Market Advisory Features
U.S. Economy Grew at Slower Pace Than Expected
America’s False Profits
The American Economy: Bush's Jobs DeficitRealistic Rewards
The American Economy: Bush's Jobs Deficit
: The future's a Gas
The Bush Presidency
Pouring Oil on the Flames
The Oil Market : Pumping all they can?
The Future of Russian business
August 27, 2004
The adjustment in the annual gross domestic product rate — a rise of 2.8 percent, from the 3 percent first estimated a month ago — represented a sharp decrease from the 4.5 percent rise in the first three months of this year.
Consumers, whose spending accounts for about two-thirds of all economic activity, and a surge in imports, had a particularly strong impact on the slowdown.
Their spending, especially for food and clothing, the report said, increased at an annual rate of only 1.6 percent. This was the slowest pace since the second quarter of 2001, and down from a lively 4.1 percent growth rate in the first quarter of 2004.
The new estimate of consumer spending, however, marked a slight improvement from the 1 percent growth rate first estimated. Spending on big-ticket goods, such as cars and appliances, was flat in the second quarter, compared with a previously estimated decline.
Business spending on equipment and software, meanwhile, grew at a sizable 13.6 percent annual rate in the second quarter, better than previously estimated and up from an 8 percent growth rate in the first quarter.
Financial analysts had expected today's figures to be lower than
predicted — some had even forecast a growth of only 2.7 percent —
but the news will hardly provide any comfort for
The economy has been identified as perhaps the key issue with
voters, and Mr. Bush and his Democratic challenger,
Mr. Kerry's spokesman, Phil Singer, wasted no time in taking the offensive.
"The ink on George Bush's economic record is starting to dry," Mr. Singer said in a statement. "These G.D.P. numbers are the latest piece of evidence that George Bush is misleading Americans when he says that the economy has turned the corner. No matter what happens in the next two months, nothing will change the basic fact that George W. Bush is going to the be first president facing re-election with a net job loss record."
The net job loss since Mr. Bush took office in January 2001 is 1.1 million, according to the Bureau of Labor Statistics. But Mr. Bush points to a recent surge that the bureau says has added 1.5 million jobs since last August.
The growing trade deficit — it increased to $55.8 billion in June — was reflected in figures showing that imports climbed sharply in the second quarter, by 14.1 percent, compared with a rise of 10.6 percent in the first. Exports, on the other hand, rose 6.1 percent in the second quarter, compared with an increase of 7.3 percent in the first.
The director of global economic research at Credit Suisse First Boston, Kathleen Stephansen, said that "given that you have an upward revision in inventories, and to the extent producers were taken a bit by surprise by the slowdown in consumption," activity in the third quarter output might be potentially slowed, too.
Essentially, she said, "what this tells you" is that the slowdown is to some extent oil-price induced. Oil prices this month set a record at nearly $50 a barrel before beginning to decline.
America’s false profits
Aug 27th 2004
From The Economist Global Agenda
American firms are not as healthy as you might suppose
THERE are not many Wal-Marts in St James’s, the swanky part of London that The Economist calls home. Actually, there aren’t any. And it is our loss, for however grand, charming and quirky the shops, cheap they are not. Wal-Mart, in contrast, is nothing if not cheap, which is why this one chain alone accounts for 8% of all American retail sales. So it would be no exaggeration to say that when Wal-Mart says that its sales are sluggish, as it did on Monday August 23rd, you should take that as strong evidence that America’s indebted consumers are tightening their belts and the economy is having a rough spell. This will not be good news for corporate America if it continues. Might it be positively bad?
The very thought! American companies, as we all know, are money-making machines. Having gone through a bit of a rough patch post Enron, their chief executives are again being lauded as the titans they clearly are. Profits for those companies lucky enough to be included in the S&P 500 index increased by 20% or more in the second quarter. They have increased by over 20% for four quarters on the trot—only the fifth time they have managed this feat in 50 years. While markets have in general fallen this year, heady corporate profits have at least provided corporate-bond and equity markets with support at their current, still elevated, levels. Anyone who thinks that they will continue to do so might not want to read what follows.
The conventional view of corporate America is that it is in splendidly lean shape. Low interest rates and giddy profits have enabled firms to pay off debts and extend the maturity of those loans still outstanding, thus making them less vulnerable to rising interest rates. Indeed, the repair of their debt-heavy balance sheets was the main justification for the sharp contraction in the spreads of corporate bonds over Treasuries last year, and provided extra oomph to shares. Even though this process really only involved a transfer of debt from companies to individuals, who have borrowed mightily to spend and buy houses, even Buttonwood, ever the sceptic, was prepared to concede that it had taken place.
Too soon, perhaps—for evidence that corporate debt has fallen in the economy as a whole is scant. For one thing, you would have thought that companies paying off their debts at a rate of knots would have attracted a nod of approval from the credit-rating agencies. But the average rating of American firms from Moody’s, which crunched the numbers for The Economist, has actually fallen over the past three years, from the lowest investment-grade rating, Baa3, to Ba1, or junk. Small wonder, perhaps: CreditSights, an independent research firm, calculates that while companies have become a bit less leveraged recently, total debts for a sample of 175 firms are still almost 40% higher than they were in 1999. Measured as debt compared with market value, leverage has fallen. But this is almost entirely due to rising share prices, not falling debts.
Yet, in contrast, the average rating of financial firms has risen over the same period. According to the National Income and Product Accounts (NIPA), calculated by the Commerce Department’s Bureau of Economic Analysis, the nadir for financial firms’ profits came in 1994 (when the Federal Reserve last raised interest rates aggressively). In the first quarter of that tumultuous year, the profits of all of America’s financial firms fell to $82 billion at an annual rate. Since then they have soared, and by the first quarter of this year had risen to $356 billion at an annual rate—almost 40% of all profits and a quarter of total stockmarket capitalisation in America. (For comparison, they were 6% of stockmarket capitalisation in 1980.) But in a time of rising interest rates, you can’t help feeling that the best years for this sector are behind it. Indeed, the sector's annualised profits fell by $3.6 billion in the second quarter, according to figures released on Friday.
A collapse in financial-sector profits would leave something of a hole. Strip out financials, an unfair though illuminating exercise, and the S&P 500 would have put in a decidedly poor performance in recent years. From its peak in March 2000, the S&P excluding financials would have dropped by 50% by October 2002, its low. Since then it has risen, though it is still down by 30% from its peak.
The surprise, if any, is that it was so high before. According to the NIPA numbers, only in the first quarter of this year did the profits of non-financial firms exceed the record of 1997: $605 billion against $595 billion. For all the talk about the miraculous “new economy” of the late 1990s, the truth is that American firms’ profitability was dismal, presumably because any company that did not squander squillions of dollars on technology and shifting out of businesses that actually made money was shunned by investors. By the fourth quarter of 2001, annualised profits had dropped to $324 billion. Big companies, of course, could disguise some of this with accounting practices that were as surreal as the level of the stockmarket.
There is, of course, no denying that companies have been raking it in lately. But if they haven’t been paying off debt or investing (and investment has been lacklustre), what has happened to that money? According to the NIPA figures, an astonishing 90% of it has been paid to shareholders. In an era of low interest rates, investors presumably want money up front.
But in the absence of investment and with balance sheets still heavy with debt, jam today does not necessarily mean jam tomorrow. Companies lack pricing power. The cost of oil and other raw materials has been rising this year, but consumer-price inflation has remained subdued, suggesting that companies are finding it very hard to pass on higher costs to consumers. Now even the mighty Wal-Mart says that sales are slowing. To Buttonwood’s mind, this cocktail makes financial markets about as cheap as the goodies on offer in St James’s.
The future's a gas
Aug 26th 2004
From The Economist print edition
Why worry about high oil prices, when a boom in natural gas may be on the way?
EVEN as headlines scream about $50 a barrel oil, energy firms and their investors are becoming increasingly excited about its likeliest replacement: not wind nor wave nor solar power, but gas—or, to be precise, gas that is frozen and transported as liquefied natural gas (LNG). This is expected to become as ubiquitous and crucial to the global economy as petroleum is today. Scenario planners at Royal Dutch/Shell think that gas may surpass oil as the world's most important energy source by 2025.
While oil became increasingly important during the past century, for much of that period natural gas was seen as its ugly stepsister: burnt off or “stranded” when discovered by accident, and rarely sought after. Demand for gas has taken off in recent years, thanks chiefly to its greenness—it burns far cleaner than oil or coal, making it ideal for new power plants from California to China. And burning gas is much less carbon-intensive than burning coal—making it helpfully less easy to blame for global warming.
Until recently, the development of a global gas market has been hindered by one inconvenient fact. Gas is, by definition, gaseous at room temperature; oil is a liquid that can easily be transported. Gas traditionally needed elaborate systems of pipelines to get it from the wellhead to the customer. That meant it was typically used fairly close to where it was produced, shipped at great expense via pipeline—or, more often, simply wasted.
The rise of LNG promises to change that. Put simply, gas can be frozen into liquid form near its source, shipped to market in refrigerated tankers, warmed back into gaseous form on foreign shores and injected into the local pipeline system. Thanks to this technological advance, gas has the potential to be a fungible, global commodity like oil.
True, energy-poor countries such as Japan and South Korea have long relied on a rather clunky form of LNG. But soaring demand for gas has unleashed rapid innovation and investment that is driving down the capital cost of LNG. Tanker ships are getting bigger and more affordable. One-off project planning is giving way to economies of scale. Even so, shipping gas remains much more capital intensive than shipping oil. Building typical 5m tonne “trains” of LNG—which include liquefaction plants, tankers and regasification terminals—can cost $5 billion. Thus, as one senior gas executive puts it, “only a few firms can play in this game.” Still, leading executives now expect the energy industry to invest a massive $100 billion in expanding LNG over the next decade.
This expansion of LNG is being driven by America, the world's largest energy market. As demand for gas has taken off in recent years, North American supply has not kept pace, causing a spike in prices (see chart) that, last year, alarmed even Alan Greenspan, chairman of the Federal Reserve, America's central bank.
America's market is clearly ripe for imported gas. On one estimate, North America's now puny gas imports could soar over the next decade or so to be as large as today's entire global LNG market.
Yet already energy pundits in America are ringing alarm bells about rising gas imports. In particular, they point to three long-standing worries about oil that they now think may be true of gas, too: scarcity, ever-rising prices and oligopoly power.
It has become fashionable to claim that the world is running out of oil and gas. Several alarmist books have just been released, ranging from “The End of Oil” to “Out of Gas”, claiming that the hydrocarbon age is drawing to a close. To the doomsday crowd, the spike in natural gas prices is permanent, the result of scarcity.
From OPEC to OGEC?
This is not the first natural gas “crisis.” In the 1970s, fears of global gas scarcity led many governments to ban the use of gas in electricity generation. Price controls at the wellhead in America held back the development of new supplies. Yet, in fact, there was never a genuine shortage of gas, merely a disincentive for firms to find it. When America deregulated its gas markets in the 1980s, unleashing the incentive to discover and market gas, prices collapsed—and stayed low for more than a decade.
