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Economic Outlook
November 27, 2000 Despite the continuing controversy about the presidency, the real drama, as far as the capital markets are concerned, center on the extent of the economic slowdown. Economic growth over the next twelve months is expected to slow to 3% or less, hardly "new economy" levels. And, although the fourth quarter has started out moderately strong, the probably of a "hard landing" cannot be ruled out. Despite the recent fall in the equity market, a sharp slowdown in growth is not built into the stock prices. The bond market, however, is fearful, and yields on lower grade corporate bonds have been surging. Interest rates on the lowest B rated bonds are near 14%, a level not seen since the recession (and junk bond collapse) of the early 1990's. Usually equity markets dive when bond markets get tense, but this time the concern appears limited to fixed income securities. But the reason is not hard to find. The telecom area notwithstanding, most of the prime technology stocks have little or no debt. And most of the "old economy" stocks have been keeping their spending in line and their credit lines open. But technology, despite being debt free, is hardly immune to the slowdown. One by one, the overvalued technology issues have been falling. There were ten stocks with capitalizations over $85 billion with a price-earnings (PE) over 100 in March. Now only EMC and Time Warner remain valued in triple digits. Earnings per share need to grow at 35% per year for ten years to justify triple digit P-E ratios. And that is very hard to do when the economy is growing at 2 to 3%. Given the economic slowdown, it was disappointing that the Fed did not shift to a "neutral bias" in its November meeting. Inflation outside of the energy sector is virtually non-existent and the "pipeline" data from the producer price indices are very favorable. The Fed appears to be fixated on tight labor market indicators, such as the unemployment rate (at a 30-year low of 3.9%) and Greenspan's favorite indicator, the supply of "available labor" -- unemployment plus individuals willing to work but not actively seeking a job. But there are numerous signs of cooling in the labor market. The level of unemployment claims, an important early indicator of the economic activity, bottomed in midyear and has been moving steadily upward. Labor costs have remained tame all year. With the stock market down and internet bubble pricked, consumer spending has clearly cooled. Although the Fed has not acknowledged the slowdown by dropping its threat of further tightening, the Fed Funds futures market is clearly betting that the next Fed move will be downward. JP Morgan economists, often overly hawkish in predicting Fed policy changes, have now forecast two Fed easings by the middle of next year. I found it regrettable that Greenspan did not concede the accumulating evidence of a slowdown by shifting to a "neutral bias," paving the way for lower interest rates. If there can be one criticism of the Greenspan's monetary policy over the past 13 years, it is that he has dragged his feet in lowering the Fed Funds rate in the face of declining economic activity. By thumbing his nose at a potential slowdown, the Fed raises concern that help for a slumping equity and bond market will not come as quickly as it did two years ago, when the Asian crisis paralyzed the securities markets. Despite the financial stresses and economic slowdown, the housing market and the mortgage market are in very good shape. Even if a hard landing does materialize, the housing overhang is so light (especially compared to a decade ago), that the real estate market should hold up well. The low government bond rates mean that insured mortgage rates are low, and the lack of overall speculation in real estate means that most prices are not inflated. The strength of the real estate market means that the odds against a recession are still very long. But a severe adverse shock, such as an escalation of hostilities in the Middle East, a constitutional crisis emanating from the presidential election, or a continued bear market in stocks could push the economy towards recession. This 11-year-old expansion still has life in it, but there are still significant hazards to be negotiated.
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