year-on-year but down 3 percent on an annualised seasonally-adjusted quarter-on-quarter basis. Any pickup in the fourth quarter is likely to be minimal; October manufacturing output in the island economy was up only 2.4 percent from the year before, although it was up 5.1 percent on a seasonally-adjusted month-on-month basis, largely on the strength of a resumption in biomedical output after production had been affected the previous month by a switch in product lines.

In Europe, the two biggest economies have also reported slowing growth. In Germany, GDP growth moderated from 0.4 quarter-on-quarter in the second quarter to 0.1 percent in the third. In the UK, growth in the third quarter was 0.4 percent, down from 0.9 percent in the previous quarter.

And the prognosis for the world economy is not improving. Oil prices are still flirting near US$50 for NYMEX light sweet crude, which will raise costs for both consumers and businesses going forward. The falling US dollar will frighten investors away from US financial assets, including bonds, which will translate into higher interest rates.

All these bode ill for stocks. And with the US presidential election just over, it is also worth remembering that the first two years after the election tends to provide poorer returns than the preceding two years.

In a market commentary on GloomBoomDoom.com on 11 November, investment adviser Marc Faber said that the stock market often bottoms out around election time. However, he also warned that "many post election rallies fizzle out relatively soon and give way to renewed weakness".

Similarly, in an article on 24 November for CBS MarketWatch, Peter Brimelow quoted an analysis by Investors Intelligence's Michael Burke on the US stock market as follows:

The large number (500+) of buying climaxes last week is a worrisome event, and we plan to get a bit more defensive in the days ahead. We have been thinking that the post election rally could last into December or even January, but that outlook could change. With current broad overbought levels, and historical precedents, we are nervous that next year will be negative and will be looking to reduce our invested position here in the next few weeks.

According to Brimelow, Burke's record is "solid", with market-timing a particular strength of his.

Stock market weakness, however, may not be uniformly felt everywhere. Burke, for example, appears relatively sanguine on Asian stocks. He thinks that the Japanese market "could well rally if the US market falls".

Indeed, stocks in Asia could well benefit from liquidity fleeing a falling US dollar. Asian countries -- many of whom have large current account surpluses -- are under pressure to allow their currencies to appreciate to balance the world economy as well as their own. That may attract capital into these Asian countries, potentially causing interest rates to fall and liquidity to rise, which could then flow into Asian stocks.

Today, The Straits Times market report mentions a recent Citigroup report which pointed out that the strengthening Asian currencies implies that "domestic sectors such as importers, real estate and banking stand to benefit". The newspaper also mentions that Singapore brokerage UOB Kay Hian thinks that banks and property are likely to do well, the former because of rising interest rate spreads and the latter from low interest rates as well as a recovering job market.

The main caveat to this optimistic scenario for Asian stocks is that a weakening world economy -- especially one with its engine of growth, the United States, fast losing its purchasing power as a result of a weakening currency and possibly rising interest rates -- is not the most favourable backdrop for a bull market in stocks.

US dollar affected by both trade deficit and inflation

The US dollar has been falling of late and the conventional wisdom is that the large US trade deficit causes the US dollar to be weak. However, Donald Luskin of Trend Macrolytics thinks that the reason for the fall in the US dollar is inflation rather than the trade deficit.

In an article for SmartMoney.com on 12 November titled "Buffett Is All Wrong on the Dollar", Luskin wrote:

The falling dollar is the one dark cloud on the market horizon right now, the one thing that has the power to threaten the post-election "Bush rally." But the reason you should be worried about the dollar is very different from the scare stories you're hearing in the media...

Warren Buffett...has shorted the dollar because he is worried about the impact of the U.S. trade deficit... [T]ake a look at the chart...which plots the value of the dollar vs. a trade-weighted basket of foreign currencies...compared with the U.S. trade deficit...all the way back to 1973... As far as I can see, the dollar and the trade deficit simply have nothing to do with each other...

So if Buffett is so terribly wrong, how come he's making money on his short position in the U.S. dollar? Why is the dollar falling?... It all comes down to...Fed chairman Alan Greenspan... Greenspan's mistake is that he has kept interest rates too low for too long, and now inflation is beginning to creep back into the U.S. economy... And that's why the dollar is falling. It buys less than it used to...

In the chart that Luskin shows, there is indeed no apparent correlation. The problem is that the trade-weighted index that Luskin uses covers only the major currencies -- that is, the currencies that are widely circulated outside the country of issue. So it conveniently excludes the renminbi -- the currency of the Chinese economy with which the US has a large part of its deficit -- and the currencies of many other emerging economies.

A broader trade-weighted index would have shown that, after a relatively stable period in the 1970s for both the US dollar and the trade deficit, the US dollar has been on a rising trend for most of the period since the early 1980s, and the trade deficit has risen along with it for much of that period.

So Luskin is wrong in saying that the dollar and the trade deficit have nothing to do with each other.

That does not necessarily mean that he is wrong about the impact of inflation on the dollar.