This time prices have soared because—with the exception of Alaska, which is distant from most consumers—North America is indeed running out of gas. Yet the rest of the world is awash in gas. The reason that this was not recognised sooner, says Joseph Naylor, who runs Chevron Texaco's gas efforts, is because “firms simply never looked for gas before.” As energy liberalisation gathers pace, from Spain to South Korea, argues BP's Anne Quinn, “fungible markets will attract supply.”
If scarcity is not a serious worry, what of ever-rising prices? Certainly, there are plenty of experts who expect prices to remain high for many years, even if rising supply pricks today's gas bubble eventually. That is because, with LNG capacity taking years to build, supply will rise slowly. Sara Banaszak of PFC Energy, a consultancy, says that “LNG cannot prick the price bubble in the next 6-8 years.”
Still, it will be surprising if LNG imports do not ultimately lower American gas prices below $5 per mBtu from today's over $6. LNG is usually profitable at $3.50 (BG, a British firm, says it is profitable at $2.50), so there is plenty of incentive to invest in capacity at today's prices—as long as local planning rules and safety fears do not stop LNG terminals being built.
What of the third comparison with oil: the threat that a new cartel will be established, a gas version of OPEC? Around three-quarters of the world's proven gas reserves are in the former Soviet Union and the Middle East. Amy Jaffe of Rice University worries that rising LNG imports may give Russia, the kingpin of gas reserves, huge market power from around 2020. Maybe. But there are several reasons not to expect an OGEC gas cartel.
What gives Saudi Arabia power over the oil markets is its massive investment in spare capacity, says David Victor of Stanford University. Indeed, the main reason oil prices are now surging beyond OPEC's control is that the Saudi buffer is precariously low. The capital expenditure needed to build spare LNG capacity is so much larger than that for oil that nobody with any sense will do this. Firms with control over local pipelines may well exercise some market power, argues Mr Victor, but a global gas cartel seems unlikely.
Moreover, gas reserves are in fact more widely dispersed and more abundant than oil reserves. That means that the potential troublemakers, from Iran to Russia, are not guaranteed to attract investment. Rather, Mr Victor and Ms Jaffe agree, western capital will probably flow to those countries with the most investor-friendly policies. That is why Trinidad is being developed as an LNG producer before its turbulent neighbour, Venezuela, and why Qatar is emerging as the Middle-Eastern Goliath of LNG even as massive gas reserves in investor-unfriendly Iran and Saudi Arabia remain largely untapped.
Despite the current optimism, the huge political and financial risks inherent in the LNG business mean that the boom is not yet certain to happen. The capital required is huge, the number of firms with deep enough pockets very small, and the memory of the earlier gas-price collapse induced by America's deregulation is fresh. As Malcolm Brinded of Shell puts it, “our hopes have been dashed before.”
Yet, at today's prices, the potential rewards are fabulous for those firms with the courage, capital and competence needed to complete LNG projects. As Mr Brinded himself concludes, “gas will be the fuel of choice for at least the first half of this century (and) flexible, long-distance supplies of LNG are the key.” Get ready for a $100 billion investment boom, the prelude to the “century of natural gas”.
The Bush presidency
Je ne regrette rien
Aug 26th 2004
From The Economist print edition
After a tumultuous first term, George Bush has much to be proud of—and much to reconsider
FOUR years ago, George Bush presented himself at the Republican convention in Philadelphia as a “compassionate conservative”. After the dramas and division of the Clinton years, the Texan dynast, backed by reliable old hands such as his running-mate, Dick Cheney, would provide a more modest, grown-up approach. Abroad, Mr Bush promised a humble but strong foreign policy. At home, there would be a big tax cut, affordable thanks to the large budget surplus—and, unusually for a Republican, Mr Bush talked a lot about social issues such as education. After two Republican conventions with the Christian right in full cry, he softened the party's stance on social issues at Philadelphia, and gave a hearing to homosexuals and minorities. This prospect of a moderate presidency was further advanced, or so it seemed, by the narrowness of his election victory: having won fewer votes overall than Al Gore, Mr Bush promised to be a president for all Americans.
Now Mr Bush approaches next week's convention in New York a very different figure. The “accidental presidency” has become a transformative one. The divisions within America are much greater than they were under Bill Clinton. Our YouGov poll this week shows that, although 86% of Republicans approve of what their president is doing, a mere 8% of Democrats do. Abroad, the “polarisation” is less evident only because so few Europeans are prepared to take the side of the smirking “Toxic Texan”. Those “safe hands” advertised at Philadelphia four years ago—men such as Mr Cheney and Donald Rumsfeld—are now more often cast as ideological revolutionaries, often fiendish ones.
There is exaggeration in this, and often crass anti-Americanism (more on that later). But the vitriol and adoration that Mr Bush inspires both stem in part from the policies he has chosen. It is not just a matter of waging the most controversial war since Vietnam and dramatically increasing the size of government. Name your subject, from education and health care to missile defence, AIDS policy, gay marriage, stem cells and civil rights, and this presidency has sought radical change.
Radicalism can be good—but Mr Bush's brand has turned a compassionate conservative into a contradictory one. What is conservative about allowing government to grow faster than under Mr Clinton? What is humble about announcing that you are trying to introduce democracy to the Middle East? Where is the compassion in his support for a federal ban on gay marriage, the limitations on stem-cell research or his other moves to accommodate the zealots of the Christian right?
In a race where Mr Kerry now seems to be the narrow favourite, the president is going to Madison Square Garden promising, in large part, more of the same. Yes, there will be an attempt to reach out to independent voters: moderates such as Arnold Schwarzenegger and Rudy Giuliani have been given prominent speaking slots. But Mr Bush is undaunted. His message is that America should stick with a man who faced hard choices and took the right decisions. Il ne regrette rien.
For this newspaper, that verdict looks mostly right for Mr Bush's foreign policy. The charge that he set off in a needlessly unilateralist direction on taking office is vastly overdone; he sought allies throughout; and in many ways his forthright style was a breath of fresh air after the muddle and evasions of the Clinton era. Yes, he dropped out of the Kyoto Protocol in a tactless way; but that was a bad treaty which America was never going to accept in any case (the Senate voted against it by a margin of 95-0). Mr Bush upset many people by ripping apart the outdated anti-ballistic-missile defence treaty with Russia—then baffled his critics by getting both Russia and (more hesitantly) China to go along with him.
But it was the thunderbolt of September 11th that counted most. Those atrocities set the course for the remainder of his presidency. Since then, we continue to think that Mr Bush has got the big foreign-policy decisions right. He understood the nature of the war that had been declared against America and the western world. He made it clear that it is not a war between civilisations, let alone religions; but he has also served notice to Arab regimes of the need to change. He rightly decided to destroy al-Qaeda's home in Afghanistan—and, yes, on the evidence that presented itself at the time, he rightly decided to invade Iraq.
Could France be mistaken?
Many of these decisions were bound to be unpopular with his allies. That does not make them wrong. Nor does it justify the anti-Americanism that many politicians have recklessly tried to stir up, particularly over Iraq. Some Bush-bashing foreign governments seem to hope that Mr Kerry will adopt a different set of priorities. Tellingly, he has stuck pretty close to Mr Bush.
To be sure, the president has got some things wrong in foreign policy. He did not outright lie about Iraq's supposed weapons of mass destruction, but he misled the country about what was known and not known. His administration exaggerated the case for invading Iraq in another way too, by falsely linking Saddam Hussein to al-Qaeda. Elsewhere, his failures have mainly been errors of execution.
He called for the establishment of a Palestinian state, but did little to support it. In Iraq, he destroyed a dangerous and odious tyrant, but lamentably failed to prepare for rebuilding the country after fighting what was, whatever Mr Bush says, a war of choice. And, in a conflict where hearts and minds count for so much and where America's reputation has been so badly wounded, the president was unwilling to acknowledge the gravity of the abuses at Abu Ghraib. That calamity warranted the resignation of Mr Rumsfeld. (The fact that a commission this week cleared him of direct responsibility for the torture is beside the point. He was the man in charge.)
Effective execution is partly a matter of experience. There are signs, including in Iraq, that the Bush administration has learned from its mistakes. The Economist's bigger disagreements with Mr Bush lie beyond the war on terror, in areas where Mr Bush's very aims are questionable or worse.
This president, despite impassioned avowals to the contrary, has been no champion of open international markets. He caved in to protectionist pressures and imposed tariffs on steel; he also signed an absurdly bad farm bill. His fiscal policy is nothing to boast about either. Here Mr Bush can plead with some justification that, as with foreign policy, he was ambushed by events: yes, he inherited a Clintonian budget surplus, but he also had to deal with the burst Clintonian bubble. A big swing into deficit was needed, he would argue, to avoid a much worse recession. Up to a point, Mr President. Unfortunately, the Bush deficits are not temporary. They stretch into the distance: the ten-year deficit is projected at $2.7 trillion, even after a lot of dodgy accounting. He cut taxes in the best conservative tradition, but spent vastly more as well. Mr Bush is a conservative who believes in big government.
This failure to curb public spending is all the more alarming because the next president will have to prepare America for the retirement of the huge baby-boomer generation. Four years ago, Mr Bush talked, albeit tentatively, about partly privatising the pensions system; almost nothing has been done. And he has made the fiscal burden of entitlement worse by increasing the prescription-drug benefit in the Medicare system—again without undertaking meaningful reform.
The other problem is social policy. The American conservative movement has always been a marriage between “western” anti-governmentalism and “southern” moralism. Four years ago, Mr Bush made no secret of his own religious beliefs, but he gave the impression he would hold the often intolerant religious right in check. Instead, he has given it a big role in his administration on a host of issues. No doubt Mr Bush's convictions are sincere; but they were not to the fore in 2000 and they are not shared by many of those who supported him then, nor by this newspaper.
Tumultuous though it has been, and despite the passions it arouses, Mr Bush's first term should in the end be judged in the same measured way as most previous ones. It is a mixed bag: successes and failures must be set beside each other. And deciding whether Mr Bush deserves a second term calls for more than an appraisal of his own record: the American people will have to judge whether Mr Kerry, another mixture of good and bad, represents a better choice. At his convention in Boston, Mr Kerry made an effort to cast the Democratic Party in a new light. Mr Bush needs to attempt something similar in New York. More of the same just will not do.
Aug 19th 2004
From The Economist print edition
The return on equities over the next decade is likely to be much lower than most investors expect
AFTER rebounding strongly in 2003, America's S&P 500, the benchmark index for American stockmarkets, has fallen by 8% since its high earlier this year. America's battle-hardened investors seem to think of this as little more than a flesh wound. Surveys suggest that they still expect average annual returns from equities of at least 10% over the next decade; many, indeed, have based their retirement plans on this assumption. Alas, they are likely to be severely disappointed.
That might seem strange. After all, these expectations are far lower than at the peak of the bubble in 2000, after five wild years had delivered annual average returns of 25% and investors expected more of the same. They also look fairly conservative compared with the annual return of 13% that stocks delivered during the 45 years to 1995, before the bubble inflated. However, a study by Martin Barnes, an economist at the Bank Credit Analyst, a Canadian research firm, concludes that, at best, the average return over the next ten years is likely to be half that over the past half century.
