US investors may be riding for a fall
Sunday 12 November 1995
True, by Friday the mood of the markets had become a touch more sombre, with weaker bonds pulling down share prices. But it is an odd juxtaposition, is it not? If it were some small Latin American country that was in danger of defaulting, then US financial experts would be intoning about the dangers of losing credibility in the eyes of the bond market. But if it is the US, somehow this does not seem to matter very much.
Odd maybe, but interesting, for it says something about American investors' attitudes in general, and in particular about the great financial and economic self-confidence evident in the US at this time. This has, in a small way, been dented by the debt default threat. But while such a default would undoubtedly have a profound effect on foreign opinions of US finance, within the US the perspective is quite different. Indeed, since it is the ferocity of the budget tussle between the Republican majorities in both houses of Congress and the Democratic President that is leading to the threat of default, it is almost as though the threat is a sign of American's new fiscal probity, rather than the reverse. The Republicans will not approve an increase in the US debt ceiling until and unless the President accepts many of their tax and spending proposals. These on paper at least would lead to a balanced budget more quickly than the President's own proposals.
If the US does default, so this argument would run, there will be some market disruption, but the greater good will have been achieved by forcing the swifter path to a balanced budget. The US is in good shape otherwise: unlike virtually every country in the European Union, it would already qualify for the Maastricht convergence criteria. A balanced budget would be icing on the cake.
This sanguine view is probably justified, and in any case the default may be avoided. But in finance there is always the danger that brinkmanship will lead to unexpected consequences. On Friday, the markets did suddenly start to take on board these dangers.
The striking thing, though, talking to people on Wall Street is their confidence: confidence in the competitiveness of the US economy, confidence in its continued lowish inflation, confidence in the sustainability of the long expansion. This is reflected in consumption. Look at the left- hand graph. European consumers have enjoyed 18 months of 2 per cent increases in their spending, after a pretty miserable time before that. Japanese consumers are barely holding their spending steady. But Americans are sufficiently confident to push up their spending by 4 per cent month in, month out. As the headline in J P Morgan's World Financial Markets (which produced this graph) puts it: "Can't keep a healthy economy down."
This confidence is evident in share prices. Events such as the Dow's new "high" on Wednesday, or even the sustained strong performance of equities since the beginning of this year are less significant than the longer- term impact of the increased financial wealth of Americans over the past 10 years. Some work by the Montreal-based publication The Bank Credit Analyst shows this. Ten years ago, total financial assets of US households were about three times family income. Now it is nearly four times income. It is true that about half of those assets are tied up in pension funds, trusts or capital in small businesses and so are not available for spending. And naturally this wealth is far from evenly shared: the rich owners of these assets are not about to cash in their portfolios, or even spend the profits they have made. Still, wealth brings confidence, and the rise in share prices this year has added $1,500bn to the wealth of US families.
The result of this strong performance is to push share valuations to heady heights. The Montreal team has for many years calculated whether US shares are cheap or dear by historical standards, taking a mixture of valuations based on company profits, interest rates, and strength or otherwise of balance sheets. The latest results are shown in the graph on the right. On these calculations, share prices are in seriously dangerous territory. We are at the level just before the October 1987 crash, or the peaks in the bull markets of the 1960s. By comparison with the late 1970s, the overvaluation seems almost absurd.
So is the level of speculation. The BCA editors calculate a similar market therm- ometer to gauge this, and this is also at the top of the long- term range. Their conclusion follows from this. They believe the market "may continue to surprise on the upside" for a bear market usually is triggered by a tightening of monetary policy and there seems no early prospect of that. Nevertheless, they urge caution on investors as the risk/reward balance has deteriorated though the year, and they warn about "the high degree of speculation and complacency".
There, surely, is the nub. There is a fine line between complacency and confidence. Are Americans being foolishly complacent about both their economy and the level of share - and to some extent bond - prices? Or is the confidence justified by the cracking performance of an ever- surprising economy?
It is important to distinguish between economics and finance. There are plenty of cool, rational reasons for admiring the US economic performance of recent years, in particular its ability to create whole new software industries that the rest of the world has hardly begun to comprehend. (Much of this dominance is cultural and linguistic. A sad little item appeared in the US press last week about the efforts of European companies to try to develop the use of languages other than English on the Internet to try to counter the competitive advantage of the US in this regard.)
This economic performance is cited to justify the level of share prices and to some extent it does. But finance does not accurately track economics. If the US budgetary position is not at all bad by European standards, and there is some evidence that Americans may at last be starting to save more, the fact remains that the US is the world's largest debtor nation in the sense that its international debts are greater than its international assets. That position continues to deteriorate. The US needs a continued inflow of funds from abroad to sustain its present consumption, and to sustain that present level of share and bond prices. This imbalance between savings and investment continues to hold the dollar far below its purchasing power parity.
Looking ahead a week, there is the immediate danger of a default. Americans might be happy to take the long-term view that this was a bit of roughness on the path to a balanced budget, but foreign opinion might be far less trusting. The US still needs foreign savings.
In any case, the US equity market feels "toppy". I do not think we are seeing a financial mania, one of those grand splurges when everyone acknowledges that prices are absurd but while they keep rising no one wants to be left behind. But there is danger and disappointment ahead. If the market spins on upwards for a few more months then things really will look precarious. Great economy; but even great economies can become overvalued by enthusiastic investors who have forgotten the scent of a bear.
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