China may also be heading for a hard landing as the government tries to rein in its credit boom. The UK and Japan have the threat of a severe house price correction and high oil prices hanging over their respective econ-omies. And any terrorist activities will knock equities even further.These doomsday scenarios may not constitute the views of most fund managers, but there is a school of bear investors who argue that some or all of these events are likely. Far from being a benign investment environment, stockmarkets could be facing a sharp correction, if not years of flat returns. Bear investors often point to historical trends in stockmarkets to suggest that equities have entered a secular and not a cyclical bear market. It is argued that these “super bear markets” can last many years. Proponents point to the fact that stockmarket returns over the last century have been marked by long bull and then long bear markets. US shares entered the 1900s trending higher and rose 35% in less than three years. Share prices peaked in 1909 and were 40% lower in August 1921. Between 1921 and 1929, markets returned more than 400%. Of course, share prices collapsed in 1929 and by 1948 were 50% below their peak at the end of the 1920s. Next came a bull market in which share prices increased sixfold. The S&P 500 was lower in 1982 than 1973, to be followed by the long bull market that culminated in the bursting of the technology bubble. Between 1982 and 1999, the S&P 500 rose by 12 times, while the Nasdaq was 21 times its 1982 level. Proponents say that if the three bull markets of the last century are excluded, then the compound annual price change of the S&P between 1900 and 1999 was -1.1%. If this view is correct, then it is likely that the world is still in a bear market and this will probably last for many years to come. This is because the two bull markets before 1982 in the last century (1921-28 and 1946-66) were followed by long bear markets. Share prices fell 86% between 1929 and 1932 and then 54% from 1937 to 1938. There was a 34% drop in the S&P from 1969 to 1970, while it declined 47% in 1973/74. If investors had put money in the stockmarket in 1929, it would have taken them until 1953 to recover it. From 1966 it would have taken 27 years. Thus, it is argued, super bear markets historically follow super bull markets. Proponents of this view do not rely Tsolely on historical trends to suggest that the world, particularly the US, is still in a bear market, however. They argue that consumption in the US will slow as savings increase and inflation and dollar weaknesses limit the Federal Reserve’s freedom to reduce interest rates, while the excesses of over-capacity and consumption need to be tackled. Concerns are also expressed about US reliance on foreign investors, particularly Asian central banks, in funding the US’s current account deficit. Around 40% of US treasuries are now held by foreign investors. Indeed, non-US investors own more than 10% of US equities. It is argued that foreign investors could withdraw their funding if returns look more attractive from other currencies, if there is a perception that returns on US assets will decline, if they prefer physical assets like gold or if domestic economic and currency concerns limit Asian central banks’ purchases of US treasury bonds. Bears say that super bull markets are caused by excess credit, which can be prompted by borrowing or pumping money into the economy and results in a mis-allocation of capital. They argue that the excesses of the 1990s have yet to be eliminated and that looser monetary policy exacerbates the situation. The fiscal policy of Alan Greenspan and the Federal Reserve, they say, has merely postponed a recession rather than prevented it. Bears add that expanding money and credit attempt to reinflate the bubble, but the problem is that there is too much debt and not too little. This has prevented the economy from crashing, but may prove to be more damaging in the long run. For example, Stephen Roach, chief economist at Morgan Stanley, last year stated: “Since early 2000, the US has gone through a mild recession and the most anaemic recovery on record. Over that same period, the US’s net national saving rate has plunged to a record low, the household sector debt ratio has risen to an all-time high and the US current account has gone deeper into deficit than ever. “All this smacks of a US economy that is living far beyond its means. Far from purging the excesses of the late 1990s, the US has upped the ante on structural imbalances as never before.” Some bears say the greatest credit boom has been in China, which has led to unsustainable economic growth and inflationary pressures. These bears argue that China will inevitably head for a severe correction, which, in turn, will lead to negative economic growth in the US and thus a worldwide recession (see