Slowing economy may weigh on Singapore stock market

The Singapore economy is clearly slowing, as indicated by the latest export figures. While economists expect the economy to continue to grow moderately in 2005, the slowdown does leave the question of what is likely to drive the Singapore stock market higher going forward.

In the latest survey of economic forecasters by the Monetary Authority of Singapore (MAS), the forecasted growth rate for 2005 was 4.3 percent, well below the 8.3 percent expected for this year as well as the 5.0 percent forecasted for 2005 in the middle of this year.

Recent economic indicators have provided good reasons for expecting a slowdown for the Singapore economy. For example, third quarter gross domestic product had been down 3 percent on an annualised seasonally-adjusted quarter-on-quarter basis.

The November trade report released by International Enterprise Singapore on Friday shows that non-oil domestic exports (NODX) rose 16.5 percent from a year earlier, but fell 9.1 percent on a seasonally-adjusted month-on-month basis, well below economists' expectations. NODX had risen 1.0 percent in October.

On a more positive note, non-oil retained imports of intermediate goods (NORI), a short term leading indicator of overall manufacturing activity, rose 4.1 percent on a month-on-month seasonally-adjusted basis in November, similar to the 4.2 percent increase in October.

While economists surveyed by the MAS expect the manufacturing sector to grow by over 5 percent in 2005, this represents a marked slowdown from the 12.8 percent growth expected for 2004.

On the domestic front, the economists expect private consumption to grow about 4 percent in 2005. Again, this represents a slowdown from the expected 7.6 percent gain in 2004.

Last Thursday, the Ministry of Manpower had reported that Singapore's unemployment rate had fallen to 3.4 percent in September from 4.5 percent three months before. Also, the economy added 14,100 workers in the third quarter of 2004, up from 10,900 in the second quarter. This was the fifth consecutive quarter of gains.

However, the ministry expected the growth to ease as the Singapore economy "transits to a slower rate of growth amidst the anticipated slowdown in global IT demand and weaker growth in the world economy". It also expressed concern over structural unemployment. Indeed, neither the ministry nor the economists surveyed by the MAS expect the unemployment rate to fall significantly next year.

The property sector has been in the doldrums for the past few years, and while many analysts have been expecting a pick-up soon, that pick-up keeps getting pushed back. The latest figures from the Urban Redevelopment Authority show that the vacancy rate of private residential properties at the end of September was 8.5 percent, after the stock of empty private properties had risen 4 percent from three months earlier.

However, with the US dollar weakening of late, capital flow into Singapore has caused interest rates to fall, with ten-year treasury bonds falling below 3 percent. This may conceivably boost property and the rest of the domestic sector in Singapore, although economists still forecast a rise in interest rates in 2005.

Apart from this, things currently do not look good for the Singapore economy. The next question then is: How vulnerable is the Singapore stock market to a correction as a result of the economic slowdown?

To answer this question, let us look at valuation. The Singapore stock market as a whole is currently trading at a price-earnings ratio of about 14. While low compared to its historical trading range, it does not necessarily mean that the market is cheap. The economy's long-term secular growth rate has slowed down markedly from historical rates, so lower valuations are to be expected. Furthermore, the on-going slowdown means that earnings growth is likely to moderate substantially next year.

Indeed, a price-earnings ratio of 14 is actually close to the historical average for the US stock market, which means that the Singapore stock market may already be fully valued.

There is, of course, still a possibility that the stock market will continue higher. Markets seldom trade at average or fair value, and often overshoot the latter on the way to a peak.

I had pointed out in July last year (see article) -- when the current cyclical bull run was still in its infancy, with the Straits Times Index (STI) at 1,544.84 -- that at the start of the last bear market in early 2000, the STI had found support at around the 2,000 level. I thought then that this provided a technical basis for the bull market to end with the STI between 1,800 and 2,000. The STI closed on Friday at 2,057.98, slightly above the top end of my forecast.

So the stars seem aligned. Are they pointing to the start of a bear market?

The falling US dollar and rebalancing of the US current account

In the ongoing debate over the fall in the US dollar, some economists have taken the stand that the currency's decline will have little impact on the US current account deficit because it does not affect the fundamental imbalances that cause the deficit in the first place. To these economists, the current account deficit can only be corrected by tackling the structural problems that give rise to the imbalances.

