President to preside over a weakening economy and dollar?

The Presidential election race and outcome has dominated the media over the past month and means a short term US sharemarket rally is likely. However, long term economic issues still remain.

Thursday, November 4th 2004, 5:21PM

by Anthony Quirk

The Iowa futures market was predicting a clean sweep for the Republicans and so it proved, despite the polls suggesting a much closer race.

This was also repeated in the recent Australian election where the polls had Howard and Latham neck and neck but Howard was the hot favourite with the betting agencies.

So given the same US Administration is in place the market's attention will once again return to the outlook for the US economy, dollar and sharemarket, much of which is outside the President's direct control.

For example, economists suggest that global economic growth would be about 0.5% pa lower next year if oil stays around current prices.

The high oil price is also a reflection of the positive demand forces generated by China, which has higher demand for this (and other commodities) than it can supply itself. There is also an element of speculation in the oil price, with hedge funds contributing to the price rise as they hunt for returns across the various markets.

Buying pressure from US refineries as they stock up for the winter has also been a factor.

We have seen both these influences dissipate over the past week, bringing down oil prices.

I feel that the concern about the impact of the oil price rise on the global economy and on share markets around the world is somewhat misplaced.

The rise in the cost of oil is effectively a tax on most of the world and will help a very strong global economy to slow down to more "normal" levels.

If the oil price had not risen as dramatically then, in any case, the US Federal Reserve would have been compelled to raise rates.

The Fed needs to ensure the US economy does not over heat from the effects of the current very stimulatory low interest rate and lax fiscal policies in that country.

Granted, the impact on different sectors of the economy does vary, depending on whether higher oil prices or interest rates occurs. However, either way slowing down US consumer spending is a positive development in terms of the adjustment necessary to improve that country's huge trade deficit.

Thus, some decrease in growth after a very strong global economy over the past 12 months is not unexpected. Likewise if oil prices suddenly collapse (an unlikely scenario at present) expect to see the US Federal Reserve to have a more aggressive attitude to raising US interest rates.

While inflation is their main concern this response would also be influenced by the United States having its trade deficit at record levels.

The most probable levers for some adjustment to this are:
a slow down in its economy to decrease import growth; and/or decreasing the US dollar to make its exports more competitive and decrease import penetration.

Thus the orderly decline in the US dollar is welcome. However, financial markets do not always adjust smoothly and an orderly decline can quickly move to a dramatic sell off, particularly if speculators accentuate the movements in currency markets.

If a dramatic sell-off in the US dollar does occur it will have significant impacts on economies around the globe.

It would undoubtedly result in higher interest rates in the US, which combined with the high oil price would be a "double whammy" for the global economy.

Like the US dollar the kiwi dollar is subject to forces which may bring it down over time. New Zealand's economy is set to slow, its interest rates have probably peaked and we have a large current account deficit.

So there is currently a "Mexican stand off" between the US and kiwi dollars, as both have reasons to be weaker in twelve months time.

My pick is that the New Zealand dollar would once again test the 70c US mark, as the US currency weakens further.

However, there is a possibility that the kiwi has peaked. On the domestic front there was the somewhat strange sight of declining fixed long-term mortgage rates as short term rates were still rising.

This comes back to last month's graph that suggested long-term bond rates can start falling before short term rates peak.

This appears to be the case again this time through with the Reserve Bank of New Zealand signalling that it is tightening.

Defensive, high yield stocks should out perform in this environment and the market has started to adjust to this as well as the reality of a slower global economy, whichever Presidential candidate was elected.

Review of the month's numbers: It was difficult for most of October for sharemarkets around the world, with many testing new lows.

However, a rally at the end of the month did help lift some into positive return territory. For example, the S&P 500 was up 1.4% for the month, with the Nikkei 225 the only major index down in October (-0.5%).

The New Zealand sharemarket under performed global markets in October, as signaled in the last month’s commentary.

On the bond side domestic and global bonds both produced returns around the 1% mark for the month.