box on page 21). Smithers & Co chairman Andrew Smithers articulates a common view that expectations of equity returns are irrationally high. This means stockmarkets are more risky than they have been in the past, because it is likely that companies will fail to meet these expectations. This, in turn, says Smithers, leads to investors panicking. He has highlighted another argument of the bears – that stockmarkets, particularly in the US, are overvalued. Indeed, Smithers has suggested that the US and UK markets are overvalued by around 45%. He adds that as equity markets tend to overshoot on the downside, “there is a strong chance they will move from being overvalued today to being significantly undervalued in a few years’ time. If Wall Street fell by a third it would be fairly valued, but on past experience it could easily become undervalued and fall to half its current level.” Smithers evaluates the cost of equities through what he calls the Q ratio, which is the ratio of market value to the replacement costs of assets. This suggests the US stockmarket is valued at twice the historical average. William Pattisson, manager of the Liontrust First Large Cap fund, says the UK FTSE 100 would need to fall from its current level of around 4500 to nearer 3000 to offer attractive valuations, although he is not convinced this will happen. Other bears say the US stockmarket is expensive relative to earnings, book value, sales and dividend yield. The price/earnings ratio of the S&P 500, for example, is still above 20x. David Winters, manager of the £21.8m Franklin Mutual Shares fund, says the US stockmarket may need to fall by at least 10% to make share prices very attractive. Fund managers say the US is on an historical premium to European equities. “The average valuation of stocks in Europe compared with the US market on a price to cashflow and price to earnings basis is at a 30-year low. European stocks are at a 30% discount to the US,” says Ken Cox, manager of the £30m Templeton Growth fund. Further threats to the US economy and stockmarket come from the high oil price, high pension liabilities of companies and the growing cost of stationing troops in and rebuilding Afghanistan and Iraq, as well as the threat of another terrorist attack. Last week, the oil price touched $50 a barrel. The bears point to continued potential supply-side problems. As well as attacks on Westerners in Saudi Arabia, disruption of supplies in Iraq and the uncertainty surrounding the future of Yukos, the Niger Delta People’s Volunteer Force has threatened war on the Nigerian government. The Niger delta, where the rebel group is fighting the government, pumps all of Nigeria’s 2.3 million barrels a day. The rebel group has advised oil companies to shut production and foreigners to leave the region. Schroders chief economist Keith Wade says $40 a barrel reduces global growth by around 0.5%. But he adds it can take a year for this to feed through to the economy: “One of the major threats to the global economy is a high oil price. It is very difficult to predict future oil prices and therefore to make assumptions about economic growth. The biggest threat is to Japan and China as net importers of oil.” Consumer spending in the US is likely to slow regardless of the price of oil. Wade believes US economic growth will fall to 3% next year as the largest fiscal stimulus since the second world war comes to an end and therefore the pace of consumer spending slows. But Wade admits his estimate of 3% growth next year relies on an increase in corporate expenditure. “If corporate spending does not pick up, then we are looking at very low economic growth,” he says. “If the economy slows, US companies may hold back on expenditure. The problem is there is little scope for further fiscal stimulus.” If consumer spending stalls, this could lead to companies holding cash and reining in expenditure, and this would result in the US economy weakening. “If Asian central banks do not continue to buy US treasuries, the dollar will weaken,” says Wade. A weakening dollar would boost exports, but it could also lead to higher inflation in the US as imported products become more expensive. These inflationary pressures could be compounded by an oil price at or above $40 a barrel. Economist Marc Faber, author of The Gloom Boom and Doom Report newsletter, does not believe the bear market has finished. He says this will occur only once the excess credit “has been cleaned out of the system. If I had to buy shares at this point, I would choose Asian equities. This is because they are less expensive than the US and UK markets. Asian markets are still below their 1990 levels. The US would have to go to 2500 to reach its 1990 level.” Between 1980 and 2000, the Dow Jones, for example, rose 1,100%. Furthermore, Faber says the US stockmarket does not believe the quality of earnings of companies. “With