How the world will carry the US economy

By Michael Coote

Friday 27th February 2004

American presidential politics have heated up the investment climate for 2004. George W Bush, running for re-election, will do anything it takes to stay in the Oval Office.

The president is likely to play the war on terror record ad nauseum to justify massive economic stimulus through defence-related spending for the rest of this year. His self-definition as a war president stakes everything on Iraq while leaving him open to charges of neglecting the US economy.

With little over nine months to go, the president will have to oil numerous squeaky wheels to prevent his electoral bandwagon from tipping over.

Whether or not he is re-elected, the implication is for 2005 to be the year of reckoning for various investment markets. Supposing, for example, that the US Federal Reserve does its usual trick of trying to seem neutral in a presidential election year, interest rate increases are likely to be delayed until after voting day. If inflationary pressures are building, belated reaction to them could result in more drastic action when the smoke has cleared from the election battlefield.

Allowing the greenback to slump is a way of adjusting the massive US trade and fiscal deficits at a cost to other economies. The Bush budget blowout will be dumped on the doorsteps of the rest of the world. There will not be time to effect this rebalancing before the end of the year and it is therefore likely that the fallout will continue under either a Democrat or Republican administration in 2005 and beyond. Economies like Europe and Japan, which have been showing signs of recovery and contribution to world economic growth, will probably suffer as a result through impaired trade competitiveness.

Companies in the US that earn revenues in these economies will not necessarily suffer from any slowdown imposed, because they will record favourable exchange rate boosts to earnings. Instead of carrying the world along with its growth, the US will be able to reverse the relationship and be carried instead.

While this relationship could assist domestic investors in the US, it will not be of much help to foreign investors who will face a trade-off between American returns and currency translation losses. At some point these investors may be tempted to cut and run, especially if Asian central banks decide to stop trying to support the greenback.

Europe in particular looks vulnerable, with the stance over war with Iraq taken by France and Germany taking on the appearance of chickens come home to roost. The slogan of the Bush administration toward these countries was punish the first and ignore the second. What better way than to escalate the euro? What is more, the EU is grinding along toward enlargement on May 1 in what could prove to be a gigantic rerun of Germany's rough ride to reunification.

China, another US bugbear because of its allegedly undervalued currency, will enjoy even greater competitiveness against other economies by virtue of its currency peg to the greenback. There will be little reason for China to float its currency while the Americans are being so helpful, even if inadvertently, in giving its growing export manufacturing base increased trade advantage.

The politically parlous state of the Bush administration, shown in some US polls as likely to lose the 2004 presidential race, will create repercussions that will persist beyond this year for investors.

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