DR.

KURT RICHEBÄCHER
.

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'0:,
J
UtiLitas Verlag
Mühlegasse 33
8001 Zürich

Currencies and Credit Ma~kets

No. 189 / 19. January 1989

Stocks a~e going up, therefore they will continue to go up. The
logic isn't exactly Cartesian, but it does apply a
rudimentary law
and has the added filip of
of inertia to the movements of markets,
helping technicians earn their daily bread.
John Liscio, Barron's

Highlights:
The big question impacting and worrying the world financial and
exchange markets is the fear that the American economy is over-
heating with sustained upward pressure on interest rates.
One thing is clear: America's manufacturing industry has enjoyed
an unexpec ted boom yeap, and now its manage rs see no obvious
o reason why it should end.
In our view the U.S. economy is not nearly as hail and hearty as
many people assume given fi~st impressions of recent strong data.
The trouble with many traders and economists is that they don't
feel they have time to read the small print.
What are the differing arguments? Just what are the objecti ve
facts of the situation?
The near euphoric forecasts for the U.S. economy are fueled by the
belief that exports and capital spending, though moderating, will
continue to make substantial gains. Consumer spending is expected
to strengthen.
Central to our own assessment is the fact that the major engine
of recent growth -

exports has stalled as early as Ma~ch. Capi-

-

tal spending, too, has sharply slowed down.

On top of these strong dampening effects that are already in train
Fed
comes now a
severe moneta~y tightening. Yes, over-kill by the
has not been anunfimilar possibility.
We ask ourselves whether it will take weeks or months yet, until
the Fed will ease again.
That could cause quite a rally primarily in the bond ma~ket but
also in the stock market.
. Ina somewhat longer run, however, the markets of the major deficit
countries a~e threatened a by plunge of their cur~encies.
 - 2 -

.
Unfounded- worries and newfound real concerns
The big question worrying the world financial and exchange markets
is the fear that a seemingly irrepressible American economy 1s
overheating just as the last slack in product and labour markets
is being exhausted by expanding demand. Then, as the Fed responds
to this worry by pushing up interest rates, upward pressure on the
dollar is anticipated, which in turn, may force competitive hikes
of interest rates in other countries, also hitting capacity
constraints.
That's of course what has been happening since last April when the
new rise in short- term in teres t ra tes began But how long will .

this yet go on? It appears that the consensus sees no slowing down
of the U. S. economy befo[1e some time in the second half of this
year. The idea is that the economy is now drawing additional
energy f~om stepped-up consumep spending. Most only anticipate a
recession in 1990 at the ve~y earliest or as fa~ out as 1991. We
find the reality much different.

The chronology
with current
of shift ing cons ensus leaves 1
it t le credibili ty
themes as well
Never before, though, have forecasters been changing their views
as frequently and sharply as last year. Just a year ago, with the
s
tack market crash fresh in their minds, the great majori ty of
economis ts at banks, insurance companies, inves tmen t firms and
univepsities foresaw a
recession in 1988, or in 1989 at the
latest.
Soon enough, they realized that these early recession fears had
been a false alarm. The North American economy had rebounded with
unexpected vigor. The worry of the Fed and markets now turned to
economic ovepheating and inflation. By
early August, these in~
flation fears had become substantial enough that the Fed raised
its discount rate 50 basis points to 6.50%.
Bu t as new tat is tics arri ved wi th the usual lag, the
economic s

numbeps again looked weak. Notably~ the rise in payroll employment

slowed and petail sales flattened. P~omptly, forecasts and senti-
ment in the financial markets changed again, that having been
predominantly signalled by a growing enthusiasm for fixed income
inves tmen ts. As the fear of inf la t ion and ris ing inte res t rates
cooled, the dollar nose-dived.
But the shifting sands of economic debate still did not find solid
footing for long. It took only a few new statistics for October
and November to again quickly evaporate the prevailing mood. Ex-
cellent gains in employment and an apparently vigorous rise in
retail sales, again conjured up the picture of a buoyant economy
 -
3 -

on the verge of overheating. According to the postulation accepted

by the great majority of forecasters and market pa~ticipants, the
U.S. economy was held to- be fueled by ~obust consumer spending
emanating from strong employment and income growth.

