Monday, November 10, 1997

Why Worry?

Analyst Sees Deflationary Impact of Asia's Woes Whacking U.S. Profits

Kathryn M. Welling

An Interview With Martin H. Barnes ~ Surveying the complacency he's seeing all around Wall Street and Main Street despite the market's recent little record-setting dipsy-doodle, the managing editor of Montréal's Bank Credit Analyst is not comforted. Indeed, when we caught up with Martin last week in Austin, Texas, where he was about to make a presentation to clients, the self-styled "dour Scotsman" uttered a comment more revealing even than the kilt he sometimes dons. The intellectual content of much recent market commentary has been on a par with the "What, Me Worry?" of Mad Magazine's Alfred E. Neuman, Martin opined. His own most recent missive excluded, of course. Its message, as Martin elucidates in this Q&A, is don't underestimate the deflationary forces at work around the globe.
Martin Barnes

Barron's: Martin, your latest report calls the upheaval in global markets a symptom of gathering deflationary forces from which the U.S. isn't immune. Barnes: Well, it is hard to argue that actual deflation is occurring in North America, or even Europe, right now. But certainly in Asia all the classic background symptoms of deflation are present. Excess capacity. A fragile banking system. A fragile economic system, very leveraged to real estate. Then we've just had this tremendous wealth destruction. Falling equity prices of truly epic proportions, the consequences of which will decimate real estate. The economic fallout, in Asia, will be severe. We estimate the decline in stock-market capitalizations in emerging Asia at more than 40% of GDP. And of course, we've already had a very deflationary environment in Japan for the last seven years.

Q: But -- did we hear right? -- you're nonetheless joining the Wall Street chorus that says we don't have to be overly concerned about what's happening in those small countries, way over there?
A: Not at all. We believe it's important, during periods of extreme market volatility, to step back and consider whether the gyrations we're witnessing are merely irrational swings in investor sentiment or reflect something more fundamental. And, while most of Wall Street has generally argued that this is just another blip in an ongoing bull market, because of the U.S. economy's low inflation, steady growth and continuing improvements in corporate profits, we have a much darker view.

Q: But not as black as deflation here-at least, not yet?
A: The market gyrations do reflect deflationary forces at work, we believe. Tradionally, stock-market corrections are triggered by deteriorating liquidity as central banks raise interest rates to combat inflation. But this time around, equity prices tumbled in the developed countries in the midst of a bond bull market and generally accommodative monetary conditions. Moreover, the contagion has spread from Asia -- first Thailand, then Malaysia, Indonesia, Hong Kong and Tokyo -- to the developed world. Which isn't a usual or healthy pattern. So we suspect that the deflationary nature of the current environment has major implications for the financial and economic cycles.

Q: Such as?
A: To use a dangerous phrase, the cycle could be "different this time." The typical monetary-induced stock market cycle that everyone is used to generally proceeds along a well-defined path. Once the central bank has achieved its objective of slowing economic growth, investors start to anticipate an easing of policy and stocks rise in advance of the upturn in economic activity. In a deflationary environment, however, lower interest rates may not help. Witness the experience of the U.S. in the 1930s or Japan in the 1990s.

Q: That sounds like an ominous forecast.
A: It's not. We're painfully aware that Wall Street's powerful bull market has thwarted many a bearish predictionours included-and may continue to do so. Still, we're amazed by the level of complacency that exists about the outlook for the U.S. economy, corporate profitability and the stock market in the face of these deflationary forces.

Q: In other words, investors are underestimating the impact Asia's deflation will have here.
A: Exactly. There is still a naive tendency to argue that the implications for U.S. investors can be quantified in terms of the share of U.S. exports that go to non-Japan Asia, which is about 20%. But the impact will be far more widespread and destructive than implied by such a bland statistic.

