Market background
- The US dollar plumbs new lows as investors shy away from US credit markets. However, the continued slide is at least helping to erode the US' huge trade deficit
- Japan's mid-cycle slowdown keeps policymakers from raising interest rates for now
Demise of the US dollar
At the height of the technology bubble, the US dollar seemed invulnerable, as investors worldwide poured money into the US stock market, anxious to buy a stake in the US' productivity revolution. Those days are long gone: the technology bubble burst, productivity growth has plunged and foreign investors have lost much of their appetite for US equities. Since the beginning of 2002, the US dollar has fallen 40% against the Euro, and in October it reached a 26-year low against the pound and a 33-year low against the Canadian dollar.Although the bursting of the technology bubble put foreign investors off US equities, investment in bonds has boomed as investors have sought to take advantage of the US' relatively higher yields. This is just as well, since the US' deficit with the rest of the world has swollen from 1.5% of its annual output 10 years ago to more than 6% last year. In fact, the whole US trade deficit has been financed in recent years by foreigners' net purchases of government and corporate bonds.
However, as the recession in the housing market has deepened - the stock of unsold properties has now reached a 22-year high, while homebuilders' confidence has plunged to a lifetime low - the prospect of the Federal Reserve cutting interest rates more sharply has increased.
As a result, US bonds have lost their appeal relative to markets elsewhere as yields have fallen - even more so after the shakeout in the collateralised mortgage market - and the dollar has fallen out of favour. Until recently, interest rates still looked sufficiently high to cushion the dollar's fall. But with the US slowdown already 18 months old and set to last well into next year, and the likelihood of some fallout from the summer's mortgage market blow-out, the interest rate outlook has turned more unfavourable. The dollar's slide has further to run yet. Nevertheless, the dollar's slide has an upside. As the US imports half as much again as it exports, exports have to grow 50% more quickly than imports to make any impression on the trade deficit. As a result of the dollar's fall, coupled with weaker economic growth which has curbed the US' demand for foreign goods, exports have grown four times as quickly as imports over the past year and the trade balance has shrunk 8%, despite the drag from the ever-rising import bill for crude oil. The boost to trade from the weaker dollar and the Federal Reserve's willingness to cut interest rates, could be all that keeps the economy from recession. Over the past year, trade has contributed 0.5% to US economic growth.
The economic environment remains weak but lower interest rates should underpin Wall Street. Investors may also be discounting too much bad news, especially compared to markets elsewhere where investors may have been a little slow to appreciate the extent of the slowdown. Moreover, with 10-year yields having fallen to 4.4%, US stocks look better value than bonds. Consequently, US stocks ought to bear up reasonably well despite the downturn.
Japan's mid-cycle slowdown keeps policymakers on hold
Since its last recession in 2001, Japan has enjoyed five years of strong economic growth, the country's longest expansion since the Second World War. However, much of the impetus has come from an upturn in investment by businesses in new premises and equipment, and buoyant export orders. Ignoring trade and investment, economic growth has been slowing since the beginning of 2004, as consumer spending has failed to pick up.Moreover, the revival in business investment has run out of steam as economic growth has stopped accelerating, and has even gone into reverse as growth has begun to slow. Export orders have also weakened despite the 20% fall over the past three years in the real value of the Japanese yen against the currencies of Japan's main trading partners. However, there are at last signs that export orders are improving, although the economic climate remains soft, continuing to favour government bonds.
Nevertheless, sentiment towards Japanese equities looks more favourable than in other markets, suggesting Japanese stocks could outperform their peers. The key question in the next few months will be whether the boost to trade from the yen's slide can sufficiently offset the likely impact of a global slowdown on demand for Japanese exports.
The Bank of Japan remains keen to continue raising interest rates gradually towards a more neutral level - the Bank's official rate is currently still only 0.5%. The slowdown has forced it to postpone any rise for now, especially now that unemployment has begun to edge higher. Policymakers are anxious that holding interest rates steady now could lead to higher inflation in 12-18 months' time, but at the same time are cautious about the outlook for demand from the US, still Japan's most important trading partner. As a result, chances of another rate hike before the end of the year are receding, but even if the Bank of Japan does surprise investors, interest rates will remain too unattractive to stem the yen' slide.
