Rallies in domestic markets are driven by surging overseas stats: improvements in the US send foreign capital to Japan - Investor Insight

Japan, Inc., Dec, 2003 by Darrel Whitten

HAVING SWALLOWED A GOOD deal of the US economic recovery story without a sizeable chunk of evidence, stock and bond investors were having some serious second thoughts. And with policy missteps aimed at getting China to devalue the yuan, the US dollar's renewed sell-off made investors nervous.

Since the US recession supposedly ended in November 2001, economists have been looking for a recovery. But they have been equally reluctant to give the "all clear" sign. The "shocks" of the last three years--the September 11 terrorist attacks, the Iraq War and the Enron as well as other accounting scandals--have made forecasters gun shy. Consequently, the US market has been climbing a wall of worries: The current rally has begun from the highest trailing price/earnings ratios on record, and the US has swung toward ballooning trade and fiscal deficits.

The dollar has already declined significantly, both nominally and on a trade-weighted basis. While this is ostensibly positive for corporate profits and US exports, too sharp a dollar fall would have foreign investors packing up their bags of money and going home, leaving the US in a pickle regarding its substantial deficit-funding needs.

Bond yields have backed up sharply, and this could potentially threaten any recovery, particularly hitting durable goods and housing consumption. In addition, the budding recovery has not led to job creation so far. This could strangle any consumption-led recovery.

But it's beginning to look like stock prices were more right than wrong after all. The US and global economies increasingly look like they are turning the corner. Despite much hand-wringing by cautious investors, the economic numbers are coming through just when it seems the market rally needs them most, and the majority of the figures are consistently more surprising on the upside, which is typical in the early stages of a recovery.

The commodity-price rally continues

The rally in commodity prices, which bottomed out in late 2002, began amid a raging debate about encroaching global deflation. Futures prices of Brent crude oil hit bottom at $16.65 a barrel in late 2002, then surged 107 percent to $34.55 a barrel this March. The oil-price surge was first attributed to concerns that military action in Iraq could disrupt world oil supplies, but Brent crude oil prices have tested downside resistance at $24 a barrel five times since 2002 and are currently trying to rally above $30 a barrel.

Gold prices rose 41 percent from late 2002 to March 2003, allegedly on global geopolitical tensions and the falling dollar. But even after bond yields reversed and stock prices surged, gold continued to rally. Numerous studies on the link between gold prices and inflation expectations show that gold has no particular significance for forecasting inflation, but it remains a leading indicator for other industrial commodity prices, whose rallies are another indication that a global economic recovery is under way.

The rally in industrial metals reflected the fact that by mid-August, reports were filtering out that US industrial output had recorded its biggest gain since January, marking the third increase in a row and pleasantly surprising consensus forecasts. By late August, economists were raising US growth forecasts for the third quarter to as high as 7 percent, or more than two times growth levels in the preceding quarter.

The Economic Cycle Research Institute's leading index hit a record high of 129.5 during the week of September 12. The index's growth rate, an annualized rate for the four-week moving average that evens out weekly fluctuations, has slowed somewhat in the latest reading, but the institute says that "we should be prepared for above trend US GDP growth for the next couple of quarters."

The US jobs surprise

This US recession, which began in March 2001, has seen the longest slump in the US labor market since World War II, with a loss of 2.7 million jobs. This figure had economists fretting about a "jobless" recovery. But more recent US payrolls in the US showed the first gain in several months, defying forecasts of more job losses. While economists are still leery of calling tiffs solid evidence of a self-sustained recovery in the US, it does indicate that even the labor market, a lagging indicator of any recovery, is showing signs of bottoming out.

At the same time, the Institute of Supply Management released numbers indicating that the service economy was expanding at its second-fastest pace this Autumn for its sixth consecutive monthly gain.

Anything that bolsters confidence in the US recovery helps to support the US dollar, which had been supported by a strong domestic economy, an inviting investment climate and competitive markets. If the US has actually abandoned its "strong-dollar policy" to stein criticism of the Bush administration from Congress and US manufacturers, it is playing with fire. This is because the policy, without the support of a strong domestic economy, is an emperor with no clothes.