His sobering forecast is based on two assumptions, both very reasonable. The first is that, because of lower inflation, company profits are unlikely to rise by more than 5% a year over the next decade, a bit slower than the average of 7% a year over the past 50 years. In the long run, profits tend to grow in line with GDP, and America's nominal GDP is thought likely to grow by around 5% a year over the next decade (3% real growth plus 2% inflation). Although profits have outpaced GDP over the past couple of years, this is unlikely to continue because pre-tax profit margins are nearly at their highest in 35 years. And since firms now operate in a world of greater competition, profit margins are, if anything, more likely to fall than to rise.
Mr Barnes's second assumption is that there is little scope for a sustained rise in the valuation of shares. The S&P 500 is currently trading at around 18 times historic operating profits. That is far below its ratio of almost 30 at the peak of the bubble, but still higher than its 50-year average of 15. Mr Barnes's “optimistic” scenario assumes that the p/e ratio stays flat over the next decade as a whole and the S&P 500 rises in line with profit growth of 5% a year. Adding in dividends, this would give an average annual return of 6.7%. That implies an average real return of only 4.7%, compared with almost 10% in the half century to 2000. However, history suggests that there is a risk that the p/e ratio could fall over the next decade. In an alternative scenario, Mr Barnes assumes that the p/e ratio reverts to its historic average of 15. If so, the annual return would be a measly 4.7%.
Investors have become used to much higher returns than the range of 4.7-6.7% suggested as likely by Mr Barnes because their expectations are still coloured by the 18% average annual return of the bull market from 1982 to 2000. But those two decades of falling inflation and falling interest rates provided an exceptional, probably unique, boost to equities. The present era of low and stable inflation is good for economic growth. It is unlikely to be good, however, for financial markets or, indeed, those that rely on them for their living.
Lower equity returns have serious implications for financial-services firms and consumers. The bloated financial sector will need to go on a diet. Two decades of above-average returns from shares and bonds (thanks also to falling inflation), and hence a big increase in the public's appetite for investing in shares, caused a huge expansion in the financial-services industry. Employment in the financial sector and its share of GDP more than doubled between the early 1980s and 2000 and have fallen only slightly since. More extraordinary still has been the surge in the financial sector's share of total stockmarket capitalisation, from 6% in 1980 to 23% this year.
Lower financial returns will mean slower growth in commissions and investment-management fees. Over the past two decades, as markets have been liberalised, financial firms have relied less on commissions and more on trading revenues. But these will be harder to come by in a world of low returns. That is why many banks are now gearing up their returns with more borrowed money. But when this latest strategy comes unstuck because of the greater volatility which the strategy itself will eventually cause in financial markets, banks and fund managers will be under pressure to shrink.
Far more worrying, of course, is what lower returns mean for consumers. Underfunded pension schemes hoping for another bull market in shares to fill the gap are likely to be severely disappointed. And because companies' profits will be squeezed as employers are thus forced to make bigger contributions to pension funds, the death knell for defined-benefit pension schemes cannot be that far off.
Partly for the same reason, those that rely on their own investments are unlikely to fare better. Anybody who has based retirement plans on the assumption that equities will do as well in the future as they have done in the past is in trouble. Big gains in share prices boosted household wealth and caused a large drop in saving over the past two decades. Why save much if booming shares did the job for you? Since this particular get-rich-quick scheme lost some of its allure after 2000, households have shifted their affections to property, the price of which has taken over where stockmarkets left off. Surveys suggest that home-buyers also expect double-digit returns over the next decade. Alas, this is very unlikely: house prices in many cities are already at record highs compared with incomes and rents.
If actual returns on assets turn out much lower than expected, households will be forced to save more and spend less to meet their retirement goals. Mr Barnes hopes that household saving will rise gradually over several years. This would present only a gradual headwind to economic growth. The risk, of course, is that saving rises much more quickly.
Pouring oil on the flames
Aug 20th 2004
From The Economist Global Agenda
How would financial markets react if the oil price stays stubbornly high?
AFTER a long and acrimonious dispute with his insurance company, Buttonwood is pleased to report that his Fiat Punto is no longer being carted off to the great garage in the sky. Your columnist has previously been scathing about the Punto’s attractions, the lack of which was brought home to him recently when a friend lent him a much racier car (thank you, Juliet). But he now realises that, for all its many failings, not least that it seems to be as robust as a Coke can, the Punto has one big advantage: it doesn’t use much petrol.
Which is just as well, really, given the rising prices of oil and petrol over the past few years. In recent months they have been climbing very fast indeed, and on Friday August 20th the price of West Texas Intermediate, the American benchmark crude, reached yet another new high of around $49 a barrel. A bubble, many have said. Buttonwood is not so sure. There are good reasons to suppose that the world will have to get used to a high oil price for a good many years yet. Why might this be so? And what might it mean for the price of financial assets?
OPEC, the oil producers’ cartel, has put the blame for the rising oil price largely on speculative excess. According to this argument, large purchases by hedge funds, those free-wheeling pariahs of international finance, have been responsible for pushing up the price—witness the growth in speculative positions on the New York Mercantile Exchange. When the hedge funds cut and run, the argument goes, the oil price will fall. If this line of thinking had any merit to start with, it would seem to have been somewhat undermined in recent weeks by the fact that the price has continued to rise even as those positions have been reduced.
In any case, long-term consumers clearly do not believe that the oil price will fall much. When the spot price (ie, for immediate delivery) has soared in the past, the forward price (for delivery in the future) has barely budged, because consumers expected the price to fall again: in October 2000, when the spot price reached $38, the forward price stayed at $20. This time, the forward price has climbed sharply too: the price of oil for delivery in ten years’ time has reached $35 a barrel.
Perhaps buyers are willing to pay this apparently heady price because it is, it transpires, not so elevated after all. Since January 2000, the average price of oil has been about $30, points out Jeffrey Currie, head of commodity research at Goldman Sachs. The only time in that period that it has fallen below that price for any length of time was immediately after the terrorist attacks on September 11th 2001.
An unexpected increase in demand from a growing world economy, in particular from China, has helped push the oil price up. So have growing worries about supply. The world still relies heavily on exports from Saudi Arabia, an unpleasant, apparently unstable country in a region where things are bad and getting worse. Alas for oil consumers, the Middle East does not have a monopoly on instability: from Russia to Venezuela, fate has decided to hide oil under some pretty unsavoury countries. The oil price has climbed further of late as the troubles of these two countries in particular have bubbled to the surface.
But these supply worries reflect deeper problems of under-investment, argues Mr Currie. There has been no growth in pumping and refining capacity since the 1970s; all the growth in output of the past three decades has come from squeezing more oil out of existing fields. Last year, growth in demand outstripped growth in refining capacity by 15:1. The rise in the oil price is both a reflection of past under-investment and, of course, a spur to future investment. It will, however, need oil to stay above $30 a barrel for several years to solve these supply problems.
What a high and rising oil price might mean for the world economy is the subject of much debate among economists. The sanguine point out that the price is still considerably lower in real terms than it was when it hit giddy heights in the 1970s. And rich countries are, moreover, less dependent on the stuff than they used to be. However, the more nervous, Buttonwood among them, worry about the situation in America. An increase in gasoline prices acts as a tax. And this sharply higher tax is being forced through just as interest rates are rising and fiscal policy is being tightened.
American households are already stretched, with debt-service costs at record levels. It should therefore come as little surprise that the economy is showing signs of weakness. The message from the Treasury-bond market, which tends to thrive on slow growth and low interest rates, is not a heartening one: yields are little higher than they were at the beginning of last year. Weaker growth might, of course, translate into weaker demand and thus lower oil prices, at least briefly. But clearly that point has not yet arrived. And governments and companies will probably take advantage of any drop in the oil price to build up stocks, thereby putting upward pressure on the price.
Splitting the tab
The big question for financial markets is: who will pay the tax that a higher oil price represents? Clearly, America as a whole will fork out in some way because it is a net importer of oil, and the effects of the rise in the oil price are greater there because gasoline is taxed so lightly and oil is denominated in dollars, a currency that shows every sign of weakening further. It is, of course, a moot point whether it will be mainly consumers or companies who pick up the tab. In the 1970s the tax was paid for largely by consumers in the form of inflation, which ate away at the worth of any investment with fixed returns. But this time inflation is muted, for now at least: consumer prices actually fell in July. This may be because, with the world economy now so interconnected, companies find it hard to push up prices.
If consumers do not pick up the full tab, companies will have to pick up some of it through lower margins. There is plenty of room for them to do so because profits are at record highs. Falling profits are unlikely to be anything but baleful for a stockmarket that is generously valued and under pressure from rising interest rates. Any industry heavily exposed to a high oil price and falling consumption would not seem the most toothsome of investments. Possibly, then, car companies and (especially) airlines might best be taken off the menu. Shares in both have already lost around 20% of their value this year, compared with a fall of some 4% in the S&P 500. Given how it treats its customers, shares in Buttonwood’s insurance company might best be avoided too.
Aug 18th 2004
From The Economist Global Agenda
As the American consumer tires, can shoppers in Europe, Japan and China take up the burden?
CAPITALISM is all about getting and spending. In America, where household debts amount to about 115% of disposable income, capitalism is often about spending rather more than you are getting. In recent months, however, American consumers have appeared uncharacteristically hesitant: their spending fell by 0.7% in June and their confidence ebbed last month, according to the University of Michigan's latest survey.
But as Americans acquire new inhibitions about spending, the French are shedding some of theirs. Their spending on manufactured goods surged by 4.2% in June (the biggest leap since the mid-1990s) and their saving rate dropped from 15.8% for the whole of last year to just 15.2% in the first quarter of this year. The French state, famous for intervening on behalf of its favoured companies, has recently stepped in on the side of shoppers. Nicolas Sarkozy, France’s finance minister, has arm-twisted supermarkets into cutting their prices, and part of the interest on consumer loans is now tax-deductible. In the French republic, thrift is now a vice, borrowing a virtue.
Partly as a result, French capitalism, for one brief moment, looks sprightlier than the American variety. According to figures released on Thursday August 12th, French GDP grew by an annual rate of about 3.2% in the second quarter. America grew by just 3% over the same period. France’s performance was not matched by other members of the euro area, however. In Germany, which grew by an annual 2% last quarter, household spending has been flat for a year or more; Italy is slowing; Dutch output actually shrank. The euro area as a whole grew by 2%, slower than in the first quarter. The long-awaited European recovery may have peaked before anyone really noticed it had arrived.
Japan’s recovery, of course, has been much more noteworthy. But it too may have peaked. According to figures released on Friday, the world’s second-largest economy grew at an annual rate of just 1.7% in the second quarter, after posting growth of 6.6% in the first. The yen value of Japan’s output actually fell, thanks to falling prices.
Again, Japan’s consumers may be partly to blame. Their spending, which grew by 4.2% (at an annualised pace) in the first quarter, slowed to 2.5% in the second. But the numbers are apt to mislead, says Richard Jerram of Macquarie Bank. The Japanese authorities have great difficulty stripping out the effect of deflation on their measures of output. As a result, official GDP figures probably overstate growth in the first quarter and understate it in the second. Other indicators are not much better. The household spending report, which expects households to track how much they spend on each of 21 varieties of fish, is simply too onerous and intrusive to be accurate, Mr Jerram says.
