(Commentary)
(Part of UPI's Special Report reviewing 2002 and previewing 2003)
WASHINGTON (UPI) -- The stock market's recent strength has been predicated on a sharp increase in profits predicted for the first half of 2003 -- after all, based on true "core" earnings, the market is currently trading on price-earnings ratio of over 50.
Fat chance.
For a start, there is still a considerable amount of "water" in reported earnings, that the market has not sufficiently accounted for. Whether or not stock options are expensed in 2003, as they should be, as we get further from the stock market gains of the late 1990s it will become increasingly difficult for companies to pay employees primarily in options, so cash outgoings will increase, as employees (primarily in middle rather than top management) demand and get increased cash remuneration.
Pension fund contributions are also a huge issue for many companies. In the years to 2000, companies operating defined benefit schemes were able to build up surpluses in their pension funds, which allowed them both to take a "holiday" from pension fund contributions and even to recognize notional returns on the pension fund in operating earnings. GE was a primary offender in this respect. In 2001, most of the excess pension fund gains disappeared, but companies continued reporting phantom fund earnings.
For the year to December 2002, pension fund values will have dropped by a further 15-20 percent, making them "underwater" in terms of their actuarial liabilities. Furthermore, interest rates have continued to decline, which will tend to make actuaries more conservative in calculating future rates of return, and consequently further inflate the deficit between the actual value of the pension funds and the amount required to provide future benefits.
In the 1980s some companies were required by the Pension Benefit Guaranty Corporation to make supplemental pension fund contributions, beyond those nominally required, to top up their funds and return them to actuarial soundness. For 2002, assessed in early 2003, this extreme penalty will apply to at most a few companies (General Motors is one possibility.) For 2003, if the stock market continues weak, it is likely to be much more widely required, and the possibility itself will weigh on stock prices later in the year.
In addition to purely accounting issues, there are likely to be further bankruptcies in the tech sector. Tech sector companies that have survived this far are those which raised lots of cash in 1999-2000. They are now burning through this cash, in some cases at an alarming rate ($2.5 billion cash outflow from Cisco in the latest quarter, for example). Since the tech cycle in telephony remains deeply depressed, and in semiconductors appears to be turning down again after a mild recovery earlier in 2002, even these more conservative tech companies are likely to find their cash reserves running out as the drought continues. Naturally, their first resorts as cash has run low have been to raise debt finance, and to engage in accounting chicanery that hides the true seriousness of the cash position. Thus it is likely that, in a number of cases, tech sector bankruptcies will come as a complete surprise to the unfortunate outside shareholders. Avoid the sector.
From the above discussion, it is clear that I expect the stock market to continue weak in 2003, probably posting its fourth successive "down" year, although if the Fed continues accommodative, an actual short term "crash" in which prices decline catastrophically, as they did in October 1987, may be avoided. In addition, whatever the Fed does, I do not think it possible that the housing boom will extend itself far into 2003. Long term interest rates are already showing a tendency to increase, in spite of the recent half-percent cut in the Federal Funds rate; if this continues, or even if rates stabilize, I expect the house purchase market to cool off considerably and the opportunities that have been available for "cash out" mortgage re-financing to disappear. Since "cash out" re-financings, in which a borrower gets extra cash through refinancing his home mortgage, have added close to $100 billion in consumer purchasing power to the economy in 2002, the downside economic effect of this change alone will be very significant.
Economically, 2003 is likely to be decisive for the Bush administration's long-term future (defining the elections of November 2004 as, politically, the long term). As outlined above, it is likely that both the stock market and housing markets will be in a generally downward trend, and with the Federal Funds rate now at 1 ¼ percent there is little that the Federal Reserve can do to reverse this. It is therefore likely that the foreign funds inflow into the United States, currently balancing the payments deficit of $500 billion per annum, will decline, putting further pressure on both stock markets and the dollar exchange rate (which should decline against the euro, but may be relatively strong against the yen, which Japan's authorities want to keep weak).
If President George W. Bush wants to be re-elected, he will need to be able to show in November 2004 that the economy is on the road to full recovery. Fiscal and trade policy are the only weapons available by which he might achieve this.
On trade policy, the Bush administration's record is somewhat mixed, but far more favorable than appeared likely at the time of the steel dumping duties and the farm bill early in 2002. At mid year, it seemed as though Bush might be going the same way as Herbert Hoover (who signed the Smoot-Hawley Tariff Act in June 1930) reacting to the onset of recession by protectionism, thereby greatly worsening it.
