Author: David Roche

Author: David Roche

The dollar and the Dow have dived. Serious imbalances in the US economy are now evident. The current account deficit is nearing unfinanceable proportions. The US economy could only grow at an above-average, yet disinflationary, pace while the rest of the world remained stagnant. That's no longer the case. Global growth is accelerating. So the dollar is no longer the currency of choice. And a weak dollar is synonymous with rising commodity prices and resurgent inflation. And it's not just the US economy and financial markets that are becoming paralysed. I reckon 2000 will be a year of US foreign economic policy paralysis. At its heart lies the presidential campaign. The impact on international relations could be severe. Those with Russia are already becoming strained. A deal on Chinese World Trade Organization accession may be missed, undermining Zhu Rongji and China's reformists. Trade tensions with the EU will escalate. And no action will be taken to support the dollar.

Faster and more synchronised world growth is bad news for bond markets. But the prospect of accelerating growth in Europe and a slowing US economy next year points to the outperformance of US bonds vis-à-vis the EU.

by David Roche

by David Roche

by David Roche

The contrasting economic fortunes of the core of Europe and those at the edge of, or outside, the euro area persist. The consensus view has been that euroland economic growth will begin to accelerate this year and that there will be a slowdown (or even recession in the case of the UK) in the periphery.

It's not just the tragic events in Kosovo that are hitting the economies and financial assets of central Europe. The current state of the European Union isn't helping either. It's ironic that, just as central Europe's reorientation towards the EU once underpinned its post-communist revival, it's now proving to be its nemesis. Slow growth in the EU this year means big external financing gaps for Poland and Hungary. Germany, which accounts for around 30% of the region's exports, is crucial. But the collapse of demand from Russia, which accounts for another 5% to 8% of exports, doesn't help.

The fall of German finance minister Oskar Lafontaine is bullish for German financial assets, but only in the short term. Euroland remains a slow-growth region. So, after a brief rally, I reckon the euro is set to weaken again against the US dollar, moving towards parity. The European Central Bank will now be much less reluctant to cut interest rates in order to fend off EU recession. There's no justification for maintaining real rates of 2% to 2.5% when real GDP growth in the euro zone is sub-par and slowing and inflation below 1% and falling. Short rates could go 50 to 75 basis points lower by the year-end. That will help German Bunds and equities, which have underperformed the EU average by over 10% so far this year. That performance gap will narrow quite quickly.

The euro will fall by a further 10% against the dollar and reach parity with the US currency within a year.

It is ironic that the strongest disciples of free markets are often the messiahs of currency pegs, fixed exchange rates and currency target zones. Those who believe the market should set the price for everything reject its decision on pricing international economic input and output.

The key to prospects for world growth in 1999 is Japan. I expect the US economy to slow during the year and the core of Europe to grow by less than 2%. So the OECD as a whole is unlikely to achieve even 1% real growth this year unless Japan picks up.

It was before the wave of strikes that hit France in December that I glided into the Gare du Nord on one of France's ultra-smooth, ultra-expensive (to the taxpayer, not the traveller) TGVs. I had two questions begging answers. First, would the Franco-German axis in Europe hold? And second, would France meet the Maastricht criteria for a European single currency by the end of 1997?

Continental European equity markets have rallied hugely since the US Federal Reserve began to cut interest rates. It's an opportunity to sell.

Global interest rates are falling, and will fall dramatically. Alan Greenspan has already cut rates by 0.5%, with one surprise cut in between meetings of the Federal Reserve. And the Fed is going to cut some more this month.

Next year, the world economy will shrink. Only Europe will have moderate growth. Wealth destruction will produce a growth recession in the US. Japan will continue to emulate an economic black hole in the middle of a time warp. Emergent economies' growth will be negative.

When Germany's federal election takes place on September 27 the miracle of chancellor Helmut Kohl's winning in 1994 against all predictions won't be repeated. There are good reasons why. Germany's economy may be picking up, but domestic demand recovery is tentative. During 1997 the rebound was export-led, and although the domestic investment cycle is turning up, household spending remains flat at best. At 10.7% unemployment is still too high and much of the recent job creation has come from government-sponsored schemes, especially in the eastern Länder where Kohl's ruling Christian Democrats (CDU) remain deeply unpopular.

The emerging-market crisis will roll on, mutating like a virus as it kills investor dreams. Sure, Latin America's flaws are not those of Asia. But they're deep enough for the region to get whacked.

The initial membership of Emu is decided, as is the board of the European Central Bank (ECB) and the exchange-rate parities for converting Emu participant currencies into the new euro on 1 January 1999.

I expect the US equity market to fall 30% to 40% this year. The catalyst for the turn in sentiment will be static (or falling) corporate profits, rising inflation and higher interest rates. Mania will drive the collapse. When the dust settles, the US economy will slide into recession. Consumers will retrench to pay down debts. The dollar will fall. It will be the dawn of a two-year bear market.

Japan is stuck in a time warp. Little has changed, and what has is for the worse. The economy is in dire straits. Half-hearted reform erodes the real incomes of households and corporations without the stimulus of real supply-side deregulation. Household savings rates are already historically low. Export demand is waning. The economy will be down this year and next.

Despite the current signs of relief in Japanese and other Asian financial markets, deflationary forces in the region are set to grow. That will force the US and Japan to signal the end of the Asian crisis with a new global policy framework and massive fiscal stimulus in Japan. Investors should prepare for a policy reversal.

The financial world will feel better now Korea has got most of its foreign debts rolled over. The bankers who lent Korea the money in the first place declare they have solved the Korean crisis a mere momentary liquidity squeeze and the Asian crisis along with it. The world may believe them for a short while (though it's ironic it should grant credibility to bankers it was their stupidity that let the crisis happen).

Economic growth in several major east Asian, Latin American and eastern European economies will halt in 1998. Emerging market banks' $550 billion of non-performing loans (probably well above $600 billion if unofficial estimates are correct) may cause a rash of failures ­ or even systemic financial crisis in some countries. Korea, China and Slovakia are among the most vulnerable.

The global bear market has started. It will knock the stock markets of the mature economies back 20% off their peaks, and emerging-market debt and equity by much more.

First the UK's new Labour government dropped hints that it was gearing up to join Europe's single currency earlier than expected, and before the full launch in 2002. Then it seemed to pull back and suggest that UK entry would not happen in the five-year life of the current parliament. That's made for continued uncertainty. Financial markets want to know when.

I've just returned from Germany, visiting the great in government, bureaucracy, Bundesbank and the European Monetary Institute. I'm convinced the Bundesbank will raise interest rates by 25 basis points before the year-end and by around 200bp by the end of 1998.

The world's economic and financial leaders at this month's IMF/World Bank meeting will preside over a strengthening global economy. Real GDP will be stronger next year than this. But the reasons differ by region.

We investors are nightwalkers in a dream world, where success is not predicting what economies will do next, but what the markets will dream they will do. So in trying to predict where markets will be by the end of 1998, a realistic starting-point would be to say: we don't know. But, at least, we can outline the critical variables that will make you richer or poorer over the next year or two.