Bottom Line: Post-Iraq investment scenario
www.upi.com By Gregory Fossedal Special to UPI From the Business & Economics Desk Published 3/19/2003 5:50 PM
WASHINGTON, March 19 (UPI) -- Vast changes are in store for the world economy in the coming weeks, as the United States and its allies prepare to invade and liberate Iraq.
Oil prices should continue to coast down toward $25 and even $20 a barrel -- albeit with a final spike if Saddam Hussein attempts to destroy his country's wells and lobs a pre-emptive chemical strike at U.S. troops or tankers, Israel, possibly even Saudi Arabia.
Business, investment and consumer decisions that have been put on hold for six agonizing months will go forward in April -- with an actual impact on the real economy.
It's time, then, for a review of the U.S.-led world economic turnaround that's about to begin, one that will have implications for every country from Africa to Russia, from the Americas to Southeast Asia.
Our guide for this tour de force is John Mueller, the co-creator of the "world dollar base," a measurement of dollar creation by not only the U.S. Federal Reserve Board but also by other central banks that buy and sell U.S. Treasury securities, and in so doing, "monetize" them.
He's well-placed to provide the kind of global perspective critical to understanding a global economy that runs on global dollars. Mueller isn't a household name, but he should be.
As the former economic counsel for the House Republicans (1981-87) and longtime adviser to Jack Kemp, Mueller designed perhaps the best flat-tax package ever conceived, the Kemp-Kasten tax bill, which essentially became law in 1986. He was also a force for getting House Republicans, and Democrats for that matter, to pay attention to Fed monetary policy throughout the 1980s.
He then transitioned to the real world to co-found a private-sector forecasting firm, Lehrman Bell Mueller Cannon, Inc., in 1988. (The firm is now incorporated as LBMC, LLC.)
At LBMC, he has compiled an enviable track record, particularly at projecting major turning points up to two years ahead. Most economic "forecasts," by contrast, amount to bean-count estimates for the coming three to six months and are usually little more than slightly adjusted extrapolations of recent trends.
Mueller's best calls include a 1989-90 "double dip" recession call, followed by a 1993-94 observation that welfare reform could significantly reduce the "natural" unemployment rate, and thus, combined with surging world dollar creation, lift stock markets and economic growth.
With the latter, Mueller provided insight into something few Republicans seem able to explain: namely, the Clinton economic boom of the 1990s.
In late 1997, Mueller did a careful study of demographic trends for a private-sector Social Security reform commission, which was weighing various options for privatization. While Mueller favors Social Security reform (in the form of a tax cut), he was rightly cautious about projections for never-ending stock market growth that would make privatization painless.
Noting the rapid aging of the U.S. population, he projected a generation of generally flat stock market returns, through about 2015.
Accordingly, Mueller was bullish on bonds from 2000 onward, and generally bearish on the stock market when his stock market buy-sell index turned negative. Along the way, he took first place in the group of 50 economists surveyed by The Wall Street Journal for his 1999-2000 interest rate calls.
Anyone who sold stocks and bought bonds in the spring or summer of 2000 was considered a nervous ninny at the time, but in retrospect, it was a heck of a call.
The firm's worst calls include a call for a 1995 slowdown and mild 1996 recession, when there was a non-recession slowdown, and a 2000-01 slow growth call, when there was a very mild recession.
Investors who traded those notions, however, didn't suffer severely if they were investing the firm's short-term buy and sell signals on the stock market. The same model had investors mostly out of the market in 2001-02, with one timely "buy" interval including the market surge months after the Sept. 11 attacks.
At present, Mueller sees a number of strong trends of note for global investors. Let's focus on just two, which are likely to be at the core of the world economy over the next 12 to 24 months.
First: A return to oil normalcy
For all the talk of supply shocks, the recent rise in oil prices has been (as are all prices) a tale of supply and demand. Mueller's oil model predicted a surge in oil prices in the second half of 2002, although Mueller would be the first to say that this demand-side surge was strongly aided by interrupted supplies from Venezuela, Nigeria, and the threat of war in the Middle East.
The same model now points to a return to oil normalcy at $25 a barrel and below by the summer -- a projection "the bottom line" highlighted several months ago in advising readers to sell off oil positions in the high $30s.
Even if Saddam destroys Iraq's ability to pump oil in the short term, there will likely be a release of supplies from the U.S. Strategic Petroleum Reserve to compensate. In the longer term, there will be not an embargo on Iraqi oil, but a liberation of it. Thus, the move in prices, eventually, could be even sharper.
On the demand side, such forces, Mueller's model suggests, are already in play. The spike in dollar creation lagged by two to three years peaked last fall and is coasting down.
Another result will be a greater boost to corporate profit margins in the U.S. and the world than after the first Gulf War, because of the greater squeeze on pricing power that took place this time around.
