American resilience vs Asian hype

For financial market participants, June 2005, which also featured a meeting of the US Federal Reserve, was a busy end to the quarter. A weak economic growth report triggered needless sale of sterling against the euro. By any measure, the UK?s economy is far ahead of the eurozone. The sharp drop in sterling against the euro is a buying opportunity. In the US, the rate decision was a foregone conclusion.

It is clear the American central bank should continue to push the Federal funds rate higher, up to 4%. This is more in response to robust credit demand and the economy?s underlying strength, than to a threat of higher inflation. Sceptics who call for a pause and even a reversal in the interest rate cycle, anticipating a slowdown, may have to wait longer or look to Europe for vindication.

The American economy?s resilience continues to impress. As late as 2004, many, including yours truly, were on the lookout for signs of slowdown or even recession in the US, as the confirmation of an unsustainable bubble economy. However, the economy has been resilient. For the most recent quarter, ending March 31, the US economy is now estimated to have grown at an annualised rate of 3.8%. It was first reported at 3.1%. Further, inventory build-up was thought to be the main driver behind the growth rate, but has actually been revised down. Net exports, personal consumption and modest investment spending have underpinned the solid growth performance. So, it should create less of an overhang in the second quarter. The economy, thus, is likely to grow at a rate higher than 3.5% for the whole year.

This growth rate has been accompanied by very little inflation, despite a seemingly tight labour market and improving capacity utilisation rates in the industrial sector, thanks to globalisation of production of goods and services. Hence, the US economy is enjoying the perfect combination, of solid growth with tame consumer price inflation. While the hefty current account deficit is a worry, with the euro still up by nearly 50% from the bottom seen in September 2000, improvement in the US exchange rate competitiveness should moderate the trade deficit?s deterioration for the coming months.

American corporate profitability remains very healthy. There was a widespread perception that the bulk of profit gains was driven by the financial sector, with its massive lending to US households. Not so: since 2001, the growth rate in profits of the domestic non-financial sector has been much faster than the financial one. The non-financial sector?s aggregate profitability has nearly doubled since 2001, from $384 billion to $741 billion, around 70% of total US domestic corporate profits. With S&P 500 stocks expected to earn around $65 per share for 2005, the range for the index value should be 1,150 to 1,300. Since the index is now trading near 1,200, the reward to risk ratio for the reminder of the year remains rather favourable for S&P 500 stocks. Indeed, 2005 might well a rare year when the index ended in positive territory, despite both January and April being negative months.

This benign backdrop for American stocks should generally be supportive of stocks in emerging markets. With US short rates rising in a steady and predictable fashion, emerging market bonds and stocks are likely to continue to perform better than those in the developed world. Unlike in the past, when rising US rates posed problems for assets in emerging economies. This should be particularly so for Latin America, where Argentina is emerging from the shadows and Brazil cotinues to show solid economic performance, despite political turmoil. Indeed, the foundation for emerging markets to become a truly independent asset class has been laid in the past two to three years.

Asia, despite the hype, would remain a laggard in this re-rating. Much of Asia, with the notable exception of India, relies on external de-mand. And with the global economy outside of the US showing little dynamism, Asian economies fail to kindle excitement. Exchange rate adjustment remains the important trigger for economic reforms in much of East Asia. Unfortunately, smaller nations are waiting for China to make the first move, though economic costs of the present arrangement are hurting them more. In this context, ?The Economist? presented an argument that the Chinese currency might not be undervalued. It defied logic. A country with a high domestic investment rate is running a current account surplus close to 8% of GDP and yet, there is still debate if the currency is undervalued. The Chinese economic miracle relies on non-pricing of capital and under-pricing of its currency. A move on the latter would be a trigger for the former to be corrected. With China hardening its stance so that it is not seen as yielding to US pressure, its economic bubble keeps getting inflated.

In sum,, with the US economy remaining an oasis of strength for the global one, the current account deficit would remain easily funded. Investors would do well to bet on American assets and the currency. While other emerging markets would benefit, too, Asia would be a laggard. Investors should use the euro as a funding currency, to finance their purchase of dollar-denominated assets, either in the US or in the emerging world. Whether or not the European Central Bank follows the example set by the Bank of Japan in the 90s, with disastrous results, the euro and its interest rate are headed much lower.

The writer is the founder-director of Libran Asset Management (Pte) Ltd, Singapore. These are his personal views