Q: How so?
A: Let's back up for a minute. Investor enthusiasm toward emerging Asia in recent years has tended to focus on the prospect that economic development there would lead to steadily growing demand for goods and services-preferably produced by Western companies or their Asian subsidiaries. Thus, the vision of hundreds of millions of new Asian consumers has helped fuel the mania for U.S. multinational stocks, driving their valuations to levels not seen since the end of the secular bull market of the 1960s.
But considerably less attention has been paid to the global implications of the massive buildup in Asia's productive capacity that has occurred apace. The "Asian miracle" was characterized by extremely high savings and investment rates, which were associated with a decade-plus of explosive growth. And which ultimately led to a massive regional overinvestment cycle. Our sister publication, the Emerging Markets Strategist, recently ran this [nearby] chart highlighting the unsustainability of the Asian investment boom. It shows that when investment in the region began to soar as a share of GDP in the early 1980s, there was initially a good payoff in terms of faster economic growth. Lately, however, the region's growth has slowed, even though investment has continued to climb -- a classic symptom of overinvestment. So Asia is now burdened with huge excess productive capacity and a glut of unsold goods -- plus, in many countries, real-estate bubbles, because that's where excess liquidity flowed.
In effect, an immense pile of dry tinder was created. When the strain of maintaining their overvalued currencies became too intense earlier this year, the domino effect of currency devaluations took hold -- and triggered the equity-market declines. In effect, investors have been forced to confront the unpleasant reality that rates of return on Asian companies' capital will plummet further as they struggle to compete for market share in a world where demand growth is more likely to slow than rise over the next year.

Q: Okay, but why should anyone here -- except investors in or suppliers to those companies -- worry?
A: First, because the full extent of the economic damage from the decline in emerging Asia's currencies and stock markets will only become apparent over the coming year as real-estate markets crumble, undermining banking systems and consumer and business confidenceand as their domestic demand contracts, leading to a major downturn in 1998-99.
Second, the region's excess capacity and high inventories point to downward pressure on traded goods prices -- in other words, to intensifying global competition. That's good for consumers, but not so great for corporate earnings. And it's not going to go away overnight. It's not a simple business-cycle problem -- like excess inventory. Every Asian country is going to look toward exports to drive economic growth over the next couple of years. But to where? The U.S. and the U.K. are the only major countries with strong domestic demand growth-and in both, growth seems likely to weaken. Thus, another round of competitive devaluations can't be ruled out-possibly extending into Latin America and Eastern Europe.
Finally, this all feeds back onto Japan, which is already extremely weakand now we're talking about a meaningful percentage of the global economy. Japan is the second-biggest industrial country. China, of course, is still an enormous question, but the origins of the region's competitive devaluations go back to its 50% depreciation in the renminbi in late '93. Anyway, now virtually the whole of Asia is feeling the effects of this. We're seeing some impact on Latin America. And Europe was struggling, even before this happened, certainly in terms of its domestic economy. So all of a sudden, you are talking about large parts of the world that are not looking so good.

Q: Yet you're saying deflation won't spread here?
A: I don't think it's right to say we're going to have deflation in America. But we are going to have a squeeze on profits, as a consequence of what's happening in Asia. Those countries are going to be exporting like crazy, at a time when Europe is looking to its own exports for growth, as is Canada. So who's going to be importing all these exports?

Q: There's a limit to even the U.S. appetite for imports, you're implying?
A: You know, America has done very well. It has carried a lot of countries on its back in the last few years, but there is a limit. In fact, there are good reasons to believe U.S. demand is going to slow anyway, independent of global problems. Which, again, points to a real buildup of competitive pressures. The pricing environment for U.S. corporations has been tough for the past couple of years -- and will get a lot tougher. And, of course, it's the large multinational companies that may actually suffer the most over the next several years, given what's going on globally.

