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U.S. ECONOMIC AND
INTEREST-RATE OUTLOOK
Prepared by Merrill Lynch & Co.
International Fixed Income Research
The stock market rout lifted Treasuries, although the bill curve
flattened rather than steepened, as would be expected in a typical
flight to quality. Yields on three-month bills were up slightly due
to a $21 billion cash management bill plus ongoing selling by
central banks.
Whatever course the U.S. stock market takes, one lasting result of
the past couple of weeks is that the growth outlook for the Asian
economies is lower than it was before, and so is the outlook for
U.S. export growth. Asia accounts for 25%-to-30% of U.S. exports,
which could subtract about 0.5% from U.S. GDP growth next year. The
declines in Asian currencies should also be positive for U.S.
inflation, provided of course, that the dollar stays firm against
the currencies of our other major trading partners, as we expect
that it will.
While all of this should be good for the Treasury market, one
caution is that during the next few weeks, some institutions may
need to raise capital to shore up their balance sheets and sell
liquid, current issue Treasuries. Thus the market will be
characterized by two-way trading and potential air pockets.
Finally, the sooner confidence returns to the international
markets, the sooner market participants will return to a focus on
labor-market tightness here. At present yields, these factors could
eventually become negatives as investors recall the 1988 and 1989
experience where a return to normalcy following the 1987 stock
market plunge led to sharply higher rates.
It will take some time before we can see the impact of the latest
set of troubles in Asia. We know that what has happened in Asia up
until the last few weeks has not been especially troublesome.
Recent data suggest that GDP and manufacturing activity remained on
solid ground during the third quarter, and labor markets stayed
firm in October.
Meanwhile, Fed Chairman Greenspan has found enough evidence of a
slowing in demand to keep policy on hold for at least the rest of
the year. Even if the stock market heads higher again, the
potential drag from Asia will remain and will keep the Fed on the
sidelines.
Martin J. Mauro
Fixed Income Trading
Strategy
Market volatility continues to be the central issue for both equity
and fixed-income investors with the bond market taking its cue from
the intra-day and daily directional movement of the stock market.
Moreover, the markets' increased volatility has significantly
diminished the relationship between economic data and market
reaction, which has produced some interesting opportunities. First
and foremost, corporate spreads have changed enough to cause us to
increase our allocation to the corporate market from an
underweighted 18% to a modestly overweight 22%. The sharp rise in
implied and historical volatility, which has been accompanied by
widening swap spreads, has not been met with a corresponding
widening in mortgages. We are therefore electing to reduce our
allocation to the mortgage sector from 27% to 26%, while continuing
to allocate 3% to the asset-backed sector and 8% to the agency
market. We are increasing our allocation to Treasuries from 39% to
41% and reducing our cash position to 0% from 5%.
Thomas J. Sowanick
(Reprinted by permission. Copyright <189> 1997 Merrill Lynch,
Pierce, Fenner & Smith Incorporated
November 6, 1997Merrill Lynch & Co.
International Fixed Income Research
North Tower 21st Floor
World Financial Center, New York, New York
Financial Commentary Index
Copyright 1997, by Consensus Inc. All American and Pan American
rights Reserved. editor@consensus-inc.com
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