However unreliable, the numbers cannot obscure the most important question hanging over Japan’s recovery: can it survive China’s slowdown? Last year, China accounted for almost 80% of Japan’s export growth. But China is overheating—not only in economic terms but quite literally too. The China Meteorological Administration last week warned that temperatures could reach 40ºC in the southern coastal areas. Fans, air conditioners and industrial coolers are putting an intolerable burden on China’s power generators, inflicting blackouts on homes and stoppages on factories. Volkswagen has shut down plants in Shanghai twice in the past month.
Meanwhile, the inflationary dragon has returned. China’s consumer prices, which fell for much of 2002, rose by 5.3% in the year to July. The figures, released last Thursday, will revive troubling memories of a decade ago, when an unsustainable investment boom pushed inflation past 20%. In the spring, the People’s Bank of China said it would raise interest rates if inflation exceeded 5%. That limit has now been breached for two months in a row, and real interest rates, taking into account rising prices, are near zero. Nonetheless, the central bank has stayed its hand. It seems resigned to inflation rising through the third quarter, hoping it will ebb thereafter.
Should the government do more to slay inflation? Perhaps not. Higher food prices, the result of poor harvests, account for much of the inflationary pressure. According to Capital Economics, a consultancy, the best remedy for inflation may be more effective use of agricultural land, not higher interest rates.
For most of its short life, Chinese capitalism has been all about getting and investing. The Chinese invested over $660 billion in fixed assets last year, dotting the country with industrial parks, steel mills and office towers. Qu Hongbin, an economist at HSBC, reckons that about $200 billion-worth of this investment is surplus to requirements. Thus the task for the Chinese authorities is not to restrain the economy so much as to rebalance it, away from investment towards consumption.
To a certain extent, this shift is already taking place. Growth in investment in fixed assets slowed a bit in the first half of this year—though figures released this week showed an acceleration in July. Meanwhile, retail sales have been strong. As J.P. Morgan reports, the disposable income of city-dwellers is accelerating, and income per head in rural China is growing at its fastest pace for seven years.
Still, the authorities may be asking rather a lot of the Chinese consumer. Investment accounted for well over 40% of GDP last year. If such an important yet volatile component of Chinese demand were to collapse, could consumption ever compensate? Even if it could, Mr Qu argues, this would be cold comfort for Japan or for any other economy dependent on exports to the Middle Kingdom. What China buys from the rest of the world, after all, are commodities and machinery, not consumer trifles. If its growth were to shift from investment to consumption, its demand for the rest of the world’s products would slump, even if its growth did not slow that much.
The Chinese invest too much, Americans save too little and the Europeans, especially the Germans, could stand to spend more. The fate of the world economy in the year to come depends a lot on how these imbalances are resolved.
Pumping all they can?
Aug 6th 2004
From The Economist Global Agenda
As the oil price rose to a new high of more than $44 a barrel this week, amid concerns about supply, OPEC’s president said the cartel was unable to pump more oil and thus bring down the price. He later contradicted these comments, but observers remain sceptical about OPEC's ability to turn on more taps
ANYONE who expected that the invasion and occupation of Iraq would lead to a sharp decline in the price of oil has been sorely disappointed. Instead of falling, the price has risen sharply, and this week West Texas crude rose above $44 a barrel for the first time since New York’s Nymex exchange started trading oil 21 years ago.
Not only has Iraq’s oil industry, hampered by creaking infrastructure and sabotage, been unable to pump anything like its potential capacity, but supply elsewhere is under pressure too. Last week, it appeared that Yukos, Russia’s biggest oil producer, might be forced to stop production, as part of its ongoing battle with the country’s tax authorities. That fear proved unfounded, but it still appears that some in the Kremlin are bent on destroying Yukos, and oil traders remain nervous.
They are also worried by the apparent impotence of the Organisation of the Petroleum Exporting Countries (OPEC). On Tuesday August 3rd, Purnomo Yusgiantoro, president of OPEC and Indonesia’s oil minister, stunned observers by saying that the cartel would be unable to pump any more oil to alleviate the pressure on prices. “The oil price is very high, it’s crazy,” he said, adding that “there is no additional supply.”
However, he contradicted that statement the next day (most likely after coming under pressure from Saudi Arabia, the leading member of OPEC), claiming that the cartel has around 1m to 1.5m barrels per day (bpd) of spare capacity that it could tap immediately. This, combined with a surprise increase in American gasoline stocks and news that Russian bailiffs would allow Yukos access to its bank accounts to pay workers, helped bring the oil price down by around a dollar. But the price bounced back to a new high on Friday after hardliners in the Russian administration overruled the bailiffs. General scepticism about OPEC's ability to pump any more oil has also put upward pressure on the price.
Like the oil market, the money markets are fretting that the high price could hurt the world economy. Mr Yusgiantoro’s comments sparked a sell-off on America’s stockmarkets, which were already worrying about America’s flagging economic performance—GDP growth slowed to a lower-than-expected 3% in the second quarter, on an annual basis. Alan Greenspan, chairman of the Federal Reserve, has said the high oil price is partly to blame for weakening consumer spending, which fell by 0.7% in June. Dresdner Kleinwort Wasserstein, an investment bank, reckons that half a percentage point could be knocked off American growth in 2006, and 0.7 added to the inflation rate, if oil remains above $40 a barrel.
OPEC’s power has been on the wane since the oil crises of the 1970s, when the cartel was able to triple prices almost overnight by restricting supply to western consumers. Since then, industrialised economies have reduced their dependence on oil, but it is still a crucial commodity, and OPEC still accounts for around 40% of world oil production. Moreover, Saudi Arabia alone accounts for a quarter of the world’s proven oil reserves. It has been able to influence prices simply by turning its taps on and off.
Until recently it was OPEC’s ability to turn the taps off that was in doubt. Members tended to exceed the production quotas set at the cartel’s regular meetings, in the hope that other members, especially Saudi Arabia, would keep to their limits, and thus support the price. The incentive to cheat grew even stronger as non-OPEC suppliers, especially Russia, grew in importance. (Russia’s output has increased by 2m bpd every year for the past three years.) OPEC’s current production of around 30m bpd (including Iraq) is well above its official quota of 26m bpd.
But now it is OPEC’s ability to open the taps further that is in doubt—and at a time when the antics of Russian prosecutors are also raising questions about supply from that country. OPEC’s spare capacity is now thought to be 1-2% of global demand, well under the 4% that is thought necessary in order to influence prices. That gap cannot be closed quickly, since the oil-production business has long lead times and any new oil will take a couple of years at least to come on stream. In his comments on Tuesday, Mr Yusgiantoro hinted that that went for Saudi Arabia as well as the rest of OPEC.
Saudi production in July was 9.25m bpd, well above its 8.45m quota, but below its 10.5m official capacity. Following Mr Yusgiantoro’s comments, Saudi officials insisted they could indeed raise output quickly. Saudi Arabia claims that it has opened two new production plants, at Abu Safah and Qatif, three months ahead of schedule. While these are meant to replace production from older facilities, not to add new output, it is understood that the Saudis are now planning to delay the retirement of older fields in order to help ease the oil price.
In addition to OPEC’s attempts to increase supply, the International Energy Agency also expects non-members to boost output by a combined 1.2m bpd over the coming year, of which around half will be from the former Soviet Union. But that figure is hostage to events in Russia. At 1.7m bpd (more than is pumped from all of Libya’s wells), Yukos’s output makes up 2% of global oil production and thus has a noticeable effect on the price. With Russian officials now attempting to sell the company’s prize subsidiary, Yukanskneftegaz, oil traders are likely to remain jittery.
Another factor adding to nerves in the market is the alert about more attacks from al-Qaeda, issued by America’s homeland-security chief last week. This came as a stark reminder of the dangers facing America (the world’s largest oil consumer) and the instability in the Middle East (home of much of the world’s oil reserves). With this uncertainty likely to continue, OPEC likely to keep brushing up against its capacity limits, and Yukos certain to remain under fire, the world may just have to get used to oil of $40 or more a barrel.
Bush's jobs deficit
Aug 6th 2004
From The Economist Global Agenda
According to the latest figures, American companies added far fewer workers to their payrolls last month than economists had forecast. This comes a week after the equally unexpected news that growth slowed significantly in the second quarter. How worried should George Bush be?
AMERICANS have fallen prey to a variety of economic anxieties in the past year—some real, some imagined. First, they fretted that growth was not translating into jobs, then that growth might spill over into inflation, and most recently that growth itself could no longer be taken for granted. The American economy expanded by 4.5% in the first quarter of this year, by a shade over 4% in the final quarter of 2003, and by 7.4% in the quarter before that (all at annualised rates). But figures released late last month showed that growth slowed unexpectedly in the second quarter of this year, to just 3%. And now, a week later, Americans are back to worrying about jobs. According to the latest monthly figures, published on Friday August 6th, American companies added 32,000 workers to their payrolls in July, far short of the 200,000-plus that economists had been expecting.
These figures will add to fears that the employment outlook is darkening. Despite three months of strong job creation between March and May, hiring ebbed in June and the proportion of Americans participating in the labour market remains pretty weak by historical standards. Moreover, if the past few months are a guide, the actual number of jobs created in July may be even lower than the figure released this week: also on Friday, the Labour Department revised its job-growth numbers for May and June down by a combined 61,000.
None of this will please President George Bush as he battles for re-election in November. He will no doubt try to shift attention away from the job numbers' failure to meet expectations, and towards the 1.5m jobs that have been created in 11 straight months of employment growth (as well as the latest unemployment figure: the rate fell in July, from 5.6% to 5.5%). However, as his opponents are so keen to point out, a net 1.1m jobs have been lost since he took office, and there is no chance of reversing that loss before the election. Furthermore, the fall in unemployment might have as much to do with the low participation rate as with job creation.
Another worry for the president is weaker spending. One of the abiding motifs of America’s recovery so far has been the “indefatigable consumer”. But the American consumer is now looking as tired as the cliché. According to figures released on Tuesday, consumer spending fell by 0.7% in June. The Federal Reserve’s recent anecdotal report on the American economy, the so-called “beige book”, paints a greying picture: Chicago is doing well, but New York, Cleveland, Richmond, Kansas City and San Francisco show evidence of a slowdown, albeit modest.
It is becoming increasingly apparent that the gains from America’s productivity-led recovery have been unevenly distributed. Corporate profits are strong, and business investment leapt by almost 9% in the spring. But pay has lagged behind, and the wages of production workers have stagnated. Of course, through its tax cuts, the White House has done its best to provide what employers will not—a substantial boost to take-home pay. But the effects of those tax cuts are beginning to fade, just as prices at American petrol pumps rise.
What consumers do not earn, or receive back from their government, they must borrow. Household debts grew by more than 10% in the first quarter, and now add up to more than 115% of disposable income. HSBC, a bank, says that the recovery is built on “marshlands of debt”. With interest rates now rising, this ready source of spending power may be about to dry up. Indeed, the beige book reports that borrowing by homebuyers declined in San Francisco and New York, two of the hottest property markets in the country.