And now the optimism is wide-spread

That optimism is now enthusiastically

renascent echoed within
industrial management. According to the National Association of
Purchasing Managements's (NAPM) semiannual forecast, purchasing
managers predict, by a wide margin of four to one, that business
in 1989 will even be better than in 1988. The percentage of NAPM
members expressing optimism about the coming year is the highest
for any year-end forecast since 1983, which was back in the early
boom stage of this recovery. Central to their positive outlook is
the belief that exports and capital spending will continue to make
substantial gains in 1989, though at a more moderate pace than in
1988 .

One thing is clear: America's industry has enjoyed

manufacturing
an unexpected boom year, and now
managers its
see no obvious
reason why it should end. Such emphasis on mood and expectations
reminds us of a
remark by Joseph Schumpeter in his book Business
Cycles.

"Optimistic or pessimistic expectations may for a time

acquire a causal ~ole. But again it is necessary to warn
against ovep-rating their importance. No great crisis hat
ever come about that was not fully explainable by the ob-
jective facts of the situation. Expectation not so con-
ditioned never has produced more than short-lived spurts
or breaks."

Optimism may be golden but the facts of the situation are clay
The sage observation above begs the question what the objective
facts of the economic situation in the United States actually are.
Surely the answers, as was demonstrated several times last year,
have not been reflected in the ongoing economic debate. Obviously,
strong economic momentum in production, employment and income
growth has persisted into the fourth quarter. But this momentum is
not supported by can tinued strength in demand. A hos t of indi-
cators has been pointing to sharply decelerating demand, both
foreign and domestic. While industrial production rose at a 7%
annual rate in the third quarter, final demand grew only at a 2%
annual rate following a 5.8% growth ~ate in final demand during
the first half of 1988.
U-:
._~..,,,,
 -
It -

Real final sales, 1985 to 111/88

(Percent changes f~om p~eceding period)
1985 1986 1987 87
III IV 87 I 88
II 88
III 88

4.5 2.8 3.2 5.6 -0.2 5.6 6.0 2.0

Central to our consideration is the fact that the major locomotive

of the sudden revival of U.S. manufacturing (and in this case
the economy as a whole.) already stalled as early as last March. for
Between September 1987 and March 1988, U.8. merchandise exports
surged, seasonally adjusted, at an annual rate of 50% accounting
directly for half of GNP growth during this period. By contrast,
over the last eight months, merchandise exports have expanded at
an annual rate of barely 5%. After adjustment for inflation, that
makes for little more than stagnation and ce~tainly
qualifies as
being long enough to be marked as a trend.

But the expansionary effect

of this previous burst of exports by
far surpassed its direct
impact on domestic production. In its
wake it triggered an addi tional capi tal spending and inventory
,

boom. As all three cumulated, income growth was given a boost, in

turn fueling consumer spending.
Now, however, this process has started to work in reverse. Stalled
export growth reduces economic growth directly, but in addition
also indirec.tly through weakening investment in plant and equip-
ment. In fact, sharply slower capi tal spending by business is
already evident. The main boom component that still remains in the
economy is inventory building.

The first fallacy finds root at the core of the popular theme
What lies ahead fo~ the U.S. economy? What a~e the
ments?
differing argu-
Just what are the objective facts of the situation as
Schumpeter would say? To answer that we must ask our ~eaders to
bear with our detailed focus on those issues. The questions a~e of
ovep-riding importance and key to our dete~mination that the popu-
lar view of a
sustainably robust economy is badly misplaced.
Obviously, the experience of an economy that surged despite the
stock market crash has reinforced people s belief in the f

pressibility of the U.S. economy. Asked what will generate irre-

the
strong future growth that they expect, the familiar answer is that
buoyant employment and income growth will boost consumer spending
more than offsetting any moderation in export
growth. The repo~ts
of sharply higher retail sales in October and November were,
therefore, all grist to the mill for these forecasters. ~)
 - 5 -

