BY GARETH MORGAN
The dark days of August – when western financial markets were rocked by Russia's collapse and Latin America's tremors, hedge funds failed and confidence in equities tumbled – have given way to an uncanny composure, particularly in the US. It seems that interest rate cuts have assured jaded investors that American companies can continue to produce healthy earnings growth and the US stockmarket is now back to record levels. This means that the West can rest easy doesn't it?
Certainly the US economy seems as strong as ever. Despite expectations that Americans would become less carefree in their spending in the wake of a 20% plunge in asset prices, the next month or so is likely to see consumption reach new record highs. Indeed consumer spending has not fallen in any month since mid-1996. If this continues to be the case, it will be a remarkable success story for the US economic model and for the management skills of the Fed.
But hold off ordering the champagne. The rebound in international sentiment has been astonishingly fast. From prospects of world implosion and financial system collapse just three months ago, the bounceback in the Dow Jones seems truly amazing. The concern must be, how real is this stockmarket revival and how much is purely euphoria?
Current American share prices make little sense in terms of the underlying fundamentals. Earnings have yet to recover – down by 2% on average in the September quarter compared to a year earlier – and the prospects for next year are grim. But investors it seems are not much interested in corporate profits right now. Much of their enthusiasm has been underpinned by the promise of cost reductions from the recent burst of merger mania rather than by a real lift in earnings potential. Unfortunately, as November 28's Economist reports, studies of all the big merger waves of this century show that efficiency gains tend to prove elusive – the managerial trouble associated with trying to make the merged companies work are all too real. And mergers dreamt up late in the economic cycle and at the top of the bull market tend to fare particularly badly – merger mania has often been associated with periods just prior to stockmarket crashes.
We are skeptical that the US can sustain both its rate of growth and stockmarket vibrancy. The manufacturing sector of the US economy is reeling, with capacity utilisation down to its lowest level since 1993 and layoffs looming – Boeing has recently announced that 50,000 people will lose their jobs. Corporate investment is sagging as profits weaken. And the clock is ticking on consumer spending. Buying has been financed by massive borrowing on the back of stockmarket gains, with household debt now at a record level as a percentage of disposable income. The savings ratio has turned negative – spending exceeds income – for the first time in 60 years. This cannot continue forever – especially as earnings results fail to live up to expectations and the sharemarket gets another case of the wobbles.
Irrational exuberance has broken out again. And as history has shown us, blowouts more often end with an earth-shattering bang than a benign whimper.