For example, in last week's issue of The Edge Singapore, Manu Bhaskaran of economics consultancy Centennial Group wrote:

Why is it wrong to think that currency realignment alone can or will do the job? Take the recent analysis by two highly respected economists, Maurice Obstfeld and Kenneth Rogoff. They estimate the US dollar will need to depreciate 50% in trade-weighted terms from its peak in early 2002 to bring about a more acceptable current account balance. That means a further trade-weighted depreciation of about 40% from today's level. But can such a quantum of US dollar depreciation occur without causing significant dislocation in the US itself as well as in its major trading partners such as Europe, Japan and developing Asia?

Instead, he thinks that structural factors need to be addressed.

The only solution is to go to the root of the global imbalances... These include the weak savings rate in the US (large budget deficit and extremely low household savings rate), and structural obstacles in Europe, Japan and developing Asia which limit investment spending and growth.

Similarly, in a recent article for The New York Times, Jeffrey Garten, dean of the Yale School of Management, wrote:

America's trade imbalance can be corrected, the current reasoning goes, with a much cheaper dollar -- perhaps 30 per cent cheaper than it is today... The problem with the...devaluation...is that it does not treat the root causes of America's economic imbalances. The need to borrow so much from abroad is caused by enormous consumption and anaemic savings.

I endorse the view that structural factors have a part to play in the global imbalances. It certainly seems fair to argue that a fall in the US dollar alone may not be enough to correct these global imbalances. However, should that lead one to dismiss the significance of currency adjustment? Arguing against the decline in the US dollar on such grounds misses some important points.

First of all, in practice, a decline in the US dollar cannot be isolated from a rise in US interest rates. For all practical purposes, a sell-off of US dollars must be accompanied by a sell-off of US assets and a rise in interest rates. The rise in interest rates in the US will raise the savings rate, cut consumption and hence, imports. Combined with the change in the terms of trade, it would have a substantial impact on the current account deficit.

Secondly, even if the fall in the US dollar and its related effects are not enough to eliminate the current account deficit, that does not mean that the dollar should not fall. Simple demand and supply considerations of the US currency imply that in the face of a persistent current account deficit and inadequate investment opportunities in the US, the exchange rate of the currency should fall. Failure to allow the currency to fall -- and interest rates to rise -- would result in excessively loose monetary conditions in the US, with all its attendant market-distorting and bubble-inducing effects.

Indeed, one of the reasons that Federal Reserve chairman Alan Greenspan brought up the problem of the current account deficit in his 19 November speech must surely be that he wanted a weakening of the US dollar to help him raise long-term interest rates, which had stayed stubbornly low and had been undermining the Federal Reserve's tightening stance.

Finally, the point that a fall in the US dollar may cause dislocations around the world -- or pain, to put it bluntly -- is very probably correct. However, the more pertinent point is: Is the pain avoidable? How can global imbalances be eliminated without pain?

Consider the fact that the US current account deficit can be reduced either by increasing US exports or decreasing imports. Increasing exports require other countries to import and consume or invest more. Who are these countries?

Western Europe and Japan are developed economies. Their capacity for additional productive investment is limited. Increased consumption looks more viable. However, these are also ageing societies. Their relatively high savings rates are necessary to offset current and future liabilities. How much increase in consumption can they actually afford?

The emerging economies, especially China and India, are younger, but their capacity for consumption is still relatively limited by the size of their economies as well as the limited stock of accumulated wealth from which they can draw down for consumption. For these economies, increased investment may be the better option. However, even here, remember that China, the engine of growth in emerging Asia, is already in danger of overheating from over-investment, with its banking sector weighed down by bad debts.

So there is a limit to what the rest of the world can do to increase consumption and investment without hurting their own balance sheets and creating future problems for themselves.

That leaves a reduction in imports as the remaining means to reduce the US current account deficit. A reduction in imports with offsetting increase in US production would hurt other economies. More realistically, though, a reduction of imports is likely to require some winding down of US consumption and investment; such an eventuality would hurt everyone.

So there appears to me that there is little likelihood that the US current account deficit and global imbalances can be eliminated without pain. And little reason for the US dollar not to fall further.