The Third Quarter is the Starting Point. Our difference of opln~on

about the economic outlook begins with our contrary interpretation
of GNP growth in the third quarter of 1988. The bullish consensus
found comfort within what we find to be a rather ridiculous argu-
ment. The apparent softening of GNP g~owth during that quarter was
considered an aberration attributable to the summer drought.
Without the drought, they assert, growth in real GNP would have
been 3.2% instead of the actual 2.5%. Therefore, the true under-
lying growth rate must still
be above a noninflationary threshold.
Hence, the general conclusion: The Federal Reserve has so slam on
the brakes in order to prevent imminent ovepheating.
j
Broadly and Conclusively the Facts Say Otherwise. Our careful
1
reading of third quarter data yields a starkly contrasting conclu-
sion. We noticed sweeping changes on the demand side which expose
the grandiloquent drought effect as another misleading exercise in
statistical prestidigitation.
Firstly, we noted that foreign trade, after having delivered half
the GNP growth in the prior four quapters, had turned slightly
negative in its contribution to GNP growth.
Secondly, what struck us as a
highly important the
new feature was
fact that business had drastically trimmed its spending on durable
equipment from 20% annual growth
a
rate in the first half of the
year to a 4.6% annualized rate.
The downturn in these two vital factors has in
total reduced GNP
growth by more than 3% at an annual rate during the third quarter.
And most
important, this is final demand, while the drought effect
is nothing more than -a statistical fiction about growth on the
fields (affecting farm inventories). The stark. fact is that in the
midst of the preoccupation with the drought it went unnoticed that
final sales slumped to a 2% annual growth rate, following 5.8% in
the first half of the year.

Given all
heated talk of an impending consumer boom, we also
the
took close
a
look at the pattern of consumer spending. Any such
boom must primarily show up in durable goods. However, on examina-
tion it is precisely these categories that were weakest in the
consumer sector as the following table illustrates.

87 88
Consumer spending on goods, III to III
~
(Seasonally adjusted at annual rates, billions of 1982 dollars)
87 87 88
it.
III IV I
II 88
III 88

Durable goods 15.2 -18 9 13.5 9.5 0.2

,)
-
.

Nondurable goods 2.1 -

1.4 12.3 8.9 14.1

 - 6 -

~
~.....,

Some further facts: consumer spending on durables and non-du~able

goods was just 1.1% higher than in the corresponding third quarter
of in real terms. Around 60% of incremental consumer money
1987
n
went into services, a
lot of which looks like "essentials or
tlinvoluntary expendituresfl such as housing, transportation, educa-
tion and medical care. The three biggest items contributing to the
rise in consumer spending during the third quarter were clothing~
medical care and no joke -

air conditioning
-
(due to the summer
heat). Air conditioning increased GNP growth a
little over 0.3%
while the apparent d~ought effect reduced it 0.6%. And there's no
telling how much of clothing expenditures may have been triggered
by the heat as well.

So there we have it. Weakness in growth was evident in two impor-

tant sectors: capital spending and exports. Strength in consumer
spending was centered in services and non-dupables with no support
from durables. And in the latter case, the few pockets of strong
demand actually counterbalanced the statistical drag produced by
the drought.

The state of the consumer: no boom there either

What, then, about the retail sales ftboom" that is being proclaimed
from all sides? We can only say, wait and see. The fact is that
U.S. retailers across the board, and not only auto dealers, very
early in the pre-Christmas season felt it necessary to boost dis-
appointing sales with sizable rebates. While in the end, year-
over-year comparisons may show impressive increases, we should
remember that last year's retail sales at this time were severely
depressed by the stock market crash. That makes comparisons sus-
pect and certainly distorts seasonal adjustments for the period.
Furthermore" huge stimulative rebates may inflate sales in the
short-term, but it is nonsense to use this as proof of a boom. To
a. large extent, these purchases will have been bo~rowed from
future demand. That causes us to view the sales figures for
November and December as again subjects of only transient
enthusiasm.

This applies to auto sales

particularly which account for more
than fifth
one of total retail sales. Recent sales may exceed
those of a yeap ago, at the time of the stock market crash, by a
substantial margin, but they are very poor when compared with
sales levels in late 1986.