Q: Wait. Are you suggesting that the U.S.'s growth rate was going to slow, even if the Far East hadn't hit the wall?
A: Yes. Granted, the U.S. economy has been the industrialized world's star performer during the past few years-and that fact has underpinned Wall Street's bullishness. It was also the underlying theme in the torrent of bullish commentary we've been seeing, claiming that the recent selloff was unwarranted because the economy is in such great shape.

Q: You disagree?

Martin Barnes

A: I think the bullish economic outlook is more than discounted in equity market valuations, which remain at post-World War II extremes. Besides, it's the future trend in the economy that matters, and there are good reasons to expect corporate margins to come under pressure next year. The dark side of low inflation is further erosion in pricing power amid intensifying global competition.

Q: Let's get specific. Why -- ex-Asia -- do you expect a slowdown here?
A: U.S. economic strength has been much less broadly based over the past couple of years than is commonly supposed. For instance, the levels of both housing starts and vehicle sales, while relatively high, have changed little over the past yearmeaning that two important sectors haven't been adding to economic growth. Exports, one of the earlier engines of growth, have more or less flatlined since March. What's going on in Asia implies U.S. exports will take further hits there. So you can't look to exports as a big source of growth. In fact, they'll be perhaps as much as a 1% drag on GDP over the next year. And, of course, declines in government outlays remain a modest drag on growth. The upshot is that the strength in U.S. activity is mostly concentrated in business investment and consumer spending on services.

Q: Which are going strong.
A: Yes, and falling technology prices and the continuing impetus to substitute capital for labor argue for continued growth in investment spending. But profits are likely to be squeezed -- and there is a very close correlation between swings in business investment and profits. So investment will probably slow next year. Granted, the fundamentals are currently bullish for consumer spending: Real incomes are rising, balance sheets are strong and jobs are plentiful. But you have to ask how long consumer spending remains robust when every other sector is static or losing ground. And consumer confidence is probably very sensitive to further stock-market declines.

Q: So you're predicting a U.S. recession in '98, just not deflation?
A: There's no current indication that a U.S. recession will unfold next year -- but the case for a slowdown -- say, GDP growth of 2% or less for a few quarters -- in this country is compelling. Now, that's not a disaster. But it won't be surprising to hear increasing talk of a global recession as the economic consequences of Asia's woes become more apparent. So it's plain wrong to argue that economic conditions justify current valuations.

Q: Look on the bright side, though. Now the Fed doesn't have to tighten.
A: Which is what the Fed chairman was referring to in saying the latest market drop might eventually be seen as a "salutary event." But there was an eerie parallel between Greenspan's comments and John Maynard Keynes" suggestion, in October 1929, that the Crash was a beneficial rather than evil event. I'm not trying to suggest that we're heading into a 1929-style debacle. I am suggesting, though, that even top financial leaders can totally misread a situation and I'm warning that their reassurances may create a deadly trap for investors.

Q: Keynes was scarcely alone in misreading the Crash, as we recall.
A: Right. The '29 Crash happened on a Tuesday, but the market had been very weak the week before, particularly on that Thursday. Which was when J.P. Morgan and other bankers got together and came up with a bailout fund of $20-$30 million to try to support the market. As Bob Sobel wrote in Panic on Wall Street, it was assumed that "once the public learned the "big boys" were behind the market, confidence would be restored and normal buying would resume." And the market did rally that Friday. Then, over the weekend, President Hoover told the country that "the fundamental business of the country -- that is, the production and distribution of goods and services -- is on a sound and prosperous basis."
Again, the parallels with recent experience are eerie: IBM's move to buy back its shares played a key role in restoring confidence and helping to trigger the market rebound on October 28. And of course, President Clinton -- like his predecessor -- issued a statement about the strength of the economy. Let me stress again, I'm not predicting another '29-style crash, but it's interesting to see history repeating itself.

Q: What are you predicting for the markets, then?
A: That the U.S. equity market is not priced for the kind of profit environment that I see over the next year.