an average earnings per share of $70, the US market should be higher than it is today.” Faber says the worst-case scenario is that interest rates in the US rise significantly, producing a credit squeeze, and inflationary pressures grow. This would hit consumer spending and lead to a correction in the stockmarket. Another worst-case scenario, says Faber, is for the US to become involved in a conflict with Iran that leads to an escalation of the war in the Middle East. Hugh Hendry, manager of the Odey Continental European and Pan European funds, believes in the historical analysis of global stockmarkets, and says the world is now paying for the credit boom of the 25 years from 1974. Central banks facilitated this credit boom, says Hendry, by slashing interest rates. He says equities, bonds, property and collectables have all risen in value over the past 25 years, in some cases by 20 times. Hendry argues that the loose credit policy of major economies cannot go any further, and says all assets apart from commodities are expensive. “The next 20 years will be very different from the last 20 years,” he says. “Either there will be a sharp correction and then equities will reach attractive valuations again, or stockmarkets will remain flat for many years until earnings and profits grow to justify the current prices. Price/earning ratios on the S&P 500 are still at an average of about 20 x. The danger is that 40% of earnings of the S&P 500 come from financial stocks. But this is a vulnerable sector. It is impossible to know how quickly or when share prices will fall.” Hendry says bull and bear markets take a generation to run their course. He cites the fact that the Dow took 25 years to reach new highs after 1929, and it was 25 years before the oil price reached $40 a barrel again. He believes Wade’s hope that corporate expenditure will take over from consumer spending is a forlorn one. This is because Hendry argues that companies will not increase spending until consumers do so. Isis chief economist Steven Andrew also says US companies will not be able to make up the shortfall from a decline in consumer spending. This is because consumer spending comprises more than 70% of GDP and therefore needs to grow to keep the economy expanding. In contrast, the corporate sector constitutes only around 15% of GDP. He says corporate profits as a proportion of GDP is at an all-time low. The tax generated from the corporate sector is also at historical low levels, which is partly because of cuts in the rate of tax. Paradoxically, in 2005 the corporate share of the tax burden is likely to rise but profits fall. Andrew says one of the biggest potential threats is Asian central banks not continuing to fund the US current account deficit by buying treasuries. This is a theme taken up by Mark Mobius, manager of the Templeton Global Emerging Markets fund. He says: “The deficits in the US may cause a further loss of confidence in the US dollar and treasuries. One of the biggest risks for Asia is a weakening in the US dollar, leading to a reduction in Asian exports, which is not offset by an increase in domestic spending. There is a 50/50 risk of this happening.” Robin Geffen, chief executive of Neptune Investment Management, is cautious on the US and Japan. He believes earnings in 2005 will disappoint the market, which is reflected by profit warnings in the technology and retail sectors. Furthermore, another terrorist attack on the US mainland to coincide with the presidential election, would knock the stockmarket. He expects the oil price to remain high over the next three to six months at least, which will be “very painful” for Japan in particular: “The demand for ship tankers shows the high demand for oil going forward.” A high oil price is one of the worst-case scenarios put forward by Mike Lenhoff, head of research at Brewin Dolphin, although he is confident they will be avoided. He says if the oil price rises to $70 a barrel then this will lead to headline inflation and higher wage demands, which will result in increased costs and prices. This could lead to the nightmare combination of recession and inflation. Ansbacher senior investment strategist Tim Price says that if the US suffered such a stagflation scenario and thus economic decline, “all bets are off. This would not be helped by an overvalued dollar and twin deficits.” The rest of the world would not be able to escape the consequences of this scenario. Lenhoff and Price both say that a terrorist attack is another major threat. This is impossible to predict and its effects are impossible to quantify, but, ominously for stockmarkets, the potential terrorist threat will be with us for the foreseeable future. Bears would argue that the potential for a correction in stockmarkets will also therefore be with us for some time to come as well. Collapse in the housing market