In a
concerted search for any possible or real consumer boom, we
combed the host of data from many perspectives. In sum, one theme
is obvious as the following table shows. A distinct ~ise in sales
occurred early in 1987. Ever since, sales in real terms have held
flat with only minimal fluctuations.
'\~
 -
7 -

Sales of retail stores, constant (1982) dollars

Jan. Febr. March April May June July August Sept. Oct.
1988 114.8 116.5 117.8 116.7 117.1 117.5 117.7 117.8 116.8 117.4

Source: Business Conditions Digest, U.S. Depaptment of Commerce,

Novembe~ 1988, p. 65.

As clear as our canclus ions may appear it is ac tually the re-

l
,

ported incpeases in the monthy figures that catch the attention of

the financial markets. They look rather better because they are
not adjusted for inflation. What is overheated here is rather
obvious. Ostensibly, its not the consumer but rather the people
inte~preting the numbers.

In addition to retail sales, the Department of Commerce publishes

wider aggregates "consumer expenditures1t which in-clude spending
on
on services. Again we can only ask the reader to take a look at
these figures and to tell us where ther~ is any sign of a consumer
boom. We are at pains to find any suppo~ting evidence.

Personal Consumption Expenditures

Billions of constant (1982) dolla~s

May June July August September October

Personal outlays 11.8 26.0 -3.0 17.7 -15.9 14.6

Durable goods 3.7 9.3 -7.6 2.8 -

5.6 -

1.9
Nondurable goods 5.4 5.6 1.9 8.4 -

6.4 3.6
Services 2.6 11.1 2.8 6.4 -

3.8 12.7

Source: Personal Income and Outlays, Department of Commerce, Press

Releases.

Employment data provides grist fop conflicting interpretations

as well
In pa~ticular, it
been the very strong employment
has numbers that
have pecently the financial markets. Here, too, reported
spooked

t net figures are taken as the full gospel even though strong sta-
tistical diffe~ences even exist between the two autho~itative su~-
veys. According to one survey, employment in the United States has
risen by 2.2% last year, yet the other avers a higher growth rate
of 3.6%.
.J
 -
8 -

)
One su~vey the so-called Household Survey
-

is based on a sample
-

of 55,800 households which are carefully selected to reflect the

of age 16 years and older. The
entire non-institutional population 1s
other recognized measure, called the Establishment Survey,
derived from a
sample of 300~OOO private and public establishments
employing over 38 million people. Over time~ both surveys have
always tracked each other fairly closely. For example, in 1987
both sources unanimously reported employment growth of 2.8 mil-
lion. But since last year reported figures have been grossly out
or step with each other. As might be guessed however, the subject
of publicity and market attention has almost exclusively been
centered on the stponger figues of the Establishment Su~vey.
The discrepancy between two surveys and its explanation does
these
throw some light the origins of this apparently fantastic job
on
creation. More and more Americans (above all women) are taking
second jobs. As the Establishment survey counts jobs, its results
are the pefore duly inf la ted. By con t
ras t, the Household Survey
only counts employed persons. Being doubly employed in the latter
measure still only counts as one job. In fact, the major growth
has been in part-time employment. In pecent months, it accounted
for two-thirds of all gains.

The critical factors underlying expectations are suspect

What indeed then cpi tical assumptions
are the underpinning the
popularly bullish outlook for the North American economy in 1989?
This near eupho~ic outlook is fueled by the belief that exports
and capital spending will continue to make substantial gains,
albeit at a more moderate pace. Any moderation on these counts is
supposed to be more than offset by stronger consumer spending.

It precisely with these two engines of growth of the present

is
U.S. recovery, namely exports and capital spending,
economic that
we find the fi~st decisive fallacy in these current arguments for
a
continuing strong economy. Though widely ignored, as we have
t tha t both have
pointed au t, it is ac tually an es tabl ished fac
already badly faltered.
That's not the only grave fallacy underlying the forecasts of per-
sistent strong growth. The other one lies in the assumption that
buoyant employment and income gains could largely or partly
~eplace exports and investment as the driving force of this ex-
pansion. But, as most should know, production, jobs and income
growth a~e always sequential in the cyclical p~ocess, not causal.
performed so we 11 in the pas t year, it was because
I
fall th pee
of booming exports and investment. But as these two fall away, so
will job and income growth. Coming full-circle, that bpings us
right back to the causal question of prospects fO[1 exports and in- .r

~J/
\\

vestment.
 - 9 -

Exports are the critical focus

been the engine of growth for more than

a
If exports have year,
thing to check when trying to assess the th~ust of the
the first
economy, is the state of that original machinery. In short, it is
in poor state. By now, there is truly overwhelming evidence that
any pulling power. As already mentioned,
it has lostexport exports, par-
have been rather flat since March with
ticularly volumes,
of $27 billion
minimal fluctuations since that time around
a
level
per month. That occurence in itself is quite ominous if one con-
siders that domestic demand in the other industrialized economies,
in spite of slowing somewhat, is expanding considerably faster
than in the United States.

