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Not Out of The Woods

UK-based economist, Andrew Smithers tells us that US equities are about 40 per cent overpriced even now…

Think we are out of the woods yet? No, not quite! “US equities are about 40 per cent overpriced,” warns UK-based economist Andrew Smithers.
You should listen to Smithers. The last time he warned of stocks overheating, it all came crashing down with the tech bubble. In early 2009 he held the US markets to be fairly valued before stocks rallied again. Andrew Smithers speaks with nearly 50 years of experience behind him. He has done extensive studies of the q ratio (the ratio of market capitalisation to replacement cost of assets), which was developed by Nobel Laureate James Tobin of Yale University.
His firm, Smithers & Co., provides economics-based asset allocation advice to around 100 fund management companies based mainly in London, Boston, New York and Tokyo. His latest book Wall Street Revalued: Imperfect Markets and Inept Central Bankers shows investors how assets should be valued as financial markets are neither perfectly efficient nor complete casinos.
In an interview with Mohammed Ekramul Haque, Smithers talks about the state of affairs in the US, the financial mess in Europe, and what could happen if Greece defaults. To get a grip on the global crisis read on.

There is a view that the current crisis may be worse than 1929. How realistic is that?
The cause of the recent financial crisis was the excessive build-up of debt that had taken place over the past 60 years. The trigger was a fall in asset prices. This had the impact of increasing intended savings and reducing intended investment. This is the usual pattern for financial crises and was seen, for example, after 1929 in the US and after 1989 in Japan. As debt remains excessive and many asset prices are dangerously high (e.g. US equities and UK houses), the conditions are in place for another crisis, but this does not mean we will have one now. The world is much richer than it was in 1929 and there are many more cushions to prevent the dire social impact that occurred then. We are unlikely to suffer as badly.

In your analysis, what is an early indicator of a crisis looming on the horizon?
Most financial crises are triggered by asset price collapses. This time around there is cause for concern rather than panic. This is why I hope to see a recovery in world equity markets, before the next decline.

At the beginning of 2011 there were hopes that the global economic recovery would gather pace in the second half of 2011. Instead, the recovery appears to have stalled. Why has this happened?
Economic forecasts are unreliable. The causes for the change in sentiment are, I think, one, the inability of Eurozone leaders to lead and the consequent steady escalation of the crisis; two, the knock-on impact this has had on the stock markets of the world; and three, the impact of credit restrictions on slowing growth in China.

How is the political gridlock in the U.S. preventing the formulation of economic policies that could engineer a turnaround in the economy?
I doubt whether any economic policy could engineer a turnaround in the US economy. Three key changes are needed: one, an improvement in the external current account; two, a slow narrowing of profit margins, so that real wages can rise; and three, a rise in business investment. There is not much that economic policy in the US can do to encourage these changes. They require time, so that the impact of competition reduces profit margins, and a pick-up in China and other emerging economies so that net exports of the developed world can rise. The key danger is that the US will seek to cut its fiscal deficit too rapidly, which seems more likely if the Republicans win the elections in 2012 than if the Democrats do.

The U.S. Fed first lowered interest rates, then undertook two rounds of quantitative easing, and is now going in for Operation Twist. Will this latest measure succeed in reviving the economy?
I don’t think it will have much effect.

What are your expectations from Obama’s jobs plan? Will it have a tangible impact on the economic situation?
I don’t think that economic policy in the US can do much to help, though it could do a lot of damage. The scope for damage lies largely in too hard an attempt to rein in the US fiscal deficit. Other major risks are outside the US — such as China and Eurozone banks.

What are the chances of the Fed launching QE3 and what will its possible impact be?
I don’t think that the Fed is likely to launch QE3 or that it would have much impact if it did.

Why, in your opinion, the US Fed may not be able to repeat the massive doses of quantitative easing which it had earlier carried out? Why can’t the US just print more dollars and get out of its mess, especially since it can?
The US Fed has only limited ability to engage in QE3, partly because of worries within the Fed, and partly because any success in creating inflation would drive up the dollar’s real exchange rate and slow down the economy by increasing the trade deficit.

There is talk of the US possibly witnessing a Japanese-style “lost decade”. What should one expect if the US does go into a similar “lost decade”?
Japan has grown at much the same rate as the US in terms of GDP per head over the past decade. The period of poor performance was the decade before that. It seems likely to me that the USA will have a similar decade of low growth from 2007 onwards.

What could possibly be the impact of a Greek default on the Eurozone, Euro and the rest of the world? Could such a default lead to a 2008 type crisis which saw the liquidation of one financial institution after another?
I think Greece will default. It can nonetheless remain in the Eurozone. The knock on impact should be containable provided that banks are adequately recapitalised. I expect a long period of uncertainty. The key to avoiding a financial crisis is a massive injection of equity into Eurozone banks. Unfortunately it seems unlikely to me that the planned injections will be adequate.

There is talk of the need for tighter fiscal union among countries belonging to the European Union. Will constituent countries agree to the loss of sovereignty?
I do not expect anything much to be agreed upon. Over time I think that it is essential to have risk-free assets available to Eurozone banks. Only a Eurozone government that can print money can provide this. We are a long way away from realistic policies being formulated for the future of the Eurozone. I think that muddle is going to continue for a long time.

Are there any chances of the Euro zone splintering?
Yes, but I do not think that it is a strong chance at the moment.

If the Eurozone does splinter, which country would go out first?

It is said that China is kicking the biggest debt can down the road (its local governments are said to be heavily indebted). It is also witnessing a property bubble. It also has the problem of over-investment. Do you see all these factors resulting in a hard landing for the Chinese economy?
I am not an expert on China. My understanding is that the economy has its problems and I hope that the government will seek to improve things by one, allowing the exchange rate to strengthen rather faster than it has recently; two, by easing the current credit restrictions; and three, by giving the economy a fiscal boost.

One of the reasons for the financial crisis was excessive consumption in the developed world and excessive savings in emerging economies. Do you see this imbalance getting addressed in the near future?
Yes, it is essential for recovery and requires a realignment of real exchange rates with the major currencies (Euro, Dollar, Yen and Sterling) all falling against the currencies of the emerging world. This requires a combination of very low inflation in the developed economies, rather higher inflation in emerging countries (but not too high as this creates a crisis), and stronger nominal exchange rates for emerging economies versus the major currencies.

How do you see the politico-economic relationship between the developed and the developing countries changing over the next couple of decades?
The emerging world has huge needs for investment capital if it is to grow at its potential. The savings to finance this investment can be provided by the decline in fiscal deficits of the developed world. This, however, requires the developed world to be large importers, i.e., to run current account deficits. Attempts to prevent this will depress world growth.

What is your reading of the current cyclically adjusted p/e (CAPE) and the q ratio for the US? What do the data points suggest regarding where the market is headed?
US equities are about 40 per cent overpriced, according to both CAPE and q. But value is of very little help in forecasting short-term market movements. What I would like to see is a rally, which would help reduce the risk of excessive gloom, followed by a series of falls and rallies which slowly take the market down to a less risky level.