According to Alan Greenspan, the chairman of the Fed, the American economy has trespassed on to a “soft patch”. All recoveries go through them from time to time, he says, and this one should prove short-lived. He may well be right. But if the soft patch turns out to be something a bit marshier, the recovery’s foundations may not be as secure as many had thought.
The future of Russian
Aug 5th 2004 | MOSCOW
From The Economist print edition
What the assault on Yukos means for Russian business, politics and power
“IT FEELS like we're being toyed with—like a baby seal being batted back and forth by killer whales.” Thus one Yukos employee describes the sensation inside the company that was once the alpha whale of the Russian oil industry, but is now gasping to stay afloat under a barrage of legal assaults. This week, while it became clearer that the firm could keep on pumping oil, less happily the tax ministry began looking for tax evasion in 2002 and 2003, to add to the nearly $7 billion it wants in back taxes for the previous two years. Last week prosecutors charged Leonid Nevzlin, one of Yukos's main shareholders, who now lives in Israel, with conspiracy to murder.
Foreign-investment analysts are feeling pretty seasick too. Since the attack on Yukos and its then boss, Mikhail Khodorkovsky, began over a year ago, many have assumed that the goal was to punish him for his political influence-peddling, and probably to separate him from Yukos, but to leave the firm undamaged and in private hands. Harsh on him, perhaps, but not bad for the economy, and not—as native Russian observers were more wont to say—an asset-grab by Kremlin cronies. Yet recent announcements hint at a new plan: to break Yukos up and sell it off at artificially low prices, with the main production subsidiary, Yuganskneftegaz, perhaps going to the state oil firm, Rosneft (whose new chairman, Igor Sechin, is one of President Vladimir Putin's closest aides). If that happens, says a gloomy Al Breach of Brunswick UBS, usually one of the most upbeat foreign analysts, “it would be hard not to conclude that the Kremlin's key motivations are personal power and wealth”.
Yet the end for Yukos has not yet come and may not for a while. Bailiffs last week seemed to backtrack by giving Yukos another month to pay its $3.4 billion tax bill for 2000. This still seems impossible. But the move allows room for negotiations that are rumoured, yet again, to be on. Yet such talks will only decide what, if anything, Yukos's owners will get for the firm, and how long Mr Khodorkovsky and his business partner, Platon Lebedev, must sit in jail for alleged fraud and tax evasion. And the delay could just be to allow the more important, far murkier negotiations in the Kremlin over who gets the spoils.
Presidents and precedents
Mr Putin may well have hoped for a quicker, quieter and tidier solution. But his aloofness (except for an occasional soothing but empty statement) as the battle with Yukos escalated has taught investors two things about him that they hoped were not true. One is that he would rather unleash full-blown market panic than back down and lose face. The other—not yet proved, but increasingly suspected—is that he is willing to allow some renationalisation. This raises big questions. Are other firms safe? What is the state's future role in the economy to be? And who will benefit?
In the big picture, who owns Yukos may matter little. Indeed, says Yakov Pappe of the Russian Academy of Sciences's Institute of Economic Forecasting, nationalising Yukos—if it were done right—would correct a mistake made during the privatisations of the 1990s. Rosneft was intended to be one of a few big oil firms, but ended up as one of the smallest of many.
There have been signs for months, says Chris Weafer at Alfa Bank, that the state wants a bigger role in oil. Russia is the world's biggest oil producer and second-biggest exporter, after Saudi Arabia. Yukos alone pumps 2% of world output, more than Libya. When it threatened to stop pumping last week, claiming that a court had ordered it to, it helped to push up world oil prices to their current highs (see article). Nationalising Yukos would give Russia the strategic leverage in oil that it enjoys in gas, which the state-controlled monopoly Gazprom sells to nearly all of Russia's neighbours and most of Europe.
Whether the assets of Yukos go to Rosneft, a Kremlin-friendly private firm such as Surgutneftegaz, or a proposed new oil subsidiary of Gazprom, may now be the focus of Kremlin infighting. Rosneft is already pulling its weight, in partnership with foreign firms, exploring for deposits off Sakhalin island in the far east. Similar joint ventures may be ordered to explore the untapped reserves of Eastern Siberia.
But private firms, hitherto lazy about exploration, may also be encouraged by the Kremlin to take up the burden, says Alexei Mukhin, of the Centre for Political Information, a think-tank. Given Yukos's fate, they will respond quickly to that encouragement. Firms in other sectors, too, will pay more heed to official wishes. Thus, says Mr Mukhin, the Kremlin is ushering in a form of “state capitalism”.
When Mr Putin came to power, many predicted that he would replace the “oligarchs”, the business cabal that had formed around his predecessor, Boris Yeltsin, with his own men. Vladimir Gusinsky and Boris Berezovsky, two media moguls who got in his way, had to go into exile, and several other businessmen capitulated after prosecution threats. Mr Khodorkovsky was part of another potentially troublesome group, says Mr Mukhin, that included Roman Abramovich, an oil man and now English-football tycoon, and Oleg Deripaska, an aluminium baron. “The way is now open for Deripaska to be next—though that does not mean it is going to happen,” says Mr Mukhin.
But Mr Putin, it seems, did not declaw one set of monsters only to create another set. People originally tipped to be future Putingarchs—such as two bankers, Vladimir Kogan and Sergei Pugachev—have continued to prosper, but have not become billionaires, nor won government posts. Those officials with suspected business ties are smaller fry; and the most notable ones, Leonid Reiman, the communications minister, and Mikhail Lesin, the former press minister and now presidential adviser, even predate Mr Putin.
There are incipient potential oligarchs, such as Alexei Mordashov of Severstal, a steel firm, one of whose former executives is now minister of transport. But the main new power-brokers, says Mr Mukhin, are not oligarchs but “overseers”: people such as Rosneft's Mr Sechin, his Kremlin boss, Dmitry Medvedev (on the board of Gazprom) and other advisers to Mr Putin with control over state firms.
The fear is that although, unlike the oligarchs, these men are theoretically beholden to Mr Putin, the opposite may prove true. “Without counterweights and a separation of power, Putin may end up under the influence of the people around him, always consulting him and telling him he is the master of everything,” says Yevgeny Yasin, head of the Higher School of Economics. These bureaucrats, he says, are “people who believe that their job is defending the state's interests and that business is a bunch of thieves.”
Yevgenia Albats, a journalist and political scientist who specialises in the siloviki, the former members of the security services who make up Mr Putin's inner circle, concurs: “The problem is not that the state is taking control, but that the silovik culture is taking control.” Many of Mr Putin's allies, she says, are second-rate ex-KGB officers with no business skills who now have positions of power, “a government of the mediocre”. And, says Olga Kryshtanovskaya, a sociologist, their influence in smaller, private firms and through lobby groups in parliament is growing too.
With such a group on top, Russia faces continued conflicts between the bureaucracy and big business, fought out through a biased judicial system. That has “depleted trust between business and the state,” says Mr Yasin, and will encourage local politicians and officials to use the same methods, delaying the creation of the rule of law still further. And as with the oligarchs in the 1990s, the risk is that the (private) interests of the overseers and those of economic policymaking will become hopelessly entangled. The difference is that, with government an increasingly hermetic place, it will be harder than ever to tell the two apart.
Jul 30th 2004
From The Economist Global Agenda
The oil price has hit a 21-year high thanks to a bout of nerves about supply from Yukos, Russia’s biggest oil producer. While much of the recent price rise has been due to strong demand, supply is so stretched that it would take little disruption to send the price higher still
THE curious, high-stakes poker game that is the investigation of Yukos, Russia’s biggest oil producer, appeared to have reached a climax this week. On Wednesday July 28th, Steven Theede, the company’s chief executive, said that a freezing of its assets by bailiffs seeking to enforce a 99 billion rouble ($3.4 billion) tax demand could be interpreted as meaning it must stop selling oil. Alarmed at the prospect that Yukos’s output of 1.7m barrels per day (bpd) could be taken off the market, traders pushed the price of West Texas crude up to more than $43 a barrel that day. The price fell back the next day, after a court official denied this interpretation of the asset freeze. However, the fight is still on: the court is still trying to sell Yukos’s most valuable business, Yukanskneftegaz, which is by any estimate worth several times the value of the disputed tax bill. The continued concern about Yukos, set against the backdrop of an oil industry working close to full capacity, sent prices to $43.15 on Friday, the highest level since the Nymex exchange in New York started trading crude 21 years ago.
The erratic behaviour of the Russian prosecutors, and the amazing, though plausible, idea that they might close down Yukos’s production, served to illustrate just how important Russian oil has become. Yukos alone produces 2% of the world’s output, and more than all the wells in Libya. A couple of years ago OPEC, the cartel of oil-exporting countries, was annoyed with Russia, which is not a member, for increasing production while the cartel tried to support the price through production quotas. But with demand booming and supply constrained, the world, and even OPEC, is now grateful for Russian production—it has become the second-biggest exporting nation, after Saudi Arabia. As output from oilfields in places like North America and the North Sea has declined, production from Russia and other former Soviet countries has shot up, by 2.5 billion bpd since 2001. This has helped to meet new demand from oil-thirsty China and other countries.
But suppliers are still struggling to meet worldwide demand. OPEC, which is largely made up of Middle Eastern countries, is under intense pressure to increase production, in order to bring the oil price closer to its official price band of $22-28 for a basket of crudes (which typically trade a few dollars below the West Texas benchmark). In particular, Saudi Arabia (OPEC’s swing producer) has seen its relationship with America (the world’s biggest oil consumer) come under strain, especially since the latest price spike has come in the pre-election driving season. But there is little OPEC can do to relieve the pressure: it is already operating within 5% of capacity. There are even rumours that Saudi Arabia’s state oil company is experiencing production difficulties, suggestions the kingdom strenuously denies.
At these production levels, then, there is little room for any supply disruption. But the unhappy truth about oil is that it is produced in some of the nastiest, least stable places in the world. Iraq is a case in point. Production at its oilfields has apparently risen to 2.4m bpd, much of which is being exported. However, there is a lot of scepticism about just how reliable Iraqi production and exports will be, given the state of unrest in the country. (Currently, exports are coming only from its southern fields because of sabotage in the north.) Production in Venezuela and Nigeria is running close to normal, but both countries have seen disruption over the past couple of years thanks to strikes (over Hugo Chávez’s rule in Venezuela, and work conditions in Nigeria). And a terrorist attack in the port of Khobar in May, which killed 22 workers, showed that even Saudi Arabia is vulnerable.
If the oil price remains above $40, what would it mean for the world economy? Despite the fact that the price is at a two-decade high, the real price (adjusted for inflation) is around half of the level in the early 1980s. Moreover, since the two oil-price shocks of the 1970s, western countries have reduced their dependence on the black stuff.
Still, if oil remained above $40, there would be an impact. Dresdner Kleinwort Wasserstein (DKW), an investment bank, reckons that 0.5 percentage points could be knocked off American growth and 0.7 points added to American inflation in 2006. The effect on Japan, which relies almost entirely on imported oil, would be even greater: it could see its GDP growth reduced by a full percentage point, according to DKW.
But the biggest impact of a high oil price could be on the American voter. Petrol is lightly taxed in America, and so its drivers feel the force of any price rise more than those in other rich countries. If the price climbs much further, they may even be angered enough to vote in a new president.
