Bill Sterling is Global Strategist for C.I. Global Advisors LLP, who are one of the fund managers for C.I. Mutual Funds. His reports are interesting and timely, especially for anyone interested in the larger global picture and how it may affect their investments. See our links page for links to C.I. Mutual Funds and other featured mutual funds.
His recent book, "Boomernomics", is highly recommended.

---

      World Report      

Global equity markets have had a bumpy ride in the first half of 2000, thanks largely to rising interest rates and high oil prices. As shown in Chart 1, the MSCI World Index posted a 1% decline in the first six months after a gain of nearly 17% in 1999. Only a few markets - including the Canadian equity market - escaped the downdraft.

As is often the case, the ride was most painful in sectors where investor expectations were most extreme - as in Internet stocks. Perhaps the best warning signal of inflated expectations was word from a financial consultant early this year that one of his clients quite seriously requested that he "stay away from risky dot-com investments and just aim for steady 70% annual returns."

Looking ahead, the two key issues that are likely to dominate the markets in the second half of the year are: (1) how much further interest rates will rise, and (2) how much profit growth will slow based on tighter monetary policies.

Early this year, a sharp acceleration in both U.S. growth and a variety of inflation indicators roiled the financial markets by creating fears that the Federal Reserve would tighten monetary policy aggressively, raising short-term rates to as high as 7.5% and risking a recession in 2001. High oil prices added fuel to the fire, prompting some overwrought analysts to forecast stagflation.

Soft Landing Ahead?

More recently, signs of slower growth in recent months have raised hopes that the Fed is done raising interest rates or, at worst, will raise rates one more time by a quarter point before going into extended hibernation. Under this scenario, the economy should slow to a more acceptable growth rate of around 3.5% and thereby achieve a perfect "soft landing."

This would indeed be a positive scenario for the U.S. equity market, which has historically rallied by about 23% in the 12 months following a peak in short-term interest rates. It would also mean that the U.S. economic expansion, which is already more than nine years old, would be headed for the record books as a business-cycle Methuselah.

We give this scenario at least a 50-to-60% chance of panning out, mainly because the U.S. is enjoying a "virtuous circle" whereby high rates of investment have boosted the economy's productive capacity. That in turn has raised the economy's potential to grow in a non-inflationary manner, which in turn spurs high rates of investment ... and so on.

Yes, the labour market is tight and wages are rising. But as long as productivity is rising in line with wage increases, then overall labour cost trends should not pose a problem for inflation. If that sounds a bit like economic nirvana, well, it pretty much is. As they say in the beer commercials, "It doesn't get any better than this." It also means that Fed Chairman Alan Greenspan may go down as the luckiest central banker in the history of the universe.
 

Hard Landing or No Landing?

Unfortunately, when the Fed is in a tightening mood and the economy is too strong, a few bad breaks on the inflation or economic data can easily lead to a hard landing. Although it now looks as if OPEC will try to keep oil prices from rising further, gasoline inventories are low and oil politics are fickle. Therefore, another burst of inflation emanating from the fuel pump cannot be ruled out, especially if global growth fails to slow as expected.

As we have discussed before, the dollar is another potentially important wild card now that the U.S. is running a massive trade and current account deficit of more than $400 billion at an annual rate. So far, the U.S. has had no problem financing its external deficit, especially since foreigners have been aggressive about investing there. However, such investment flows are notoriously changeable. Financial markets in the past have shown a tendency to ignore trade deficits for long periods, until something triggers a collective mood swing to a situation where the deficit is all that matters.

There is no set rule of thumb that dictates how large a trade deficit a nation can run before foreigners effectively pull the plug and stop financing the nation's growth. And in present circumstances, much depends on the economic conditions of overseas economics like that of Japan, where investment opportunities at home have been quite limited. But many, if not most, policymakers believe that the U.S. has gotten itself into an increasingly risky situation by relying so heavily on foreign money to finance its growth.