In answer to that apparent divergence many economists cite capa-

city constraints as the main reason for the disappointing perfor-
mance of U. S. exports. That may be the case in two But or three
and primary metals. as is
industry sectors paper, chemicals
-

obvious from the data, the slowdown in exports is not confined to

these sectors. Consequently, we must reject the idea that capacity
contrainst have been the chief inhibitor to export growth.

Underpinnings to business capital spending are weakening

The second main engine for the U.S. economic recovery was business
capital spending. Again, as already highlighted, 4.6% its growth20%rate
was already sharply down in the third quarter to from in
the first half. Whether that was a
fluke or something more is an
important ques t ion. In our opinion, two te 11- tale deve lopmen ts
foreshadow further weakening in capital spending: firstly, two
recent surveys of business capital spending intentions; secondly,
weak order inflows for new machinery.

Spending Intentions Faltering. The most recent survey, conducted

in October and November, comes from the U.S. Depaptment of
Commerce. Two statements from that report aptly clarify the
s i
tua t ion. Es tima tes of real spending fop
19 89 indicate a 3. 5%
increase by Manufacturing. That compares dourly with the lastest
1988 of
estimate for real spending increases in Manufacturing for
12. 7% over 1987 levels. If industries were genuinely bumping up
against capacity ceilings, it is certainly very strange that they
should so sharply curtail their investment plans, especially in
light of wide-spread bullish prognostications. And if the truth be
known, most of the forecast increase is for the first quarter of
1989 .

Orde rs Ha ve Been Enthus ias t

ically Mis- inte rpreted. The
Machine ry
other indicator of shaky capital spending prospects are, of
course, new orders for machinery. But as capital goods account for
around 30% of U.S. merchandise exports, they reflect in reality a
 -
10 -

mixture of investment and export trends. Recetit pre~s report~ on

U.S. manufacturing's new orders make highly confusing reading. The
reasons are huge and erratic movements in new orde~s for defence
and civilian aircraft (Boeing). But since the Commerce Department
~ategorizes data by industry segment it is easily possible to sort
out any distortions if the time is taken.

Yet the media continues to fabricate a bullish backdrop purely on

the face value of aggregated numbers. A
small example in' thi's
regard. The commentary to the November report published by The
Wall Street Journal stated: "Further indicating continued economic
strength, new orders for goods from U.S. factories climbed 0.3% in
November ...Economists were especially encoupaged by a 3% increase
in orders for capital goods other than defence equipment~ commonly
regarded as a barometer of industry investment plans. The strong
order picture indicated that the capital-spending boom will con-
tinue in 1989.11

To complete the pictu~e ~ here ar'e several comments transcribed

from the actual Commerce Department report that we regard as
relevant:
"New orders for manufactu~ed goods in November increased
$0.6 billion or 0.3%. Orders reached a high in June at
$228.1 billion, but have been somewhat volatile since
then, averaging $224.9 billion per month."

"Although total new orders were up slightly, the specific

major industries showed more significant changes. Within
durables, the largest increase was in electrical machi-
nery, up $1.6 billion or 8.3%; most of the increase was
in defence communication equipment. The la~gest decline
was in transportation equipment, down 6.1%. Virtually all
categories except commercial aircraft declined."
What leading economists called an "encou[lag'ing 3%
incre.ase for
capital goods" on close~ inspection reveals itself as just a big
order for commercial aircraft. Without it, capital goods orders in
reali ty would ha ve fallen by 1. 6% following a small rise in
,

