A British take on the current state of the U.S. economy

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'W' spells worry for US economy

Faisal Islam reports that the world may not be heading for a V-shaped recovery - it all depends on America

Sunday June 17, 2001

The Observer

Cynical Americans say that when the manufacturer of Calvin Klein underwear appears to be going bust, it's clear that the economic downturn has spread beyond Silicon Valley and Wall Street back into the heart of the real economy.

Jobless claims in the US are surging, and productivity growth has slumped. With the US slowdown, high oil prices, and problems in Japan and Germany, the world economy appears to be entering crunch time.

US consumers have, until now, carried on spending and supporting Asian exporters and the US economy. The fear is that rising unemployment will hit consumer confidence, and spending, far harder than the fall in stock prices did.

For the UK, the situation is rosier. Unemployment is still declining, retail sales are booming, and there is room for either monetary or fiscal policy to take up any slack. Indeed, given the stimulus coming from increased public spending, and a possible 'V-shaped' rebound in US growth to around 3 per cent, the City is talking of rates going up rather than down.

The market consensus is that a Greenspan-Bush double act will rescue the US economy by the third or fourth quarter this year. The rapid reduction in interest rates by Alan Greenspan at the Federal Reserve and President George W Bush's mammoth tax cut should provide some sort of tonic.

'On monetary policy alone he would get the economy going, but fiscal policy should add a further 0.9 per cent swing,' says John Llewellyn, global chief economist at Lehman Brothers.

The retroactive tax cut will see most individuals receiving a $300 cheque by October. The $40 billion injection by the end of the year is the equivalent of reversing recent rises in the price of crude oil.

But some economists fear that the US President's middle initial will more accurately describe the shape of his country's recovery path. 'The idea of a standard V-shape to recessions is a bit peculiar because the historical path tends to be a bit bumpier than that,' says Stephen King at HSBC.

Four factors point towards a 'W-shaped' recovery: mounting unemployment, the corporate squeeze, the decreased effectiveness of monetary policy, and the end of the 'new economy story'.

For some economists, unemployment is a lagging indicator of economic troubles. On the contrary, says Gavyn Davies's team at Goldman Sachs: the softening labour market is a key signal of the onset of recession. As a GS report notes: 'Once job losses reach a certain threshold, consumers react by trimming their spending. These changes induce more layoffs'.

The worry now is that this threshold has been reached in the US, where unemployment is at a two-and-a-half-year high of 4.7 per cent. As a result, those tax rebates are far more likely to be banked than spent.

In the corporate sector, technology investment is being cut, profit margins are being squeezed, and energy costs are rocketing. The threat of an autumn bear market is looming on Wall Street.

'The corporate sector is being hammered much more than we thought. After the tech bubble burst, profit margins are less, and corporates are having to absorb energy shocks on the chin,' says HSBC's King. The corporate sector is very sensitive to the continually high price of oil.

This story seems to have been borne out by stagnant stock markets. The Fed's rate cuts, and any bad economic news that makes them more likely, have been the only source of cheer, says Byron Wien of Morgan Stanley Dean Witter: 'Investors are confused about whether they want the economic news to be good or bad. I believe this investor preoccupation with Fed policy is the result of two-dimensional thinking that eventually will be punished.'

He has shown that year-on-year monetary growth was plentiful even as the economy turned down sharply last year. So the easy money policy pursued by Greenspan may not be the silver bullet.

Wien says: 'In a mature economy, even one with a high level of entrepreneurship and a well-educated, energetic workforce, it may take more money to achieve a given level of growth than in the past.'

Instead, US growth has been far more closely associated with the technology investment boom, fuelled by high share prices, and anchored by high rates of productivity growth.

The first two legs of this tripod were swept away last year. The portents from this month's final first-quarter productivity figures are not good. Productivity fell by an annualised rate of 1.2 per cent then - the biggest drop in eight years. If this persists, there are wide-ranging implications.'Much of the original labour productivity increase was related to the investment boom and in turn to the asset price bubble. If that goes into reverse it'll be pretty nasty,' says King.

If productivity falls show that the original increases were inflated, this implies that claims about a new economy were overstated, and that stock markets are overvalued.

'The stock market would not necessarily have to fall, but would have to "de-rate", perhaps growing in line with, or more slowly than, GDP.'

If a substantial rally in the markets is a prerequisite for kickstarting corporate investment and thus preventing job losses, we could be in for a long wait.

-- (M@rket.trends), June 17, 2001

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