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Greenspan’s ‘stagnation or worse’ warning could mean ‘run and hide’ for equity investors

by Wayne Cheveldayoff, 2005-04-28

If you hold stocks either directly or via mutual funds, you may want to take a close look at what you own and decide if your portfolio will survive Fed Chairman Alan Greenspan’s “stagnation or worse” prediction for the U.S. economy.

The prediction was conditional – phrased in the context of what could happen if the very large and growing U.S. budget deficit is not reduced – and it was aimed at stimulating Congress to take action.

But given that politicians don’t usually act until they are in the midst of a crisis, and since the U.S. economy doesn’t look so bad right now, there is only a remote chance of the right kind of political action. In short, Mr. Greenspan’s prediction is likely to come true.

Mr. Greenspan is not the first heavy weight economic thinker to sound a warning.

Former Fed Chairman Paul Volker, who led the charge (in the midst of crisis) to crush inflation in the late 1970s and early 1980s, recently cautioned that under the current “placid surface, there are disturbing trends…as dangerous and intractable as I can remember.”

Here is the situation, as Mr. Volker described it. The U.S. nation is consuming about 6 per cent more than it is producing. That’s why it has a record annual US$600 billion current account trade deficit. The savings rate has dropped to zero.

The only thing sustaining this imbalance is a massive and growing capital inflow from abroad, running to more than $2 billion every working day – a lot of it coming from foreign central banks in Asia (which are accumulating U.S. dollars in the process of intervening to hold down their currencies versus the U.S. dollar).
As Mr. Volker puts it, “at some point, both central banks and private institutions will have their fill of U.S. dollars. I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.”
He says the solutions aren’t difficult intellectually – tax increases or government spending cuts in the U.S., stimulus in Europe and exchange appreciation for Asian currencies – but at this point he has little confidence than any one of the above, let alone a combination of all three, would be put in place.
Hence, his pessimism and his expectation that “some event, or combination of events, could come along to disturb markets, with damaging volatility in both exchange markets and interest rates. We had a taste of that in the stagflation of the 1970s – a volatile and depressed U.S. dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions.”
As an investor, are you ready for this?
If your portfolio is invested in a wide range of stocks that will tend to mirror the main stock indexes, such as the S&P 500, the recent words of two Canadian stock market strategists should be of interest.
Myles Zyblock, chief institutional strategist and director of capital markets research for RBC Dominion Securities, observes that stock valuations, while down sharply over the past few years, are still at the high end of their 100-year range. He expects the S&P500 index to produce a total return of only 0.4 per cent a year over the next decade.
Nick Majendie, Canaccord Capital’s equity strategist, studied what had happened in past cycles after six interest rate increases by the Federal Reserve, which we’ve had. He thinks the current situation is similar to 1972-73 and based on that, he expects a 10-per-cent decline over the balance of this year from the recent peak for the S&P500 “followed by another potential downside of 10 per cent before the end of the cyclical bear market by the second half of 2006.”
What this boils down to is that broad-based or index-linked stock portfolios are not going to do well in the next couple of years. Stock-picking will be crucial for positive returns.
If you’re in equity mutual funds, check with your advisor to make sure the portfolio managers have proven they can steer a ship in rough waters.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2005 Wayne Cheveldayoff