The impact of China on the world economy

When a People's Bank of China Policy Board member was reported to have said a little more than a week ago that China planned to reduce its purchase of US Treasuries, the US dollar went into a tailspin. That incident highlights how important China has become in the world economy, adding to the influence it is already building up as a result of its burgeoning manufacturing muscle.

Back in the early 1990s, economists and investors woke up to the realisation that Asia had some of the most dynamic and competitive economies in the world. Funds flocked into the region, both for direct investment and portfolio investment. Basking in the admiration of foreigners, Asians became full of hubris and there was talk of the "Asian way" as the path to prosperity.

Then came the Asian Financial Crisis of 1997-98. The currencies of emerging Asian countries tanked, sending their economies into recession. The exception was China. The Chinese renminbi held up because, after all, China was indirectly the cause of the problem for the other Asian economies.

Another economy that held up was that of the United States. In fact, the US thrived in the late 1990s, with the US dollar rising not only against Asian currencies but most other major currencies as well, and the US stock market reaching unprecedented heights. Now, it was the turn of Americans to be infected with hubris. The US thought that it was experiencing a productivity miracle, helped by the innovative spirit of the "American way".

Eventually, however, the US stock market bubble burst, and now the US dollar is facing tremendous downward pressure as well. The cause of the weakness in the US dollar? The twin budget and current account deficits.

The budget deficit is the result of America's internal policies. The current account deficit partly derives from the budget deficit. However, the current account deficit is also to a large extent the product of a surging Chinese export machine which spews out manufactured goods and renders much of the manufacturing sectors in many other countries -- including America's -- uncompetitive.

Some commentators have likened the current US dollar weakness to an Asian Financial Crisis in reverse. Well, there is not exactly a crisis as yet. However, if one does eventuate, I would liken it more to the Asian Financial Crisis moving on to the US rather than a reversal. In both cases, the root cause is the same: the rise of China. China's impact is slowly moving from countries closest to it in development to countries further away.

After the Asian Financial Crisis, the Asian ex-China countries adjusted to the new economic reality and regained part of their competitiveness, mainly by adjusting their currencies downward. But they also adjusted by re-orienting their exports towards China. The Asian way proved to be the way of the dragon. The US may have to take similar steps or risk a recession, just like the Asian countries during the latter's own crisis.

As it is, the US is having trouble expanding employment. According to the latest US Bureau of Labor Statistics (BLS) employment report, total nonfarm payroll employment increased by 112,000 in November to 132.1 million, seasonally adjusted. This is lower than expected and, indeed, lower than hoped for. In particular, the manufacturing sector -- which is most affected by competition from China -- saw employment fall slightly. In fact, factory employment has shown little change since May.

It has only been in the past few years that the impact of China on jobs in western developed countries has become widely recognised. However, in the past year or so, the number of articles devoted to this topic has been coming at an increasingly fast and furious pace.

A recent article from BusinessWeek titled "Just How Cheap Is Chinese Labor?" showed just how competitive Chinese labour is. Lacking reliable data on manufacturing labour cost in China, the BLS hired a Beijing-based American consultant, Judith Banister, to come up with an estimate. The result was 64 US cents an hour. For comparison, hourly factory compensation in the US in 2002 was US$21.11. For 30 foreign countries covered by a BLS report, the average was US$14.22.

However, for those thinking that China depends on cheap labour alone, think again. In a recent BusinessWeek special report titled "The China Price", Harvard University economist Richard B. Freeman was quoted as saying: "What is stunning about China is that for the first time we have a huge, poor country that can compete both with very low wages and in high tech. Combine the two, and America has a problem."

The article goes on to expand on China's range of advantages: "China is also propelled by an enormous domestic market that brings economies of scale, feverish local rivalry that keeps prices low, an army of engineers that is growing by 350,000 annually, young workers and managers willing to put in 12-hour days and work weekends, an unparalleled component and material base in electronics and light industry, and an entrepreneurial zeal to do whatever it takes to please big retailers such as Wal-Mart Stores, Target, Best Buy, and J.C. Penney."

Jim Hemerling, a senior vice-president at Boston Consulting Group's Shanghai office, sums it up well: "There is a myth that the US would remain the knowledge economy and China the sweatshop. Increasingly, this is no longer the case."

The rest of Asia learnt that lesson in the late 1990s. It's now America's turn.