Jul 15th 2004
The rush into hedge funds is pushing down returns
A GENTLE stroll around St James's, the nice part of London in which The Economist is based, and Mayfair, a little to the north-west, reveals to those with an eye for such things the changing face of the world's financial-services industry. Almost every doorway, it seems, has a clutch of brass nameplates which, apart from the occasional word “capital”, reveal little about the occupation of those within.
In fact, though much of the money managed by hedge funds is in America, St James's is the international capital of the industry: within a short walk of our offices are at least 100 such funds. And the sums they manage are growing at a giddy pace—too giddy, say some.
You can see what they are driving at. Brevan Howard, a fund that was set up last year in London's docklands, moved to St James's this year. It has $4.6 billion under management, according to Hedge Fund Intelligence, a research firm. William von Mueffling, who ran a clutch of funds at Lazard, set up on his own last year. His fund, Cantillon Capital, has already attracted $4 billion. But perhaps the most dramatic grower has been Vega, based in New York and Madrid, which had $2 billion under management at the beginning of last year. It now has $12 billion.
Depending on whose figures you believe, there are 6,000-8,000 hedge funds around the world, which together manage $1 trillion or so. In the first quarter of this year, some $38 billion flowed into hedge funds, according to Tremont TASS, a research firm—over half of the total for the whole of last year. Small wonder that hedge funds, hitherto lightly regulated, should be attracting the attentions of financial-industry watchdogs (see article). Yet hedge funds still control less than 2% of all investible assets.
It used to be that most of this money came directly from rich people. Now much of it comes via private banks, which these days advise clients to invest in hedge funds as a matter of course. Increasingly, however, a lot of the money comes from pension funds and insurance companies, which once viewed hedge funds with the utmost suspicion, but after the dismal stockmarket of 2000-02, cannot now invest quickly enough. Mickey St Aldwyn of International Fund Marketing, a hedge-fund marketing company, reckons that such is the weight and momentum of institutional money flowing into the market, hedge funds will be managing a colossal $3 trillion within three years.
But therein lies a problem. Traders flock to set up hedge funds because they can earn a lot: typically, funds charge a 1% management fee and 20% of profits. Good, or at least popular, managers can charge what they like. Renaissance Technologies charges a 5% management fee and takes 35% of the profits. SAC takes no fee but half the profits. But whether investors should fork out such sums is debatable: the large amounts pouring into hedge funds are driving down the returns that attracted that money in the first place.
Chat to just about any hedge-fund manager and he (few are women) will at some point talk of “alpha”—the extra return that active fund managers claim to earn above the market rate. The trouble is, as one manager says, “It is not a victimless crime. To make money, you have to make it from someone else.” The losers have mostly been traditional, slow institutions. “To make money you need a lot of them willing to lose 1% a year from indolence,” he says. And institutions are starting to stir.
Most hedge-fund strategies are broadly market-neutral. That is, rather than bet on a market moving one way or the other, they play the difference—arbitrage, in the argot—between markets or individual securities. Thus they buy a cheap share and sell an expensive one; or they anticipate the effect of news on the prices of an array of companies. The need for speed helps explain why hedge funds pay up to one-third of all stockbroking commissions, and account for 10-30% of trading on the London stockmarket, depending on the day.
Such strategies might make money when there are few players and lots of inefficiencies, but they are much less lucrative when there are many funds doing the same thing. Now that there are, for example, some 600 hedge funds specialising in credit (loans and corporate bonds), the inefficiencies on which they feed are much reduced, leaving the managers scratching around for other strategies or taking more risk. Generally, this means leveraging returns by borrowing more.
Nor are hedge funds the only ones pursuing these strategies. If hedge funds look like banks' trading operations, that is because they are indeed all but identical: many hedge funds started life when a bank's traders decided that they could make more working for themselves than punting the bank's capital. And lately, banks have decided that trading is such a wonderful business that they have devoted even more capital to it.
For many trading strategies, however, there is a limit to the amount of money that can be moved around cheaply and briskly. While punting large amounts on the highly liquid foreign-exchange or government-bond markets is easy, betting on illiquid corporate bonds or shares is far harder. And the larger the amounts, the more expensive the bets are.
It is for this reason that many of the oldest and best-known hedge funds will not accept any new money. Some have even been handing capital back to investors. Vega itself had told some in the industry that it did not want to grow above $2 billion, though it now clearly has more confidence in its abilities.
Whether this is justified remains to be seen. Performance in general seems to be deteriorating. In the late 1990s, says Mr St Aldwyn, no one would touch a fund that did not claim to be able to make 15% a year. Now investors seem happy with a promise of high single-digit returns.
Even this seems beyond many. In the first six months of this year, most funds were flat or slightly positive: the CSFB/Tremont investible hedge-fund index is up a touch over 1% so far this year. April and May were two of the worst months for years. Many in the industry find that disturbing, given that almost nothing nasty happened in the markets. “It's all doomed in one way or another,” says one hedge-fund manager. From alpha to omega in a few short years?
Jul 13th 2004
Stockmarkets look set to follow corporate profits down. Technology
stocks are already showing the way
Earnings season is under way in the United States, and the proximate cause of the latest tech tumble was a series of dour pronouncements from the industry’s great and good. Veritas, a software company, was the worst-performing of the world’s big stocks last week, but many in the sector that used to be known as TMT (technology, media and telecoms) have announced results that have disappointed investors. Even some of those who have yet to post their results have been treated harshly: Intel and a clutch of others fell after Merrill Lynch downgraded the entire semiconductor sector. Nasdaq, home to many a tech favourite (and soon to be home to Google, much to the chagrin of the New York Stock Exchange) has fallen by 5% in recent days.
This may be because the shares in the index were priced at levels that would have made Icarus wince. Even after this latest tumble, the price-to-earnings (p/e) ratio on Nasdaq is around 60, a level that could be justified only if you thought that profits would continue to climb at a vertiginous rate. The question, of course, given that the broader stockmarket is scarcely a giveaway—the S&P 500 trades at a p/e ratio of about 21, far above its historic average—is whether the treatment meted out to tech stocks foreshadows something nasty for the stockmarket as a whole.
Corporate America, you might have noticed, is fantastically profitable. Indeed, pre-tax profits are at their highest for 38 years, says Mark Precious, a global strategist at UBS, and after-tax profits at their highest for 50 years. And they are likely to have grown by a fifth or more in the second quarter, which is only the fifth time in the past 50 years that profits have grown that much for that long, according to Mike Thompson of Thomson Financial. While nobody thinks that profits are likely to carry on growing at that rate—in the latest survey of fund managers by Merrill Lynch, only 2% thought that the rate of profits growth would increase—there is a school of thought that says as long as they carry on growing at all, the stockmarket will follow suit. Buttonwood went to a different school.
The historical evidence, it should be admitted, is mixed. On two of the previous occasions when profits had risen this fast for this long, stocks rose thereafter; and on two they fell. There are many reasons to plump for a less rosy outcome this time round, however. The first is that shares are expensive. High p/e multiples are perhaps justifiable when profits are depressed, but much less so when they are frothy. As your columnist has said before, when things can’t get any better they won’t. As a percentage of national income, corporate profits are already at record highs, and will, in the none-too-distant future, have to cope with, inter alia, tightening fiscal policy, tightening monetary policy, strong oil prices, the scrapping of corporate tax breaks, slowing demand (on which, more later) and quite possibly less pricing power.
For elucidation on this last, intriguing thought, David Bowers, a strategist at Merrill Lynch, suggests turning to something that Buttonwood spends less time looking at than perhaps he should: America’s inventory-to-shipment (I-S) ratio. This, says Mr Bowers, is at an all-time low, largely due to a very rapid growth in sales. But it is set to rise. When it has done so in the past, he writes, “bonds have been a ‘buy’, earnings growth has been scarcer, industrial pricing power weaker, and high-yield credit spreads wider. Ignore this indicator at your peril.”
Suitably admonished, Buttonwood read on. Shipments, it turns out, have been rising exponentially. And when things are flying out of the factory door at such speeds, factories stock up. Inventories, says Mr Bowers, could end the year 6-8% higher than they started it. Which would be fine if shipments followed suit. They are unlikely to do so because exponential growth is simply not sustainable. When final demand starts to weaken, the I-S ratio will rise, dramatically weakening corporate pricing power and (one assumes) profits.
Which is where we get back to technology. Inventories have already started to rise sharply at Intel (by 29% year-on-year in the first quarter), Texas Instruments (30%) and Cisco (47%). Possibly, this is a foretaste of a broader problem, for America relies on demand from consumers who have, to be frank, consumed to the max and done so with borrowed money. In the 13 quarters from 2000, household debt surged by $2.5 trillion, writes Kurt Richebächer, an extreme bear (perhaps, then, a polar bear?). Of late, for the first time in history, consumption growth has exceeded growth in GDP. Against such a backdrop of tiny household savings and huge debts, the Federal Reserve has started raising interest rates. Small wonder, perhaps, that although consumers say they are confident, they are starting to rein in their spending. Car companies and retailers are already suffering as a result. At some point, so will the stockmarket.
Keep an eye on it
Jul 8th 2004
From The Economist print edition
After a buoyant start to the year, the dollar seems headed for a tumble
THERE was a time, not long ago, when economists and those who dabble in the foreign-exchange market could find scarcely a good thing to say about the dollar. Last year, John Snow, America's treasury secretary, even managed to transform his country's long-standing strong-dollar policy into a weak-dollar one. All this greatly irritated Europeans, especially; as the euro rose, international meetings of the great and the good were dominated by cross discussions about the beleaguered buck. Newspapers, including this one, were full of gloomy headlines suggesting that the greenback would, indeed should, fall farther.
So it did, for a while: by early January, the dollar was worth a quarter less, in trade-weighted terms, than it had been two years before. But when everyone is betting that a market will go one way, it often goes the other. By mid-May, the dollar had risen by 8%, bucked up, as it were, by the Bank of Japan, which bought ¥14.8 trillion ($138 billion) of foreign exchange in the first quarter, almost all of it dollars, in comfortably the largest-ever act of intervention by a central bank. Then, quietly, the dollar started to drop. By July 6th, it had fallen by 4.3% from its high. Not surprisingly, perhaps: the dollar's prospects look even worse now than they did last year.
The dollar's recent decline may seem puzzling, for it began while expectations were mounting that the Federal Reserve was about to put up interest rates. The decline has continued since those expectations were confirmed on June 30th. Rising interest rates, you might have thought, would halt any such decline.
That is true only up to a point. As the American economy brought forth jobs in the spring, and the markets started to expect that the Fed would increase rates sooner rather than later, the dollar was boosted. A prime reason was that traders who had previously borrowed greenbacks in order to exchange them for other, higher-yielding currencies now needed to buy them back in a hurry. Lately, however, softer economic data have sown the idea that the Fed might not have to raise rates so far and fast after all. That has done the dollar no favours in recent days.
