Hamish McRae: Reasons to be cheerful amid gloom of new year forecasts

Not a very happy new year, is it? One of the characteristics of a bear market is that thoughtful and expensive people in the world of finance spend a lot of time thinking up reasons why the gloom is likely to continue. It is the mirror image of the bull market phenomenon of equally thoughtful and expensive people thinking up reasons why the boom would go on forever.

One house that did, however, stand a bit apart from the bull market psychosis was HSBC. It produced a memorable report, "Bubble Trouble", back in July 1999, that warned that the US was facing a financial bubble and that it would burst. It also warned of the danger of a US recession in 2001. Given the mood of the time it was extremely prescient and indeed brave. I wrote about it at the time, stuck a picture of its cartoon cover in the paper – and keep a copy on my desk now.

As a result of that, and other similar work, HSBC has earned the right to be listened to rather more seriously than most of its peers, and in particular those American investment banks that were puffing shares in public newsletters while rubbishing them in private e-mails. So what HSBC is saying now is a good starting point for any discussion amidst the present gloom. Has it gone bullish?

Er, no. Its latest commentary, "Investment Themes for 2003", identifies four themes that will drive markets – and they are mostly negative. They are the drag from high corporate debt, the danger that shares are not discounting enough risk, the need for dividends, and pension problems.

The first, I think, is really the key. The quicker the corporate sector copes with its debt burden the lower the risks that shares will have to discount and the greater the scope to increase dividends. And if share prices improve, then the problem of under-funded company pension plans becomes more manageable too.

During the boom, many companies ran up their debt, with the telecom companies in particular relying on debt to finance their investment. Much of that investment was wasted. In the telecom arena the waste is visible: fibre optic cables that will not be lit for years; third generation mobile phone licences that may never produce a decent return on the money spent. But there was also waste in other areas, in particular in takeovers where much of the cost was buying intangible assets like goodwill.

The graph on the left shows how, if you exclude the value of intangible assets (like those 3G licences), the debt to equity ratio of US and eurozone companies deteriorated sharply. UK debt has also risen but Japanese companies as a whole (not the "zombie" firms being kept alive by their bankers) have attacked their debts.

A high debt burden need not matter provided it can be serviced and it is clear that the central banks will keep interest rates down for the foreseeable future. You can see the long-term downward movement of interest rates in the middle graph. But that leads into a wider discussion as to whether monetary policy is effective in periods of very low inflation, even deflation.

The triumvirate of central bankers pictured above will presumably be very resistant to any significant rise in interest rates and there is clear scope for a further cut in rates in the eurozone. But there is a clear danger that cutting short-term interest rates does not give much help to the corporate sector as it has not, so far, made much of a dent in cutting longer-term borrowing costs.

In Japan, short-term rates have, in effect, been zero for the best part of a decade but deflation has meant that the real value of debt has not fallen – indeed it has risen.

The effectiveness or otherwise of low interest rates turns on three links. First, do lower short rates cut long-term rates? Second, do lower long-term rates on AAA debt feed through to lower rates for less credit-worthy borrowers? And third, this Japanese experience, might deflation undermine lower nominal interest rates by increasing the real burden of debts?

As far as the first is concerned, the answer so far is quite encouraging. Long rates have risen a bit in the last three or four months but given the burden on government debt markets from increased public sector deficits it would be pretty astounding if they hadn't. In any case long-term rates of around 5 per cent are fine given that inflation is still in the 2 per cent region: that is 3 per cent real rates, about right.

But real corporate borrowing costs have not fallen because of the widening spread between the yield on government debt and the yield on corporate debt. The right-hand graph shows how the cost of borrowing for decent companies (BBB is OK) has hardly changed in the UK and US over the past eight years and has actually risen in the eurozone.

That is money rates, which is the thing that matters if you are trying to roll over debt. If you look at real rates (ie allowing for inflation) US rates at 5.5 per cent are about the same as they have been for most of the past eight years, though in the first half of last year they were higher, reaching nearly 7 per cent. In the UK, at 4.5 per cent, they are a little lower than the average. But in the eurozone, at 4 per cent, they are higher than they were during the late 1990s, when they were around 3 per cent.

Of course, the eurozone real rates vary because of the different inflation experience. In Spain real rates would be only about 1 per cent, while in Germany, with its low inflation, they are 5 per cent.

What should one take away from all this? My own feeling is that all of us, as individuals as much as investors, will become increasingly concerned about debt burdens as we come to terms with the reality that inflation will not whittle away the real value of debt. From an investment point of view, companies that move swiftly to clear debt will be rewarded, while those that don't will be punished. (I suspect that many individuals who have heavy debts will have to do something about those too.)

The HSBC view is that, given these structural pressures, the outlook for global equities this year is dull. It thinks growth will slow in the US, that Japan will go back into recession and that Germany will be flat. But in this low growth, low inflation, low interest rate environment, bonds will do well.

For myself, I would accept the arguments HSBC sets out. But there seem to me to be two positive elements it has somewhat underplayed. One is the ability of companies to adjust. There is a huge rethinking of corporate strategy taking place in just about every large firm in the world. Managements have been bruised and punished and they are learning from that. As markets come to see that the corporate world is changing they will start to regain their confidence, at least in the companies that are getting things right. And that will show through in share prices, though maybe not until the back end of the year.

The second thing is the short attention span of markets. Just as they could not remain euphoric forever, so they find it hard to be glum for very long. This is indeed going to be a difficult year – no one would deny that – but unless deflation really takes hold, companies and markets will gradually realise that, well, they are still in business.