Q: Third-quarter earnings reports, by and large, looked strong.
A: True, corporate earnings rose at a double-digit rate in the three months, once again significantly outpacing consensus expectations. But the outlook for future earnings, given the deflationary forces spreading from Asia, is far less rosy than investors have been assuming. And expectations are still too high, with current equity prices discounting long-run earnings growth of about 10% a year, we estimate.

Q: Too high? That represents a considerable slowing from the recent pace of profits growth, doesn't it?
A: Well, total profits of the nonfinancial corporate sector have climbed at better than a 15.5% average annual pace over the past six years, in real terms. But they've done so on the back of sharply improved margins. Indeed, that 15.5% figure is distorted by enormous special factors, as we discussed last year [October 7, 1996].

Q: When you argued that the "new era" in profits had less to do with restructuring and technology than it did with an enormous drop in interest expenses, lower taxes and disappearing depreciation charges?
A: Yes. That is easily discernible in the fact that the annual growth in EBITD [earnings before interest, taxes and depreciation] over that span has averaged only 5.5% in real terms-or less than half the rate of the increase in reported earnings. If you'd like further comparisons, the earnings of the S&P industrials have risen at an average annual rate of 3% over the past 70 years and at 4% over the past 50. Thus, long-run growth of 8% would represent a doubling of the pace we've achieved since World War II, and this [accompanying] chart shows just how implausibly high 10% annual earnings growth would push margins, assuming corporate output rose 5% a year in nominal terms. It would truly be a new era, if we could produce such margins.

Q: What do you expect instead?
A: We could have zero profit growth, fourth quarter '97 to fourth quarter '98. That's quite a bit less than most Wall Street strategists predict.

Q: Not to mention analysts.
A: Well, that's right, but I guess we're really in the extrapolation phase of this bull market. Have been for a couple of years now. And it has paid, I guess, to extrapolate. It's gotten to the self-fulfilling stage. Because people are so interested in buying stocks, prices go up. Of course, this can go into reverse. Still, the sheer power of supply and demand forces in the equity market should not be underestimated here, either. Retail investors are conditioned to buy on weakness and shares are still being taken off the market through buybacks, takeovers and mergers.

Q: You're waffling.
A: Not really. The sharp one-day drop in the market has reminded at least some investors that equities aren't risk-free assets. Ultimately, economic fundamentals win out. If deflationary forces build as we fear, the complacently bullish view of corporate profitability will be shattered over the coming year.

Q: What's the bottom line, for stocks?
A: Equities remain in a high-risk zone. Valuations are too high and there's widespread denial about the true cause of the recent market turbulence. Leverage, measured as margin debt as a percent of GDP, is at its highest levels since the 1920s. And we will only know the true extent of the other sorts of extreme leverage being employed in this market after prices drop. So, could the market suffer a major crash? It's certainly a possibility, given current levels of overvaluation, speculation and complacency. But it's also possible, as the corrosive effects of global deflation become more evident here, that the U.S. equity market just goes nowhere for a while. Maybe the adjustment will come through time, rather than price change. That would be very debilitating on people's psychology toward the market, given their buy-the-dips mentality and overblown expectations for 34% annual returns. But I don't feel any necessity to be super-bearish.

Q: Clearly.
A: Be nice. From an immediate investment strategy perspective, it's sufficient to note that the risk-reward tradeoff favors bonds over equities -- which remain extremely overvalued at nearly 20 times one-year forward earnings. As this [nearby] chart illustrates, bonds are no longer undervalued, but their underlying fundamentals are excellent -- and the long-run trend in bonds' fair value thresholds is down. The 30-years will drop to 5 3/4 % during the next several years if inflation averages 2% and real yields stay flat. More likely, real yields will decline -- meaning fair-value yields could drop to 5% within, say, five years. I won't say it's a no-brainer, because there's nothing in the markets that's a no-brainer. But to me, stocks are expensive, bonds are cheap.

Q: Thanks, Martin.