Looking ahead into the New Year, I see four substantial trends that will shape the course of international currencies and capital markets over the next six to 12 months. Note that the following are limited to economic developments -- leaving aside noneconomic glitches like the Y2K problem, the introduction of the euro and the possibility that
will be removed from office.
1. If the U.S. sneezes, the rest of the world will catch a cold, if not pneumonia.
The dramatic widening of the U.S. trade deficit reflects the degree to which the U.S. economy has become a significant purchaser of the world's goods. And the consumer has come to account for an even larger portion of U.S. growth: Since the first quarter of 1996, overall consumer spending has grown at an average annual pace of 4%. Compare that to the 2.8% average annual growth since the beginning of the economic expansion in 1991.
While cyclical expansion and impressive job creation have bolstered income, the marginal unit of consumption appears to be driven by capital gains in the equity market. Thus, the risk to sustained consumption is not the low savings rates, as the press plays up, but rather the threat to corporate profits, earnings expectations and therefore stock prices.
Equity valuations are arguably based on earnings estimates that are still too optimistic. A recent tally by
recorded 393 companies warning that their earnings will be below analysts' expectations. This includes eight of the 30
industrials and 77 companies in the
Offsetting this somewhat is the monetary stimulus provided by the
in the September-November 1998 period, which has yet to work its way through the system. The Fed has demonstrated its ability to act decisively to protect the U.S. economic expansion (understood to include the stability of the credit markets). Some fiscal accommodation is also in the pipeline as discretionary spending by the federal government is set to rise, and a tax cut in 1999 remains a fair possibility.
2. The twin challenges of Europe.
The first is posed by its great monetary experiment, with the potential for disruptive effects on the global capital markets. Many sophisticated observers warn of a dramatic exodus away from the dollar and U.S. Treasuries and into the euro and eurobonds. Such a development would potentially raise the cost of capital in the U.S., tilting the scale against the U.S. expansion and possibly threatening the European expansion as well.
The real question of the euro's role, however, is not whether it will be a significant currency, but whether it will be greater than the sum of its parts. It is not as if global investors will begin with no euro exposure. As the
Bank of France
recently reminded the markets, noneuro-zone countries hold some $1.2 trillion to $1.4 trillion worth of bonds denominated in deutsche marks and French francs. Going forward, these will convert into euros, meaning that these investors already have substantial euro exposure. Don't forget, too, that while shifts in portfolios of asset managers have received the bulk of attention, liability managers are also subject to the same pressures of diversification and will also be attracted to the more-liquid capital markets.
The second challenge for Europe is to sustain its own growth. The euro-zone countries will be lucky to achieve the 2% growth necessary to create jobs and make further inroads into their still-high unemployment rates. Strong growth is also important to keep unresolved tensions within the euro-zone countries from surfacing; two of which are of particular importance. First, with inflation rates in Germany and France below 0.5% year over year, it is clear that the ideal interest rates there are lower than reasonable for Spain, Portugal and Ireland, which tend to run a bit hotter. Second, slower growth jeopardizes progress toward fiscal consolidation by increasing the demands on the public purse through countercyclical spending, while experiencing a decline in tax revenues.
3. The world's second-largest economy, Japan, will struggle to post positive growth.
Both fiscal and monetary policies have been extremely accommodative over the past six months. Yet, the recent announcement that the
Bank of Japan
Ministry of Finance
will no longer monetize the debt, however, means that monetary stimulus is likely to be reduced in the period ahead.
Even if Japan cannot be counted on as an engine for growth, a moderate regional recovery is still possible. Access to the U.S. market has helped several countries in the region to post current account surpluses and to rebuild their international reserves. The recent decline in regional interest rates provides hope that domestic demand can be on the mend as well. South Korea and Thailand, where both political and economic reform has begun in earnest, appear to be among the favorites for global investors.
Yet the events in Greater China (the People's Republic, Hong Kong and Taiwan) hold the key to the region's fortunes. Its economy is slowing below levels that are thought to be necessary to absorb the millions of people entering the labor market. China has already eased monetary and fiscal policies and will likely attempt additional measures to stimulate its economy and combat deflationary forces. Chinese and Hong Kong officials have refrained from devaluing in 1998 and can be expected to do so as well in 1999. Be aware, however, that the risks increase as the Chinese economy slows further and if its key export markets, like the U.S., stumble.
4. Latin America was shaken by the crisis in the financial markets last year.
support, Brazil is not yet out of the woods, and a recession seems almost unavoidable at this juncture. The deeper and longer the contraction lasts, the greater the risk the Brazilian real is devalued, unleashing another wave of contagion.
Weak commodity prices, including oil, copper and foodstuffs, have undermined the region's terms of trade. Many countries in the region depend on the revenue generated from commodity production (and sales) to finance government spending. Weak commodity prices hit both the public and private sectors and exacerbate the region's economic woes. A sharp downturn in Latin America's big three economies, Mexico, Brazil and Argentina, would threaten the U.S. expansion.
Marc Chandler is an independent currency strategist whose column appears Mondays and Thursdays. He can be reached at firstname.lastname@example.org.