In the longer term, though, higher interest rates may be a curse for the dollar, not a blessing. To see why, look at that large and growing thing that goes under the name of America's current-account deficit. A country's current-account essentially comprises two things: the trade balance and net income from foreign investments. America runs a trade deficit that in April amounted to $48.3 billion, up from $46.6 billion in March. This alone implies an annual deficit pushing $600 billion, or 6% of GDP. The current-account deficit would be greater still if America did not make more money on its investments abroad than foreigners earn in the United States.
That it makes a profit is odd, because it has net foreign liabilities (ie, the value of Americans' assets abroad is less than that of foreign claims on America). According to the Department of Commerce's Bureau of Economic Analysis, net liabilities amounted to 24% of GDP last year. America has an investment-income surplus because yields are much lower at home than abroad. All things equal, says Goldman Sachs, a yield of 6% on ten-year Treasuries would add 1% of GDP to the current-account deficit within a few years.
Economists fret about America's current-account deficit because it is a measure both of America's ability (or inability) to save and its attractiveness to foreign investors. The country's heady growth of recent years has relied on foreigners' willingness to invest there: Americans, in effect, spend other people's money. That need not matter when the sums are small, but it does when they are large and getting larger. Most economists believe that at some point the dollar will need to get cheaper, maybe much cheaper, to encourage foreigners to finance the deficit. That point may be at hand.
There are two weighty pieces of evidence to support this view. The first is that America started this latest recovery much deeper in hock to the rest of the world than it did previous ones, says John Llewellyn, the chief economist at Lehman Brothers. As the chart shows, America has usually started to pull out of recession with its current account roughly in balance. This time, it began with a deficit of 3.2% of GDP. Because growth tends to increase the deficit—America has sucked in imports and borrowed more—the deficit has widened. “I can easily imagine it going to 7% and beyond,” says Mr Llewellyn.
The second piece of evidence comes from investors' behaviour. Some say that the deficit is not a problem, but simply reflects foreigners' boundless desire to invest in a vibrant economy. This may have been true once, but not any more. Net foreign direct investment (FDI) was negative, to the tune of $155 billion, in the past 12 months, says Goldman Sachs. This ought to be no surprise: in the first quarter returns on FDI in America were 5.5%, while those on FDI abroad were 11.7%.
In recent years, the current-account deficit has instead been financed by (less stable) portfolio flows into stocks and bonds. In the past year, three-quarters of such investment in America has gone into bonds. The biggest buyers have been Asian central banks, trying to keep their currencies from rising too swiftly against the dollar (or maintaining a fixed rate, in China) and parking the money in Treasuries.
But this intervention has had a cost: inflation. Because the central banks bought the dollars with newly minted local currency, inflationary pressures have risen throughout Asia. This is fine for Japan, which has deflation, but not for its neighbours. Intervention thus seems to have stopped; even Japan turned off the tap in March. The central banks might, of course, wade back in if their currencies rose too much. But given the risk of inflation, it would be brave to bet on this. And if they do not buy the buck, who will?
Emerging markets, emerging risks
Jul 6th 2004
From The Economist Global Agenda
Investors are once again buying emerging-market debt. A perilous punt, if ever there was one
SOME things in life are not just surprising but truly astonishing. The enduring popularity of Cliff Richard is one. Greece winning the Euro 2004 football competition is another. But Buttonwood had another of those I-can’t-believe-what-I’m-seeing moments on Monday morning when idly perusing a piece of research by Credit Suisse First Boston (CSFB). Bonds issued by Bulgaria and Romania, according to a chart in the report, have rallied so fast in recent months that they now yield scarcely a percentage point over the rate at which the healthiest western banks lend to one another, also known as the swap rate.
In a spirit of honesty, Buttonwood confesses to not having known that these two countries issued international bonds, let alone that such things were written about in serious terms by investment bankers. Well, that is his loss, for bonds issued by both countries have performed wonderfully this past year. Spreads over swaps have halved. After wobbling in April, along with just about every other emerging market, Bulgarian bonds have soared to dizzy heights, and the folk at CSFB expect more of the same. Investors, it seems, are convinced that the prospect of both countries joining the European Union in 2007, remote though it is, makes them as rock-solid a credit as you could wish for. Clearly, emerging markets are once again in vogue, and investors’ appetite for risk is back—and about as selective as it was before, which is to say not very. Emerging-market debt has now recouped about half the losses it suffered in recent months. But do not expect it to recoup the rest; if anything, the outlook has worsened even as the price of emerging bonds has risen.
Events in Russia should remind investors that the rule of law is something to be taken lightly in some emerging markets, which is, of course, a big reason why they have not emerged. With oil again pushing $40 a barrel, the government seems intent on pushing Yukos, which produces a fifth of the country’s oil, into bankruptcy. More than a little unnerved that the government, via the tax authorities and the courts, is able to do this, investors have been voting with their feet, and the price of Russian assets of all sorts has fallen sharply.
This even goes for government debt, which you might have expected to benefit, given that the state’s coffers stand to be swollen by all the tax money that Yukos and other big Russian oil companies will be forced to pay. Moreover, along with Mexico, Venezuela and Ecuador, Russia has been a big beneficiary of a surging oil price. Its public finances have improved out of all recognition. Russia had a fiscal surplus of 245 billion roubles ($8.4 billion) in the first half of this year, or about 3.4% of GDP. With the other oil exporters, its external debts have fallen in recent years. By the end of 2003, they amounted to $146 billion, or 36% of GDP, compared with foreign debts of 55% of GDP at the end of 1993.
If the shenanigans about Yukos were not bad enough, two weeks ago the German government announced that it would flog up to €5 billion ($6.1 billion) of loans it had made to Russia, which may tell you something about how cheap the German finance ministry, for one, thinks Russian debt is. Bond investors were unenthused by the prospect of all this extra paper flooding the market, and the price of Russian bonds fell sharply. An understandable reaction, perhaps: Russia has some $50 billion of bilateral debt outstanding, and more of this might now be sold because selling loans is a splendid way for cash-strapped governments like Germany’s to raise money without adding to their debts. Investment bankers will no doubt be hawking similar schemes to any rich country with budget problems.
There are lots of these, and they lend lots of money to poor countries with even bigger budget problems. CreditSights, an independent research firm, reckons that the 18 biggest emerging-market countries have about $208 billion in outstanding bilateral loans, which might be parcelled up and sold—about the same amount as the par value of the Merrill Lynch emerging-market bond index. While only a small fraction of these loans are likely to be sold, and even then only slowly, the prospect of this unexpected extra supply is unlikely to make bond investors anything other than nervous.
But perhaps not as nervous as the countries that owe the money. The debts of the 18 big emerging economies looked at by CreditSights had risen by $545 billion between the end of 1993 and the end of last year. Only two countries—Thailand and Venezuela—saw their nominal foreign debts fall. Russia is in the lucky position of having relatively low debts and a big current-account surplus. Turkey isn’t: it runs a huge current-account deficit. And even those countries that run modest surpluses still have masses of debts that must be refinanced in coming months. Brazil has that problem in spades.
And that problem, says Christian Stracke, a strategist at CreditSights, is made doubly, well, problematic because rich countries have current-account deficits to finance too. The biggest of them all, of course, is America, whose quarterly deficit has risen from $30 billion in 1994 to a staggering $140 billion. Of course, one country’s deficit is another country’s surplus, but for the first time since 1994 emerging economies will have to compete for savings with an America where interest rates, both short- and long-term, are rising.
Emerging economies that depend heavily on the whims of foreign investors to keep themselves afloat will find it very tough to compete, which is why emerging debt underperforms when rates rise—however expected that might be. Turkey has a huge current-account deficit, $147 billion of foreign debt, an external-debt-to-GDP ratio of 65%, and lots of borrowing to do this year. It looks anything but a solid credit. But at least its foreign debt pays about three-and-a-half percentage points more in yield than Romania’s.
The Greenspan putt
Jul 2nd 2004
From The Economist Global Agenda
America’s Federal Reserve has raised interest rates for the first time in over four years. A steady stream of further rises in the cost of borrowing is now likely—unless America’s high-spending, heavily-indebted households suddenly retreat
NOT so long ago, the Federal Reserve was anxious to cloak itself in secrecy and shroud itself in “monetary mystique,” as Marvin Goodfriend, an American economist, has put it. When, in 1975, the Fed was petitioned to make its actions and deliberations public, it went so far as to defend its right to secrecy in court. To pierce this mystique, the world had to rely instead on legions of “Fed-watchers”, who would claim to decipher the central bank’s motives and account for its actions, rather like the Kremlinologists who, in those days, pondered over the minutest signs of activity in the monolithic Soviet regime.
But over the past year, the Fed has embarked on its own kind of glasnost. The Fed-watchers, like the Kremlinologists before them, are becoming obsolete, as the Fed becomes only too happy to talk about itself. Last August, it revealed that it would do nothing for a “considerable period”. In January, it told us it would be “patient”; and in May, “measured”. Between times, the Fed’s chairman, Alan Greenspan, and his deputies, such as Ben Bernanke, have been busy explaining the Fed’s thinking and weighing its options before Congress, businessmen, market traders—just about anyone who would listen. Thus, when the Fed finally raised interest rates by a quarter point on Wednesday, June 30th—its first move for a year and its first rate increase since May 2000—no one was much surprised. It was only doing what it had all but said it was going to do.
In truth, the end of cheap money began almost three months ago, when Wednesday’s decision was first anticipated. The Fed had made clear that it would raise rates from emergency lows as soon as the recovery of American economic output translated into convincing gains in employment. The buoyant job figures for March, released on April 2nd, were the evidence that the markets knew the Fed was awaiting. Yields on Treasuries rose almost immediately, as traders priced in future rate-rises. Corporate-bond yields and mortgage rates, not to mention spreads on emerging-market debt, soon followed suit. As Mr Bernanke pointed out in a recent speech, “For practical purposes, therefore, monetary conditions tightened significantly the day of the March employment report.”
Much tightening remains to be done—real interest rates are still negative—but the Fed likes to move step-by-step. The last bout of rate-raising, which began in June 1999, took 11 months, and six steps. Mr Bernanke has likened the Fed’s “gradualist” approach to that of a golfer not quite sure of his putter. Each stroke is a bit of an experiment, revealing something about the club, as well as getting the ball closer to the hole. Better, then, to make a series of tentative, “lagged” putts, rather than risk sending the ball past the cup with one over-confident stroke. Certainly, the markets think Wednesday’s putt is the first of many. The Fed has four meetings left this year, and, according to the prices of futures contracts, it will probably raise rates at every one of them, bringing the Fed-funds rate up to 2.25% by the end of the year. By the end of 2005, rates could hit 4%.
The Fed’s task is actually harder than Mr Bernanke’s golfing analogy allows. Not only are policy-makers unsure about the precise impact their instrument—the Fed-funds rate—will have, they are also uncertain about what they are aiming for. To preserve price stability, the Fed must let the economy fulfil, but not stretch, its potential. But the economy’s “potential” output is not something the Fed can observe. Donald Kohn, a Fed governor, believes the economy is still falling short of it by “an appreciable—albeit diminishing—margin”.