However, in recent months there has been much more cause for optimism. On agriculture, Bush has proposed a worldwide abolition of agriculture subsidies. This has almost no chance of enactment, but at least moves the debate in the right direction, putting pressure on the protectionist Japan and, more especially, the EU, which in October disgracefully agreed to extend its infamous Common Agricultural Policy until 2013.
Just before Thanksgiving, U.S. Trade Representative Robert Zoellick proposed the complete abolition of tariffs on manufactured goods worldwide by 2015. This is an enormously positive proposal, which if wholeheartedly implemented (and accompanied by abolition of such excrescences as U.S. textile quotas) would revolutionize the economic prospects of three quarters of the world's population, those who live in developing countries. Not only would such countries be able to sell into the United States without facing either protective tariffs or severe quantitative limitation through quotas, they would also be able at last to sell effectively to each other. The highest tariffs worldwide are currently between the poorer Third World countries, which protect their industries against each other, and thereby prevent the emergence of Third World multinationals, providing low cost goods for regional mass markets.
Of course, the Zoellick proposal will meet with opposition from those countries, such as Brazil and India, which fear U.S. competition in their protected domestic markets. Like the agriculture proposal, it will also face opposition from the EU, which sees a common external tariff as an essential factor binding its members together (and makes even greater use than the U.S. of textile and other quotas, in principle even more trade-destroying than tariffs).
Nevertheless, if the administration has the political courage to push the proposal hard, and to resist demands from domestic interests for further protectionism, it could result in the world moving decisively towards, rather than away from, free trade. That alone would prevent a rerun of the 1930s.
On fiscal policy, the administration can't do much, because of the re-emergence of the budget deficit, which I project to be around $300 billion (2.8 percent of Gross Domestic Product) for the year to September 2003. Of course, the 2001 tax cuts should be made permanent (or at least, not expiring on December 31, 2010), otherwise each year as we approach 2010 will produce more and more tax-generated economic distortion (particularly relating to estate tax abolition). More important, the Alternative Minimum Tax needs to be reformed, otherwise in 2005 it reverts to pre-2001 levels and gouges financial holes in a huge section of the middle class. None of these moves, however, will have a great short term economic effect.
If Bush wants to achieve in fiscal policy the kind of 1930s-averting kick that a serious move towards free trade would achieve internationally, he must abolish the double taxation of dividends, probably by making them deductible against income for corporate income tax purposes. Apart from its overall equity -- dividends currently attract tax, between the company and the recipient, at a maximum rate of more than 60 percent -- such a move would increase the intrinsic value of stocks, and thereby reduce the amount by which stock prices must further decline before they are in line with long term valuation norms. In addition, by refocusing investors on dividends rather than capital gains, such a measure would reduce the riskiness and volatility of the stock markets, highly desirable for their return to long-term stability.
This measure could be paid for either by an increase in the budget deficit (which would be stimulative in the short term but might cause long term difficulties) or by capping the deductibility of home mortgage interest at a level of say $10,000 per annum, thus removing the tax system's pernicious subsidy for home ownership, without greatly affecting income distribution (since the owners of stocks and borrowers of large mortgages are both generally fairly wealthy).
As I said, 2003 is crucial for the Bush administration's economic legacy. A further decline in stock prices, an economy in or near to recession, and an end to the housing bubble are all more or less inevitable. So is a banking crisis -- both consumer and corporate credit are at unsustainable levels, and very little further injection of liquidity and decline in interest rates is possible without seriously re-igniting inflation, which is already stirring.
However, with the right trade and fiscal policies, Bush can soften the severity of the downturn, and ensure that emergence from it is relatively swift thereafter. Policies of high public spending and protectionism, on the other hand, will bring with them a severe risk of a repeat of the 1930s, albeit probably with inflation rather than price deflation.
Given the achingly slow pace of this downturn, it is difficult to be optimistic about prospects even for the following year, since with monetary policy so loose the U.S. asset bubble is still unlikely to have fully deflated by December 2003. After "Not much glee in 2003" it's thus likely to be "Still more gore in 2004!" But with the right policies now, the November 2004 election will be both winnable for Bush and worth winning, with real economic growth resuming from 2005 on.