Inflation in the US is largely the result of excessive money supply caused by low interest rates. When money supply increases faster than the amount of goods and services produced in the economy, the purchasing power of each unit of the currency declines. A lower purchasing power tends to lower the value of the currency, so its exchange rate tends to fall, unless holders of the currency find other uses for it -- for example, for investment or as a medium of international trade (both of which apply in the case of the US dollar, which helps offset its declining purchasing power).

Having said that, one of the indicators of inflation and purchasing power in a country is none other than the trade deficit.

By creating excess money supply, inflation tends to drive up prices. This tendency is mitigated in a globalised economy by some of that excess money going oversees to seek out cheaper imports. How much, and whether it leads to a trade deficit, depends, among other things, on whether and by how much local prices are higher than foreign ones at prevailing exchange rates. Obviously, the greater the inflation, the greater the excess money and the greater the differential in prices (assuming the exchange rate stays constant), hence the greater the likely trade deficit.

Therefore, whether you look at it as excess money seeking an outlet through imports or as rising local prices relative to foreign ones inducing substitution with imports, the trade deficit is an indication that the US is indeed experiencing inflation to a greater degree than other economies.

So whichever way Luskin chooses to look at the trade deficit, he should not advise investors to ignore it.

Bush's election victory cannot blow dark clouds away

President George W. Bush has won another term in the US election. While his victory has generally been viewed as favourable for stocks, investors need to be aware of underlying economic trends that may have greater effect on markets, not only in the US but also in externally-driven economies like Singapore.

Wall Street generally prefers the pro-business Bush as president over challenger Senator John Kerry. And yet, how positively Bush's articulated policies will affect the stock market remains a question mark.

President Bush's penchant for tax cuts and his proposal to make the cuts from his current term permanent is a double-edged sword. In the short term, a tax cut stimulates the economy. In the long term, it exacerbates the Federal budget deficit. Investors will be well aware of both effects.

President Bush is generally viewed as more favourable toward free trade. During his campaign, Kerry had proposed to curb offshore outsourcing and review trade pacts with several countries. And yet, President Bush's pro-free-trade stance did not prevent him from implementing trade restrictions during his current term, most notably on imported steel.

However, perhaps most importantly -- and quite apart from whatever happens with the US presidency -- what must weigh on investors is the possibility that the economic cycle may be near its peak, if not already there. That, at least, is what economic indicators appear to be showing.

The index of leading indicators tracked by the Conference Board decreased 0.1 percent in September to 115.6, the fourth consecutive decline. While not quite signalling a downturn as yet, it clearly shows at least a deceleration.

The survey of purchasing managers by the Institute for Supply Management found a similar story. Its index of manufacturing activity fell 1.7 points to 56.8 in October, which still indicates expansion, albeit a slower one.

The jobs picture is mixed. On Friday, the Labor Department reported that 337,000 jobs were created in October, the largest gain since March. However, job-cut announcements by US companies hit 101,840 in October, according to outplacement firm Challenger, Gray and Christmas. Although slightly lower than the previous month, it was the second consecutive month that the number of jobs cut has exceeded 100,000.

Furthermore, the Department of Commerce's GDP report for the third quarter shows that the US personal saving rate has fallen to 0.4 percent, leaving little room for further strong increases in consumer spending. Indeed, the consumer confidence index tracked by the Conference Board fell to 92.8 in October, the lowest level in seven months.

If the US economy weakens, the rest of the world economy will inevitably be hit. That China raised interest rates on 28 October to slow its economy -- the world's other major growth engine -- only makes things worse.

The slowing economy is sending jitters in the semiconductor industry in particular. Semiconductor stocks throughout the world have been hit over the past few months in the face of growing inventories of chips. Last week saw both the Semiconductor Industry Association and IDC cut their chip sales forecast for next year -- to flat growth and a two percent decline respectively from 2004.

Singapore's highly externally-driven economy is already feeling the effects of the economic slowdown. Manufacturing output in Singapore grew 11.8 percent in September from a year earlier. However, on a month-on-month seasonally-adjusted basis, output shrank 1.2 percent.

Things are not likely to get better. A survey by the Economic Development Board on business expectations of the manufacturing sector for the fourth quarter of 2004 found a net weighted balance of 12 per cent of the firms expecting a favourable business situation ahead, weaker than the net weighted balance of 24 per cent recorded a quarter ago. And the Singapore Institute of Purchasing and Materials Management's index of manufacturing activity dropped 1.7 points to 51.5 in October, the lowest reading in 14 months.

In a report in the Global Economic Forum on 5 November, Daniel Lian of Morgan Stanley wrote that "the best days seem to be behind Singapore in terms of both the broad growth picture and domestic demand". Lian wrote that although domestic demand has been unleashed by the recent burst of economic recovery, it "looks set to go as quickly as it came when the economy moderates ahead. When that happens, the simultaneous retreat in consumer spending at home with a global demand slowdown will leave the economy recoiling from a double whammy."

The Singapore stock market has been one of the best performers in the world this year. Investors' confidence in Singapore has largely been justified by the economy's performance. Now, investors may want to start repositioning themselves for the economic climate ahead.