Whether it is right or wrong, that view may make some at the Fed more willing than usual to err on the side of tight money to cool off the economy and to dampen the country's enormous appetite for imports. Put differently, that means the Fed may respond to any bad news on inflation more aggressively than they would if the trade balance was not seen as a problem.

Even though we think a soft landing is the most likely scenario for the U.S. economy, we would not minimize the risks of a hard landing, which we currently put at 20-30%. These risks are high enough that we still maintain relatively defensive positions in our global equity and balanced funds. And we would not be surprised if the next 12 months or so turns out to be one of the most challenging periods for investors since the late 1980s.

Perhaps the best evidence that risks have risen is the volatility of the market itself. As we have discussed in recent reports, the day-to-day swings of technology stocks have become extraordinary by any historical measure, with recent readings exceeded only by the stock market gyrations of 1987. Even the broad market - as represented by the S&P 500 index - has recently experienced more daily swings of more than 2% than any year since 1938.

We have focused primarily on the question of whether the economy and financial markets are facing a soft landing or a hard landing. There is, of course, yet another scenario: no landing at all. That is, despite the Fed's best efforts, the economy keeps booming away with growth of nearly 5% and - miraculously - inflation either remains subdued or declines further. That would imply that a new era of productivity has indeed arrived, and would likely result in explosive gains in equity markets, especially if inflation declines enough for interest rates to be cut.

What odds should be put on the "no landing" scenario? We suspect that most conventional analysts, especially Fed officials, would say that the odds of this scenario are slim to none. After analysing the growth and inflation numbers from recent quarters, some might add that Slim just left town. As long-time technology optimists, we would put the odds much higher - say at 10 to 20%.

The bottom line? Be optimistic, but don't bet the farm just yet on a productivity miracle. Despite the impressive speed of the technology boom, there are still large swaths of the economy where productivity improvements will be incremental at best. Think of all the restaurants, construction sites, and retail sales establishments whose business practices today differ little from 10 years ago.

One final caveat regarding investor expectations: they remain sky-high. As we noted above, the economic outlook is basically good, albeit with some significant risk factors. In contrast, analysts' expectations for profit growth are extreme, at a time when the Fed is determined to slow the economy materially. As seen on the nearby chart, analysts are projecting growth in corporate profits of over 17% per year over the next five years, which is basically unprecedented.

From this perspective, even a picture-perfect "soft landing" from the Fed's point of view could initially be challenging for the equity market if the slowdown in growth generates significant earnings disappointments. This is especially likely if the Fed is content to keep interest rates high for an extended period of time, even if it has stopped tightening monetary policy. As some investment sage once said, "You pay a high price for a cheery consensus" - and the current consensus remains decidedly cheery.
 

Imagine

And now for something completely different. Despite our concern about the recent blip in inflation and the bad taste of the Fed's castor oil, we have long argued that the technology revolution gives great hope for a low-inflation environment to persist for a long period of time.

Consider the following quote from Sheik Yamani, the former Saudi Arabian oil minister who was once known in financial circles as "Yamani or Your Life."

"The price [of oil] will stay high for the moment because of the high demand. But down the road, as you call it, I have no illusion: I am positive there will be, sometime in the future, a crash in the price of oil. ... Fuel cell cars are coming before the end of the decade and will cut gasoline consumption by almost 100%."

Yamani's view has little bearing on the near-term supply-and-demand situation in the oil market, where gasoline inventories are very low. But it does suggest that long-term pressure on inflation from oil prices may be much less of a concern than many have feared.

Reinforcing Yamani's view are recent indications from General Motors that it hopes to achieve small-volume sales of its recently unveiled fuel cell prototype Zafira minivan in three years and to begin high-volume production (hundreds of thousands of vehicles) of fuel cell vehicles by 2010.

What's the lesson in this? The impact of the technology revolution is not going to be limited to the electronics industry - it will have far-reaching effects on the structure of the global economy.
 

Have a great summer!