LOM Weekly Perspectives

Easy does it, says the Chairman

Greenspan delivered his usual carefully worded testimony before the Joint Economic Committee, last week. Whatever the nuances and interpretations of his various statements, one thing was clear. The Fed is in no hurry to raise interest rates. But this is hardly a surprise. They are not going to reverse a successful policy while there is residual uncertainty about the strength of aggregate demand. Low rates have kept the household sector afloat via the wealth effect generated by higher house prices. Not least, through refinancing, it has allowed homeowners to boost their spending power.

Quite a few observers have noted the steady rise in house prices over a time period when stock market indices have been going south. Greenspan, of course, strongly denied that we are witnessing a housing bubble, which should immediately raise a few doubts among those with a suspicious turn of mind. The reality is that asset classes, real or financial, are not segregated and corrections in one class normally have knock-on effects on others. This is what happened to Japanese real estate after the stock market crash in 1989. But unlike the Bank of Japan, the Fed has done a masterly job of handling the post-bubble period. Even so, unkind souls have accused Greenspan of first puffing up the stock market bubble, in the late nineties, and after that was deflated, transferring the bubble to the housing sector. Now, house prices have indeed risen rapidly and are rather toppy, but that was essential to keep household consumption up and save the U.S. from a nasty recession. And policymakers realise that it is necessary to keep this going a while longer until capital spending picks up more strongly. Rising incomes would then, hopefully, replace falling interest rates as the main underpinning of the housing market.

As for capital formation, we should not expect a strong rebound in business investment expenditures, yet. At the same time, the remarks by corporate executives about the outlook are probably more gloomy than warranted by actual prospects. They tend to see small and miss the big picture, at this stage of the recovery. Some are even known to deliberately understate things. The evidence is that even the beaten-down technology sector has seen a few shafts of light. Meanwhile, the vigour of first quarter activity has had a beneficial impact on foreign exporters, particularly in Asia. However, the situation is less sparkling as far as the job market is concerned because corporate cost cutting is preventing a revival in employment growth. All the more reason for the Fed to continue helping consumers with cheap financing.

Although easy monetary policy may be here for a while longer, it will require fine judgement on the part of policymakers when to raise interest rates. There is a danger that if left too late, they may be forced by events to increase rates faster and by a larger amount than would have been necessary if they had moved earlier. As we mentioned last week many bond investors are watching Greenspan's actions carefully. They include foreign investors who hold a good chunk of U.S. corporate and Treasury debt. In addition to inflation jitters, this crowd may harbour worries about dollar depreciation.

There are indications that institutional money managers are becoming less enamoured with investing in America, and consider the stock market to be expensive compared with other global markets. In a survey conducted by Merrill Lynch, covering money managers located around the world, the balance of opinion was that U.S. equities are pricey, given their earnings prospects. A further swing in such sentiments bodes ill for U.S. stock markets, as well as the relatively lofty perch of the dollar. Apart from foreigners, American investors may eventually become disenchanted with meagre returns at home and look abroad for better prospects. Be it noted that large current account deficits, in the United States, have been financed by massive inflows of foreign funds. For the U.S. economy as a whole, sources and uses of funds must balance and deficit sectors must be matched by surplus sectors. Up to now, large deficits run up by the private sector were counterbalanced primarily by surpluses provided by the external sector (i.e. the rest of the world). A smaller surplus from the latter will also mean a smaller deficit by the private sector. This may necessitate a higher saving rate by the household sector.

Given low interest rates and generally poor stock market returns there has been renewed interest among some investors for stocks with high dividend yields. In recent years dividend payouts have declined sharply and growth stocks, of course, have prided themselves on paying no dividends at all. The rationale is that the company has such good prospects in investing retained earnings that it serves its shareholders best by reinvesting all income. Owners would then enjoy returns in the form of significant capital gains. For taxable investors, one issue has been that the tax rate on dividends is higher than on capital gains. However, while this is true, it is also the case that deferred capital gains can add up to quite a large tax take eventually, unless clever strategies are utilised.

Tax issues aside, for a rational investor there should be no difference between receiving returns as dividends or as capital gains. This is because she can easily create dividends, whenever she wants, by selling part of her holdings. Why should she leave the decision to the firm's management when she can do it more optimally herself? However, in an era of manipulated accounting data investors who mistrust management are keener to see cash in the form of dividends as some evidence of management’s ability to deliver the goods. Others may prefer to see cash distributions via stock buybacks rather than dividends. In the longer run the current renewed interest in dividends may not be a lasting one.