Commentary: 2001 Scenarios

As we begin 2001, we thought it would be helpful to our readers to briefly summarize two scenarios that will likely determine the rates of return earned on different asset classes this year.

In the first scenario, the slowdown in the U.S. economy accelerates, as the impact of declining consumer wealth (due to the fall in equity market values) interacts with the record high levels of consumer indebtedness to choke off spending. Reduced consumer expenditure, along with substantial increases in the costs of debt and equity capital, lead to sharp reductions in business capital investment, further contributing to the sharp reduction in U.S. economic growth. These two developments (made more vivid by a rise in both consumer and business bankruptcy filings) convince foreign investors to begin to repatriate some of the substantial amounts of money they have invested in the U.S. financial markets in recent years. This leads to a fall in the U.S. dollar exchange rate, which raises inflationary pressures and limits the Federal Reserve's ability to cut interest rates to get the economy growing again.

Overseas, the sharp slowdown in the American economy is very bad news for those countries whose growth is heavily dependent on exports to the U.S. These include Canada, Mexico, Japan, and most of the developing countries of Asia. Elsewhere in Latin America, however, countries like Argentina whose currency has been tied to the dollar could see increased growth due to a fall in their exchange rates.

Europe (which exports only 2 percent of its gross domestic product to the U.S.) could benefit from strengthening exchange rates, which would reduce inflationary pressure and create more room for interest rate cuts. On top of this, European consumers and corporations are generally far less leveraged than their U.S. counterparts. Moreover, European companies still have great potential to increase earnings by implementing the restructuring steps undertaken by most U.S. companies over the last seven years. In short, this scenario could generate attractive returns (in dollar terms) on both European bonds and equities.

If these developments happen quickly (as they are likely to in our ever more interconnected age), there is a risk that the U.S. equity market could go into free fall, while interest rates rise to offset a falling dollar. In short, it could get very ugly in 2001.

The second scenario sees a much more gentle landing for the U.S. economy, with falling energy prices reducing inflationary pressure, leading to early Federal Reserve interest rate cuts. These ease the pressure on both corporate earnings and equity market valuations, and in so doing maintain the confidence of foreign investors and keep them from pulling their funds out of U.S. dollar denominated investments. In this scenario, the returns from U.S. bonds are quite attractive, while those on equities tend to be flat to slightly down. Internationally, returns in Japan and emerging markets are also flat to slightly down under this scenario, while returns in Europe are still attractive, if not quite so much as under the other scenario.

For readers looking for early warning indicators of which scenario is developing, we would closely watch consumer confidence and spending indicators to gauge how fast the economy is slowing. We would also watch the gap between U.S. and European interest rates; if the latter begin to fall beneath the former, it is a sign that the first scenario is developing.

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