Strong hiring in the spring—over 300,000 workers on average were added to the payrolls each month between March and May—slowed in June, when, according to figures released on Friday, only 112,000 jobs were created. Furthermore, rates of participation in the labour force remain curiously low—at just 66%, compared with their peak in 2000 of 67.3%. The presence of these “discouraged workers” encourages Mr Kohn to believe that the current unemployment rate of 5.6% understates how far America still has to go before its workforce is fully occupied.
The labour market is improving, the Fed noted in the statement that accompanied its decision on Wednesday. But even if labour costs begin to rise, Fed officials argue that companies will trim their unusually fat profit margins before they will raise their prices. Mr Greenspan recently remarked that inflationary pressures were not likely to be a “serious concern” in the near future.
This inflationary outlook seems a little dovish. Growth is strong, commodity supplies are stretched, and consumer prices have begun to accelerate, rising by 3.1% in the year to May, after an increase of 2.3% in the year to April. The Fed’s statement noted that that there were risks—both upside and downside—to the attainment of price stability. Though recent inflation figures were “somewhat elevated”, much of this was due to a spike in oil prices, which the Fed hopes will not be repeated and trusts will not lead to higher inflationary expectations. The Fed’s pace of tightening may become a little less measured if this assumption fails to hold.
The Fed’s pace will also depend on how America’s households respond to its putting. By cutting rates so savagely from 2001 to last year, it openly invited households to borrow, and they heartily accepted. Their debts now total about 115% of their disposable income. Wednesday’s decision may not add greatly to the cost of servicing this burden—more than 70% of household debt is made up of fixed-rate mortgages—but it will discourage new borrowing. One of the most important sources of demand for the American economy, the uninhibited spending of unearned money, may thus begin to dwindle. Unless earned income or foreign demand replaces it, the economy will slow. And America’s households may finally turn to the unfinished business that the last, mild recession never took care of: namely, a savings rate of little more than 2% of disposable income.
The Fed seems untroubled by households’ heavy liabilities because the value of their assets has increased even more. Thanks to a strong property market and a resurgent stockmarket, households’ net worth has actually improved in recent quarters. Somewhere in the deepest recesses of the Fed, officials may be wondering if some of these assets—equities and houses in particular—are not a little overvalued. But if so, these worries remain hidden, impervious even to the Fed’s new spirit of glasnost.
Jul 1st 2004
From The Economist print edition
paper questions whether inflation will really turn out to be
America's main economic problem
Mr King's starting-point is that the Fed and other central banks need not have been as worried as they were about the threat of deflation. Certainly, debt deflation is a particularly malign economic beast, which emerges when people curb their spending in an effort to pay off their debts. Those very spending cuts cause prices to drop, and force up the real value of debts, creating a vicious spiral. As the experience of America in the 1930s and Japan in the 1990s shows, central banks can do little about this, because they cannot set interest rates lower than zero. It was fears of just this sort that caused the Fed to slash interest rates 13 times, to anorexic dimensions.
Most commentators have cheered Alan Greenspan and his colleagues at the Fed for being so aggressive in warding off the deflationary threat caused by huge corporate debts and the popping of the stockmarket bubble. After all, one of the shallowest recessions on record was followed by a strong recovery in which bumper profits enabled overly indebted companies to reduce their debts to more manageable levels.
Mr King is not among those cheerleaders. He argues that the Fed was wrong to cut interest rates so much, because much of the deflationary pressure was of an altogether more benign sort: a reduction in overall prices caused by rapid technological change, improvements in the terms of trade and other factors. Britain had long periods of “good” deflation in the late 18th and 19th centuries, when nominal interest rates and growth were both strong. In recent years, argues Mr King, there has again been deflation of just that sort, and for similar reasons. Technological change and the integration of China, and increasingly India, into the global economy have pushed down the price of traded goods in America, thus pushing up real incomes. “And, because of these real gains, any rise in real debt levels will not be a source of potential ongoing instability,” writes Mr King. Alas, because the Fed's perceptions of deflation have been coloured by the experiences of America in the Depression and Japan in its lost decade, it reacted by reducing interest rates sharply, a response that is more likely to bring about the debt deflation it most feared.
High real growth—so long as deflation is of the good sort—requires high real interest rates. If rates are too low, people borrow too much and spend it badly: what Mr King calls “happy investment rather than good investment”. For a given level of nominal interest rates, a fall in prices will deliver the appropriate level of real interest rates. But by cutting nominal rates to prevent deflation, the Fed has reduced the real rate of interest too much.
Evidence that this has been the case comes in two forms. The first is that borrowing has ballooned in America in recent years. Any reduction in the indebtedness of American firms (under immense pressure from the capital markets) has been more than matched by borrowing by consumers and the government. Even though interest rates have been so low, the proportion of household income that is spent on servicing debts is at record highs. The government's stock of debt has been rising rapidly: this year, its budget deficit is likely to be 4.7% of GDP. This is why America's current-account deficit has been rising: as a country, America borrows too much.
Here is where the second piece of evidence comes in: what Americans spend their money on. If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour, and people will spend money on riskier assets; on things that have little to do with underlying economic growth; and on things that are in short supply. As it happens, this is a decent description of America in the past few years. Companies have been slow to hire workers even as the economy has bounded along; and workers' share of national income is very low. The low cost of capital has, moreover, encouraged speculation in risky assets, such as emerging markets, or—closer to home, as it were—property. And, yes, with all that money sloshing about, it has also pushed up inflation a bit.
When economic growth is fuelled by asset prices and debt, pushing up interest rates is likely to have an effect only in so far as it affects expectations about the prices of those assets. This creates huge problems for policymakers. Will a small rise in rates have a small effect (because, say, expectations about further rises in house prices are so entrenched)? Or a big one (because people expect more rate rises)? Whatever the answers to these questions in the short term, at some point, says Mr King, attitudes towards asset prices and debt will have to change.
There is thus a distinct danger that by pushing real interest rates back to where they should have been in the first place, monetary tightening will reveal the economic recovery to have been more fragile than most think—and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid. This could even mean that rates need to fall next year, not rise. And with rates so low and budget deficits already high, America's economic armoury is much depleted.
America: the world's biggest hedge fund
Jun 30th 2004
From The Economist Global Agenda
Are markets about to start panicking about the dollar again—with good reason?
YOU, dear reader, along with everyone else from Tokyo to Tallahassee, will have been casting your gaze towards Washington this week, to see how large would be the puff of smoke emanating from the Federal Open Market Committee. Airwaves will be filled and forests felled with discussions, learned and otherwise, parsing the utterances of the members of that august committee of interest-rate setters, and particularly those of its chairman, Alan Greenspan, for clues as to how fast interest rates will rise in coming months. Precious few eyes, it is safe to aver, will have been on an annual survey of America’s net investment position released on Wednesday June 30th by the Department of Commerce’s Bureau of Economic Analysis (BEA). But since everyone knew what the Fed would decide on the same day, Buttonwood wonders whether the BEA’s was not the more important statistic coming out of Washington this week, since it provided reasons aplenty why the dollar has further—a lot further, perhaps—to fall.
Last year and earlier this year, if memory serves, financial markets were abuzz with talk of the dollar’s dismal prospects, perhaps even its imminent collapse. There was much discussion of America’s humungous twin deficits (its budget deficit and current-account deficit); fuming about Asian central banks trying to stop their currencies rising against the dollar (though less fuming about how their purchases kept down long-term interest rates); and raging about how none of this was sustainable. The dollar, most right-thinking people agreed, needed to drop, though in an orderly fashion so as not to scare off those nice Asian central banks who had bought squillions of dollars’ worth of Treasury bonds. Buttonwood himself even weighed in with a few less-than-cogent thoughts, and discussed the advantages of America as a holiday destination with his daughters. Naturally, the dollar went up, and talk about it doing otherwise has dwindled to vanishing point.
Perhaps that is why, in recent weeks, the greenback has begun to slide again, while gold has staged a comeback to $400 an ounce. Since mid-May, the dollar has fallen by 4% on a trade-weighted basis. On the face of it, this seems peculiar. The dollar has started to fall again even as the chatter about interest-rate rises has got louder. Naively, you might expect a currency whose interest rates are about to rise to go up, not down. One explanation why the reverse has been the case is that the Fed has been late in stamping on inflationary pressures, so real interest rates—ie, adjusted for inflation—are falling even as nominal rates are expected to rise. There might, however, be another explanation: that rising rates will make an already awful current-account deficit worse still, and that markets are again starting to realise that the only way in which this can be corrected in the long term is by a sharply lower dollar.
The current account essentially comprises two things: the trade balance and overseas investment income. America’s trade deficit is bad and getting worse, even though the dollar has fallen by 23% from its recent high in February 2002. A $46.6 billion trade deficit in March had risen to $48.3 billion in April. In the absence of a net surplus from foreign investment, notes Jim O’Neill, the chief international economist at Goldman Sachs, this would mean a current-account deficit for the year of more than $600 billion, or getting on for 6% of GDP. No problem, say the more sanguine: America has long been able to finance its large and growing deficit because it is such a wonderful place in which to invest.
There are, however, a couple of snags with this argument. The first is that Americans find foreign climes more attractive to invest in than foreigners regard America: net foreign direct investment (FDI) has amounted to minus $155 billion over the last 12 months. And who can blame them? Returns on FDI into America were 5.5% in the first quarter, compared with returns of 11.7% on American firms’ foreign investment. Nor is this an aberration: the returns in America have been consistently lower for many years.
This gap has been plugged by portfolio flows (investment in such things as stocks and bonds) but of late the overwhelming majority of these have been due to foreign central banks, particularly Asian ones, trying to stop their currencies rising against the dollar, and buying Treasuries as a by-product of this intervention. Foreign central banks now hold $1.2 trillion of Treasury bonds. As growth and inflation rise in Asia (or in Japan’s case, as deflation eases), the arguments for intervening look much shakier. Japan, indeed, seems almost to have stopped wading into the foreign-exchange markets. Foreign central banks are, moreover, starting to fret about the amount that they hold in dollars. None of this bodes well for the dollar’s future value.
Nor does the net income that America makes on foreign investment. In the first quarter, this surplus amounted to almost 0.5% of GDP. This seems extraordinary, for reasons that have everything to do with the BEA’s annual survey. This showed that America's net foreign liabilities have continued to rise, standing at over 24% of GDP at the end of last year, up from almost 23% in 2002. Despite that, the country still managed to make more money from investing abroad than it had to pay to foreigners, for the simple reason that American investors’ domestic financing costs were so much lower than their overseas returns. In other words, says Mr O’Neill, the United States is like a giant hedge fund, borrowing huge wodges of cheap money at home and then investing it in higher-yielding foreign assets.
Which is where we return to the subject of higher interest rates. When interest rates go up, this net surplus on America’s investment income will turn into a deficit. A yield on ten-year Treasury bonds of 6%, says Goldman Sachs, would in the space of a few years add 1% of GDP to the current-account deficit, solely through higher interest charges. Whether or not yields reach such giddy heights depends mainly on two things: how much inflation is actually picking up; and foreigners’ continued willingness to supply the giant hedge fund known as the United States of America with cheap finance. Still, Mr O’Neill, for one, thinks it “virtually impossible to be a structural bull on the dollar”. Buttonwood finds it virtually impossible to disagree. His pony-mad younger daughter is enthralled by the idea of a holiday on a dude ranch.