June 29, 2005
Two weeks ago, the central banks of Sweden and Hungry cut their interest rates. Two members of the nine member board of the Bank of England also voted to cut their rates. Rumors that the European Central Bank also is contemplating a rate reduction abound. And a prominent bond investment manager has suggested that rate increases will shift to rate cuts before Alan Greenspan steps down early next year.
Frankly, that last possibility is a Bill Gross exaggeration. The likelihood that Greenspan would admit that rates were pushed too far by cutting them before he leaves, is lower than nil. Nevertheless, bond investors want to believe that declining rates are the most likely outcome in the next six to twelve months.
Part of the belief rests upon the extent of the “soft patch” that showed up in manufacturing in recent months. Most economists were not surprised that the end of fiber quotas would create a flood of imports that overwhelmed domestic production. Economists also realized that inventories grew too rapidly during the winter and would need to be reduced in the spring.
In short, sluggish manufacturing should have been expected in the spring. Also, the inventory correction suggests strength rather than weakness later in the year.
After a modest lull, diesel consumption is 6.9 percent above last year levels. For the most part, this reflects the movement of goods, and the growth is higher than it was a year ago. Housing activity remains stronger than projected while consumer spending has again spurted following a spring lull.
If there was a “soft patch”, and the evidence is unclear on that, it certainly is over. Except for a puzzling weakness in the leading indicators, little evidence of a need for lower interest rates exists in the U.S.
The remainder of the world may be another story.
Parts of Asia are doing as well as last year. The latest Chinese production gains are 16 percent and consumption growth also is in double digits. Japan is performing better than expected, and their banks appear to have finally overcome the bad debt problems that have plagued them since the Nikkei and real estate bubble burst in 1988.
A few soft patches have appeared in the Asian Tigers, such as Singapore, South Korea and Taiwan. However, India still is gaining by more than 6 percent. Overall, Asia should grow about the same this year as last year, although some soft patches exist.
If the Latin American closed end funds mean anything, South America may be growing faster this year than last year. Mexico might be having some problems and Canada clearly is struggling to repeat last year’s more than 4 percent growth. Nevertheless, the Americas are doing their fair share.
Unfortunately, except for the production of oil, Africa hardly registers on the world economic scales. However, oil production is up.
So the concerns about a slowing are centered in Europe. Eastern Europe shows moderate growth, though activity could quickly slump if Western Europe falls into recession. Clearly, the rumors and actions of central banks show that recession fears are growing. Are they justified?
Unfortunately, the answer is yes. Monetary policy has never been rearmed. Because banks have been accommodative while economies were growing, central bank policy has limited capacity to stem any developing decline. Nevertheless, some efforts will be exerted as unemployment rates jump to the teens.
Budgetary policy, with a few exceptions, also has been relatively accommodating. Deficits are large because of massive transfer programs from productive sectors to retirees, farmers, and even some workers in declining sectors. Modest regulatory reforms have occurred, especially in Britain and France, but the efforts remain small.
Now, Western Europe is being besieged by falling currency values and rising oil prices. The former may aid the competitiveness of export industries (and most European countries continue to record trade surpluses despite lost markets to Chinese producers). However, weak currencies enhance the jump in oil prices, which are priced in U.S. dollars.
High unemployment and high energy costs are twin economic devils that may very well push Europe into recession before the end of this year.
In past world downturns, a weak Europe meant a weak world economy. Perhaps this time will be different, but investors certainly are not betting on that.