November 17, 1998
Too Much of a Good Thing
(An NY Times op-ed article)
By CHARLES CLOUGH
Last summer's collapse of the financial markets is fading into distant memory. The Fed has become more accommodating, and investors are again pouring money into stocks. But before we assume that the economy is out of the woods, we might ask why the markets so completely lost their bearings in the first place.
Two third-quarter economic statistics hold a clue.
The overall economy looked fine, but the two forward-looking components of gross domestic product, profits and investment, declined for the first time since 1991, a recession year. Consumer confidence and job growth are weakening, and capital spending (spending on new factories and equipment) has lost momentum. Inventories -- of automobiles and nondurable goods, of commodities like copper and nickel -- are growing.
Is all of this just fallout from Asia, or are there domestic problems that may need working out?
There is evidence that over-investment, widely seen as the basic cause of Asia's fall from economic grace, could be a problem for our economy as well. Simply put, excess capacity for everything from steel to semiconductors suddenly emerged on the Asian landscape. Could Asia's problems be developing here, perhaps in miniature?
Immense amounts of capital have been available in last few years. American businesses became more efficient and generated huge amounts of free cash. They used that cash to finance one of the great investment booms ever. Investment grew 70 percent faster than final sales over the past three years; it has been the engine that has produced jobs and growth.
There is a downside, however. Investment increases production capacity, and now excess supplies are proliferating. More than 20 new models of the ubiquitous sports utility vehicle were introduced in 1998 alone, for example.
Retailers and financial institutions have added capacity faster than Americans can either spend or save. Catalogue retailers are building free-standing stores while retail chains invade the catalogue business. Industrial production rose 25 percent in the past five years, yet the percentage of manufacturing capacity that is actually being used is flat.
Telephone service providers have multiplied as local phone companies vie with long-distance suppliers and newly minted "competitive local exchange carriers" to build telephone systems and interrupt your dinner with sales pitches.
In reasonable amounts, investment is healthy. It enhances productivity and profits. But, like anything else, there can be too much of it. Excess capacity eventually drives down prices, and profits begin to suffer.
For much of the recent expansion, businesses could finance capital expansion, cover dividends and have cash left over. Ominously, in 1997 that began to change -- heavily committed to capital spending, businesses began to hemorrhage cash, and many must now borrow heavily to plug the deficit. Since 1996, nonfinancial corporations have doubled the amount of new bonds they are issuing, to $360 billion annually.
The question is, Who is lending the money? The answer may come from the nation's $200 billion "current account deficit."
Economies run current account deficits when they spend more than they save. The United States has been running them off and on since 1973, so they are nothing new.
Our earlier deficits, however, were generated by the Federal Government, which overspent its tax receipts and made up the difference by authorizing the Treasury to issue notes, bills and bonds. As it turned out, those deficits caused little damage to capital markets, and interest rates fell sharply in the 1980's. Foreign central banks, particularly the Bank of Japan, were willing to step in and buy those Treasury securities in size. Treasuries are safe, they offer a high yield in a reserve currency, and they are highly liquid.
Today's external deficit is far more troubling because it is being run up by American corporations, not the Government. In other words, American business must attract more than $200 billion of foreign investment into corporate bonds and stocks. Suddenly there are business risks, quality risks, liquidity risks, a kaleidoscope of risks never faced by a buyer of Treasuries. Foreign investors understandably may balk at such a challenge, particularly if American profits continue to slump.
Curiously, hedge funds helped for a while. By borrowing at 1 percent interest in Japan and buying American corporate and mortgage securities, such funds recycled Japan's enormous savings to the American corporate and mortgage borrower. They financed home mortgages that substantially exceeded the property's value -- the type advertised by sports personalities -- and the extra business outlet or warehouse. They reduced capital costs to these sectors, no doubt extending the American capital spending boom and the economic expansion.
Now, the difficulties hedge funds have encountered have left them diminished, and the question is, Who will take up the slack? For the moment, it seems to be the banks. Bank loans to securities buyers are up 60 percent from a year ago, and banks have been buying huge amounts of corporate stocks and bonds. This has helped the financial markets, but I doubt that is sustainable.
The most likely outcome is that excess capacity and weak profits will kill off the capital investment splurge. That would reduce corporate borrowing needs, allow interest rates to fall and reduce the current account deficit. However, since growth in employment and spending depend on investment, the economy could falter, further dimming the already weak profits picture for 1999.
Charles Clough is chief investment strategist at Merrill Lynch & Company.
Copyright 1998 The New York Times Company
Louis Proyect
(http://www.panix.com/~lnp3/marxism.html)