The credit boom that helped to avoid a recession after 2000, according to some bears, has helped to produce rapid house price inflation in many parts of the Western world. But this now poses a threat to the global economy. A collapse in the price of houses would trigger slower economic growth, if not a recession. In Australia, Ireland, Spain and the UK, house prices have risen by at least 50% since 1997. The International Monetary Fund says these increases are difficult to explain by economic fundamentals alone. It adds that an orderly correction in prices would weaken economic growth in countries where it occurs, but an abrupt price correction could have far more serious adverse effects. This is because house purchases account for a large fraction of gross domestic product and household expenditures in industrial countries. Houses are the prime asset and mortgage debt is the main liability of consumers. Changes in house prices, says the IMF, influence demand and output by affecting households’ wealth and capacity to borrow. Therefore, large house price movements, by affecting households’ net wealth and their capacity to borrow and spend, have important economic implications. The IMF has used its own model to analyse the effects on UK house prices of a rise in interest rates to mid-2005 consistent with current expectations in futures markets. The model forecasts that real house prices will slow down significantly, and a fall in real house prices cannot be ruled out. This is based on an increase in interest rates from March 2004 to June 2005 of 1.4%. According to the IMF, there is a substantial degree of uncertainty in this forecast. But it adds the warning that the model assumes house prices are driven by fundamentals. The IMF says that house prices in the UK exceed predicted values that are based on fundamentals by between 10% and 20%. Consequently, the IMF says there is a danger that higher interest rates could trigger a large downward adjustment in the price of houses, with a severe impact on economic growth. The IMF adds: “The strength of the housing market has played an important role in supporting activity during and after the bursting of the technology bubble. The outlook for the housing market will play a key role in shaping the extent and nature of the recovery going forward. Higher global interest rates will result in a slowdown in house prices.” China’s ‘great depression’
The debate among fund managers about China this year has been dominated by the question of whether its economy is to suffer a soft or hard landing. The International Monetary Fund has estimated that Chinese economic growth is likely to slow to between 7.5% and 8% in the second half of this year and then 7.5% in 2005, compared with 9.1% in 2003. Bears, including economist Dr Marc Faber, disagree on the sequence of events that will lead to a hard landing in China, and how quickly it will occur. During the 1920s, the US experienced an inflationary credit boom, fuelled by a credit expansion and low interest rates, that was reflected in booming stock and property markets. China is currently enjoying an inflationary credit boom that dwarfs that boom. According to the People’s Bank of China, money supply increased by 34.2% in 2001, 19.3% in 2002 and 18.1% in 2003. Over these three years, money supply grew three times as fast as in the US during the 1920s. Like the US, the Chinese government is trying to curtail the growth of credit by providing it only to those industries that need it. For most of the current boom, Chinese consumer prices have been tame, while raw materials have been booming. This shows inflation is at an advanced stage. As with the US in the 1920s, China finances foreign countries, by buying US government bonds with its trade surplus. China is trying to support the US dollar, boost American demand and stimulate manufacturing exports. China is establishing its trade on foreign lending. Such lending could prove expensive as it could well be repaid with depreciated dollars. Bears argue that the longer the economy expands and the more it fights the downturn, the more likely it is the Chinese slowdown will turn into a hard landing. Just as the US’s depression of the 1930s triggered a worldwide slump, so a Chinese correction will trigger a bust in the US and therefore a recession in the rest of the world. Other bears believe that a US recession will trigger the slowdown in China. Other potential threats include a Chinese decision to abandon its currency peg to the dollar, particularly if commodity prices continue to rise and its trade surplus turns into a deficit. This would exacerbate the problems in the US and thus in turn hurt China. The economy in China would also be detrimentally affected by long-term high oil prices as a net importer. Whatever the trigger, some bears believe the inevitable correction will lead to a worldwide slump.