Stephen King: Do not assume all recoveries aid stock markets

Attempts to maintain US consumer demand in the short term may undermine medium-term prospects

Last week, I was over in America. Security really has been toughened up. I had never before been subjected to so many airport security searches and it is very much a new experience to be removing one's shoes every five minutes. But it's not just security that appears to have been toughened up: it is also clear investor confidence has staged a significant revival after the disasters of 2001.

While I was there, it became increasingly apparent many investors now think the worst is behind them. The economy is recovering. The stock market has held onto its end-2001 rally. And money talks, particularly when it is aggressively injected into the economy courtesy of Alan Greenspan and his merry men at the Federal Reserve.

Despite this new-found confidence, there must still considerable doubts about the sustainability of the recovery and its implications for the performance of financial markets.

The knee-jerk reaction is to assume economic recoveries are always of roughly the same pace and are always good news for profits and, hence, for the stock market. Knee-jerk reactions, however, should never be trusted. Previous recoveries have varied enormously. After the early-1980s recession, the US economy stormed back, delivering extraordinarily rapid growth rates in 1983 (4.3 per cent) and 1984 (7.3 per cent). At the beginning of the 1990s, it was a different story. After the 1991 contraction, GDP rose 3.1 per cent in 1992 and by only 2.7 per cent in 1993. Outside the US, there have been even bigger divergences: in the 1970s and the 1980s the Japanese economy, for example, was able to recover sharply from recession but has manifestly failed to do so over the past 10 years.

Part of the variance relates to the size of the initial contraction in economic activity. The bigger the initial contraction, the better the chance of a subsequent very strong rebound in economic activity. The early-1980s US recession was very deep while the early-1990s recession was very shallow. This, however, is not the whole story. It may also be the case that some recessions prompt structural changes in an economy that are ultimately a positive for growth over the medium term whereas other recessions lead to no structural reform whatsoever. After all, Japan's recession just seems to have gone on and on, without any lasting benefit to either economy or stock market.

This distinction suggests that all may not be well with the American recovery. The key losers in recession were shareholders and companies as a result of a collapse in profitability. Profits roared ahead in the early to mid-1990s as US companies extracted more and more efficiencies out of a relatively flexible workforce. Productivity growth was high and wage increases were low, implying profits grabbed a bigger and bigger share of the national income cake. Something then went wrong. A combination of excessive capital accumulation – based on hopes of ever rising profits as a result of the "new paradigm" – and a rapidly tightening labour market choked off companies' ability to make money. Suddenly, they were faced with a new world of collapsing profits and, in turn, collapsing capital spending.

Faced with a perfectly reasonable desire to keep America's economic head above water, the Fed cut interest rates very aggressively last year and, for the time being, these rate cuts appear to be offering support. Consumer confidence has recovered (to a limited degree) and consumer spending boomed in the final quarter of last year, helped along by the extraordinary generosity of zero-finance deals on cars. So far, so good. But think about how this mechanism has worked. If companies now have a low marginal propensity to spend, the only way to keep domestic demand going in the short term is to encourage either an increase in consumer indebtedness or a redistribution of income away from companies towards households. In fact, both of these effects are already well entrenched. Consumer debts have continued to rise. And, although there has been a significant rise in unemployment, the general trend of wage growth has remained relatively firm. Consumers have benefited at the expense of companies and shareholders.

That's fine in the short term. If, however, you believe economic growth over a longer-term horizon might depend on capital spending and if you believe that capital spending might depend on profits growth, this doesn't sound like an ideal recipe for lasting economic health. The US recession at the beginning of the 1990s was very much a "restructuring" recession: growth may initially have been weak but, ultimately, companies emerged with higher profits, forming the basis for the exceptional economic performance of the mid- to late Nineties.

The latest episode is partially reminiscent of Japan's experience of the past 10 years. As the Japanese bubble burst, there were initial hopes that Japan would avoid the traumas of "Western-style" recessions. To be fair, Japan did exactly that: economic growth slowed significantly in the first half of the 1990s but Japan avoided the heavy output losses seen in the US, the UK and other G7 economies at that time. Short-term success, however, created a dangerous illusion that Japan was still on a strong upward path and, as a result, a lot of much-needed surgery at the corporate level was postponed with ultimately disastrous consequences.

I would not like to take this parallel too far. After all, the US unemployment rate in recent months has already risen aggressively, a much swifter response than Japan has managed at any point over the past 10 years. Nevertheless, attempts to maintain consumer demand in the short term may still be undermining medium-term prospects for the US economy. Go back to the late 1960s and early 1970s. During that period, the US authorities strenuously attempted to keep growth going, despite a dramatic decline in corporate profits. The mechanisms were similar to today's: loose monetary and fiscal policy designed to keep the labour market relatively tight and so ensure persistently high real wage growth.

But this kind of story is never going to be successful over the medium term. There will be a loss of competitiveness that might, ultimately, undermine the currency. There will be a persistent loss of profits that will undermine the performance of the stock market (the late 1960s and early 1970s were a dreadful period for the US stock market, even before the 1973 oil price shock). And, in today's world of financial market liberalisation, there may be an excessive build-up of household debt, undermining the ability of the economy to sustain decent growth over the medium term.

Under these circumstances, you might as well wave goodbye to the knee-jerk assumption that all recoveries are good for stock market performance. Recoveries that are not associated with rising profits, that are based on consumer borrowing and that follow on from earlier periods of excessive asset price inflation are not healthy recoveries and, for the most part, are unlikely to generate healthy returns for shareholders.

Stephen King is managing director of economics at HSBC.