October of 0.4% and a decline in September of 6.2%. In our humble

interpretation that's hardly a boom.
Backlogs Show the Same Bias. That brings us to another point that
plays a great role in the bullish forecast for the US economy. It
is continued bulging opder backlogs. Over the past twelve months,
these backlogs have risen by $ 42 bill ion or ove r 10%. Here the
unevenness of these reports is again evident. Aircraft orders
alone, mainly Boeing, account for' $27 billion representing more
than 60% of this increase. Clearly, most of these orders will go
into production only in later years.
~,J
 -
11 -

It all adds up to a
colder reality
In our view the U.S. economy is not nearly as hail and hearty as
many people assume given fi~st impressions of recent strong
employment and ~etail sales data. Even if these were not illusory,
we wouldn't see any basis for their continued strength. The
stillboom
export was the key to the past sha~p recovery of industrial
production. As explained in the last letter, both exports and
80% GNP growth between
capital spending had accounted for of real
mid-1987 and mid-1988. Now, since they have weakened drastically,
a
corresponding impact on the whole economy should follow with a
short lag.
On top of dampening effect that is already in train
this strong
comes nowsevere monetary tightening. Taken together with much
a

weaker exports and business investments, this could slow down the
economy much more quickly than seems feasible today. And to add
possible injury, the strength .of this economy is not dèep-seated.
High debt levels add a vulnerability that did not exist in pre-
vious post-war cycles.

What will be the response of the Fed?

Admittedly, it has astonished us how seve~ely the Federal Reserve

has reacted to the employment and retail sales data. Given all the
other evidence of generally weaker demand, these indicators appear
doubtful. But with production resou~ces close to full capacity and
4 the Fed has obviously decided
inflation already well above %,
that only inflation, not recession, is the current major threat to
sustained economic expansion.
We think that the advocates of this policy may well underestimate
the dynamics of slowdown when
a weaker exports, investments and a
retrenchment by the consumer cumulate. The consumer is not the key
to economic growth at this phase: export and investments are and
they have slowed down drastically. -

From this pepspective, the industrial recove~y that started in

early 1987, has passed its cyclical peak. Inventory accumulation
might yet mask the downturn, but when sales slow, inventories
quickly reach excessive levels. Companies thereupon cut their
buying. Industrial production declines.
Fo~ these reasons, we don't expect a substantially tighter mone-
ta~y policy by the Fed, if at all. Yes, over-kill by the Fed has
not been an unfamiliar possibility. The next economic data will be
crucial. But we recommend, as we haveGNPdone throughout this letter,
that one look to the composition of and in particular at final
demand, exports and capital spending.
 -
12 -

,.r)
Capital markets will then likely exult for a
time
We ask ourselves whether it will take. weeks or months yet, until
the Fed will ease again as evidence of a slumping economy becomes
overwhelming.

How will this affect the U.S. financial markets? As soon as they
recognize a weakening economy, they will undoubtedly anticipate
easier money. That could cause quite a rally primarily in the bond
market but also in the stock market. It is not unusual for the
stock market to make a strong advance after the cyclical peak in
business activity is recorded.
An additional bullish case is to be found in the high levels of
cash held by the U.S. mutual funds and in the fact that pension
funds have the lowes t
level of equi ties in their portfolios in
more than 20
years.
Not to forget that in the past twelve months, New York -

together
with London, Toronto and Sydney have been the trailing -

caboose
of the international stock market train.
In the somewhat
longer run, howeve~, the markets of these major
deficit countries are threatened by a plunge of their currencies.
The present strength of these currencies is based on the idea
that~ given buoyant economies, the central banks have to keep
0
interest rates high or push them even higher to fight inflation.
Lowe~ interest rates associated with weakening economies will pull
this crucial prop from under these currencies.
With the benefit of hindsight, we would say today that the sharp
decline in the U.S. dolla~ in October/November' had in reality
little O~ nothing to do with president-elect George Bush and the
budget deficit. The operative factor was the apparent weakening
of the economy over this period of time.
The dollar and all the other high-interest rate currencies will
stay strong as long as the economies of these countries appear to
be strong and tight monetary policy is supposed to continue. But
now longer. Whenever these economies will finally weaken and their
monetary policies ease, the critical phase both for these curren-
cies and their financial markets begins.

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1
~.....
~
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