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Finance - The cycle turns? |
A heck of a lot has happened in the last two months - economically speaking at least.
While most of Australia was at the beach the US economy took a sharp downward turn.
The US Federal Reserve has gone from hinting at further interest rate rises to slow the American economy, to action bordering on panic to prevent the US slipping into recession.
In less than four weeks interest rates in the US have been cut by a full one per cent with further cuts possible.
US growth has slowed almost to a standstill, unemployment is rising, business investment is being slashed and consumer confidence is plummeting.
What is happening? Why did the turn in the economic cycle happen so quickly? How bad can it get and what does it all mean for us?
It will be some time before we can work out accurately what happened in the US but there are some guilty looking suspects.
Of course the US boom could not have gone on forever.
Economic growth in America has been rising strongly since the end of 1990 – a record period of peace-time growth rivalled only by the period where the military spending on the Vietnam war kept the US economy humming.
The strain of all this uninterrupted growth was showing. Unemployment had fallen sharply, the US trade deficit was soaring and consumer confidence was high. So high in fact that Americans believed the boom would go on forever.
The US stock market rose and rose and rose. The so-called wealth effect took over and Americans stopped saving and went into debt in a big way.
Early last year we had the ridiculous spectacle of the dot.com companies where valuations went through the roof. Companies with no record of profitability and with little prospect of making any money in the future became the darlings of the market.
Small investors, according to a number of surveys 12 months ago, believed that they could earn 20 per cent or more from the market every year for the next twenty years or more.
Anyone who has any sort of mathematical ability would know that this was just not on.
The collapse in the dot.com companies was inevitable despite the earlier suggestions from stockbrokers that we had it all wrong – that companies no longer needed to be valued on their profit potential but on the rapidity of their growth.
So much for that little gem.
However the collapse in the hi-tech section of the market explains a lot about what is happening now. Around 50 per cent of adult Americans now own shares and during the share boom they found they were becoming quite rich, at least on paper.
When the hi-tech sector collapsed, consumer confidence started to fall.
What happens from here on is anyone’s guess. There could be a sharp recovery, a recovery after a short, pause or an elongated slump. It depends largely on how US consumers react. If they suddenly decide en mass to save and to cut back on spending we could be in for a very rough ride.
High spending US consumers have kept the US and world economies going over the past few years. In 1998 they stopped the Asian economic crisis from becoming a world-wide recession.
So far the reaction to the Fed’s cut in interest rates has been positive – share markets have gained ground. Investors apparently feel that Fed chairman Alan Greenspan has it all under control. But if unemployment starts to rise, consumers run into debt problems, corporate profits fall and the market recovery is short lived then things could easily get a lot worse.
Australia to a certain extent has a cushion against what is happening in the US. Our boom was not as big, our debt levels are not as high and we were not as infatuated with the hi-tech sector. But of course we will feel the effects.
So what are the appropriate strategies? At times like this the usual advice is to resist the urge to panic and if anything adjust long-term strategies only after careful thought. The market cycle will turn up again – at some point.
In the meantime if you feel the need to do anything, a more defensive position may be the right course - just in case. This means getting out of speculative investments and concentrating on quality. In the share market this means buying into companies with strong profits and some resilience if things get bad.
It could also be a good time for fixed interest investors. As interest rates fall bond prices go up. Some of the best returns over the last decade came from bonds that benefited from falling interest rates after the 1990 recession and the slow-down in inflation. Many investors received returns of 20 per cent plus over several years.
For the more conservative investor, the relative stability of the share market (at the time of writing) provides an opportunity to convert some assets to cash.
If the worst happens there could be some bargains a little further down the track.
David Tomlinson is a finance journalist based on the North Coast of NSW.
This article was published in the February 2001 edition of GPSpeak.
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