The Dull Compulsion of the Economic (#5)

by Dollars and Sense

A series of blog entries by D&S collective member Larry Peterson.

Note: After a month of (utterly futile) job-searching, I am ready to resume my blog responsibilities. As usual, I am going to be aiming for one 700-1,000 word entry a week.

The stock market sell-offs in all the major markets of last week appear to be tapering off. The New York indices, having taken their worst two-day hit for five years, made reasonable gains on Monday, and are continuing their halting advance as I write at noon on Tuesday. The Dow is leading the pack, with GM posting stellar second-quarter earnings; the S&P (being a broader index than the Dow) is finding the earnings momentum from GM somewhat more diluted; and the NASDAQ, more exposed to creative financing and, hence, continuing worries about the sub-prime debt situation, is more or less standing still (but that's better than being knocked down). The reasons for recovery? Commentators are focusing today on earnings strength and consumer resiliency (consumer confidence hit a 6-year high). Needless to say, the story is far more complex than that.

First of all, the underlying chaos in the sub-prime market is far from even showing a recognizable pattern, never mind sorting itself out. More and more hedge funds are following two of Bear Sterns' hedge funds into insolvency, and confusion about the pricing of many assets held by large investors (or of the identity of counterparties to sales of the assets, for that matter) will only grow as time goes on. In a strange twist, such confusion may, far from prompting further sell-offs, be serving as a very delicate, if not potentially perverse, safety valve in this case: given the lack of hard information about underlying values, large selling moves can only lead to further sales. And, as the Economist noted last week, one thing that distinguishes the present conjuncture is the existence of huge profits and, correspondingly, cash piles, on the part of many investment funds; and even funds that have taken significant losses, like Bear Sterns, are finding it worth their while to eat the losses with their retained profits rather than risk unwinding even larger positions by selling.

So an even greater source of worry right now appears to be the chilling effect the confusion will have on merger-and-acquisition activity and share buybacks, both of which have accounted for much of the rises on Wall Street for some time. At this point, several deals have been postponed, and a rise in corporate debt yields almost assures a more forbidding environment for some time to come. Such worries will only cascade if long-term interest rates are forced up by further post-subprime rises. Still, as Anatoly Kaletsky of the Times has noted, U.S. price-earnings ratios, buoyed by bloated profits, remain much lower than they were during the waning days of the Internet bubble. And with European, Chinese and even Japanese economies enjoying cyclical upturns, the outlook for US exports remains good, and gets even better as the dollar continues its slide. But then there's the question of how low the dollar can go before its losses begin to hurt, rather than help, the profitability outlook for U.S. corporations. And here, the data again yield no clear pattern.

The Economist has also noted (in this week's issue), that, to a certain extent, the much-feared central banks of China, Russia, and the others, including the OPEC countries, have not been the big sellers of the dollar during this period of weakness; instead, U.S. mutual funds have been the ones diversifying into foreign assets and taking the currency down to record lows versus the Euro and generation-long depths against the pound sterling. And here is where things get really interesting: U.S. overseas earnings have been outperforming those of foreigners' U.S. holdings for some time; and this provides an offset of sorts against American economic weakness (as foreigners' dollar claims on the U.S. decline with the currency). It's hard to say exactly how important things like this, and the "carry trade" (borrowing in low-cost yen, say, and investing in high-yielding New Zealand dollar or even Icelandic kroner—15% interest rates!—denominated assets), have had on corporate profits in the last few years, but it is clear that the benefits have been considerable.

And, then, of course, many governments have reduced corporate taxes considerably (one of the effects of globalization and financial liberalization) in the last few years, which has played no small part in keeping profits high. But, inasmuch as further financial deal-making is threatened, clouds will hang over the horizon. One other safety-valve, though, consists of investments by the Chinese and other foreign investors who are looked at with some wariness by Americans; for, if dealmaking in the West dries up for lack of liquidity, it may be that these investors, flush with cash, could provide a vent for M&A activity, if only U.S. and Western regulators—not to mention politicians—are ready to sell to them. This would be a strange reversal (probably on a much smaller scale, as it is clear the Fed will drop interest rates at the first hint of big-investor distress in the United States) of what happened in much of the Far East in the late 'nineties.

Barring this somewhat fanciful outcome, and returning to the more visible effects of earnings and consumer confidence, some troubling things lurk behind today's seemingly good news (for investors, anyway). Regarding profits, forecasts of 5% for the year are becoming increasingly popular after years of double-digit gains. But, as second-quarter GDP surprised on the upside, and as earnings have done so often in the last few years, it is possible that further streamlining of production and outsourcing will continue to contribute (along with the murkier sources noted above) to outsized profits. Productivity appears to be recovering a bit, and this will only be helped as huge bonuses cease to be awarded to corporate dealmakers, helping to take overall unit labor costs down as the rest of us continue to get squeezed by the bosses. But consumers my be a bit over-optimistic: a few weeks ago, one of the major outsourcing consutants (I think it was Challenger, Gray and Christmas), put out a report in which they showed that the temporary-employment market has seized up significantly. Since this is often considered a proxy of hiring capabilities in the economy, such a situation may offset the decent jobs gains posted in June. Friday's employment report could be pivotal if stocks are to recover from the losses of last week fully. 

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7/31/2007 01:27:00 PM