In the last Gulf War, producer input prices, measured by the Bureau of Labor Statistics' broad commodity index, rose 7 percent in the year leading up to war. The prices that producers charge, measured by the BLS's finished goods index, also rose 7 percent -- a relative wash for profits.
In the 12 months through this February, by contrast, prices for producer inputs rose 8.2 percent, while finished goods prices rose only 3.5 percent.
Thus, conversely, a return to oil normalcy will provide greater relief than in 1991. This assessment of the impact of oil price normalcy differs from that of many other economic forecasts.
The bottom-line implications of this forecast: Take profits in oil stocks and futures and oil-sensitive economies such as Russia, Indonesia and Mexico. Or, keep those positions, but hedge against oil price declines.
Buy U.S. cyclicals and technology and their Asian equivalents, as oil returns to normal. Japanese and Taiwanese technology stocks are a value play and a growth play.
And if (as we expect) there is continued and even heightened geopolitical unrest surrounding the North Korean nuclear program, you can short the South Korean market as an Asian-crisis hedge.
Second: The Bush recovery
Mueller agrees with the economic consensus that the U.S. first and second quarter will be weak. But he parts company with many in seeing a strong (4 percent) third quarter this year, surging toward 5 percent in third-quarter 2004 and 6.5 percent growth in the fourth.
None of which makes Mueller especially bullish on U.S. or other world stocks over the coming months. His model of price-earnings ratios on the U.S. market implies a range of as low as 700 on the S&P 500 index through summer.
If his short-term indicator is right, then rallies like the recent it-will-soon-be-over Iraq surge are a time to lighten up, at least into May and June.
The same model, however, implies an upside to the S&P 500 of perhaps 1,400 by late 2004, and of perhaps 2,500 on a revived NASDAQ market.
Assuming there is perhaps one more sell-off to test recent lows in the United States, Europe and Asia, this implies taking some profits, or putting on short-term-expiration puts, on rallies in March and April. By summer, Mueller would be fully invested -- expecting the biggest market gains in 2004 but wary of missing the rally by holding off too long.
The one caveat, Mueller says, is if the Fed cuts interest rates again, in the common but false assumption this will stimulate the economy.
At this point, Mueller said, further rate cuts have the primary effect of delaying an economic upturn as investors, employers, and consumers continue to wait for the bottom before locking in loans to expand output. A further Fed rate cut, say during the Iraq war, wouldn't reverse the long-term upsurge, but it might (like last fall's move, Mueller argues) delay it.
The bottom line implications: Sell U.S. bonds. Now.
Buy equities, especially in the technology and cyclical sectors in the United States and Asia, hedging on rallies over the near term. Utilities, as we've said before, should also be a value play, and many will actually provide an interest payout, through dividends, to match or exceed the rate on U.S. Treasurys.
Latin equities, in sympathy with the U.S. market, should be a strong buy around the third quarter -- especially as a new round of trade liberalization kicks in. Brazilian President Luiz Inacio Lula da Silva, initially an opponent of Bush's proposed pan-American free trade zone, has quietly toned down his opposition.
There's a second-order implication to all of the above that is political and long-term in nature, but no less important.
There will, at least in the United States, be a surge in Bush's job performance ratings, and, accordingly, in his ability to win domestic legislation. Assuming he shows the same confident stubbornness he did in dealing with the Democrats in Congress last November, and the United Nations this February, Bush will win a major tax rate cut, probably even the majority of the dividend tax cut he is seeking.
Deficit projections reaching into the heavens will prove, as in the 1980s, to be unduly pessimistic, especially in 2004 and 2005. If this is combined with the rapid establishment of self-rule in Iraq, and a Middle East economic boom built around U.S.-led free trade agreements, all these affects will reinforce one another, synergistically.
The prospects for Social Security and medical insurance reform, a Middle East Marshall Plan, and other Bush initiatives, should all rise.
The upshot would be a classic election-year bull market, and a likely Bush sweep at the polls in 2004. If the Mueller model pans out, Bush will have no need to rely on chads in Florida. The only political question, at that point, will be who Hillary Clinton and Jeb Bush will put on their respective party tickets in 2008.
It's possible to look this far out thanks to minds like Mueller's, which treat economics as a science, but a human one, and make actual predictions. It's part of what makes an encounter with this true forecaster both interesting and potentially profitable.
Harry Truman, tired of hearing his advisers answer questions by saying, "on the one hand," this, and "on the other hand," that, once impatiently asked his chief of staff to go out and "get me a one-handed economist." Mueller has only one hand, but it's highly skilled.
The bottom line is, sell oil and the countries that go up with it, get out of bonds, and buy into a long-term surge in equities starting, approximately, in May or June -- if Mueller is right. He usually is.
-0- (Gregory Fossedal is chief investment officer of the Democratic Century Fund, managed by the Emerging Markets Group. His firm may hold some of the securities mentioned his articles. Individual investors should contact their own professional adviser before making any decisions to buy or sell these or any related securities.)