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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(November 3, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–ASIAN CONTAGION AND U.S. TREASURYS–Flight to safety into U.S. Treasurys last week sent yields to near the cycle lows across the curve. Bond yields are once again testing the 6.15% region. while short-term rates have fallen through the old lows. The economic data for the U.S. have become irrelevant as the market assesses the impact of Asia's problems on the U.S.
To put it in perspective it is worth viewing Asia's problems as a massive currency revaluation. With Japan having allowed the yen to devalue by 30% over the past few years and the Chinese Yuan pegged at an under valued level to boost exports, the rest of Asia was caught with currencies pegged to the U.S. Dollar at very high levels. This led to growing trade and current account deficits, leaving the currencies vulnerable. Eventually, they nearly all devalued to bring their currencies in line with the major Asian competitors. The impact of competitive devaluations is usually a painful restructuring where fiscal policy is tightened and interest rates raised in order to slow the economy, hold down inflation and limit imports. Exports usually get a boost from the decline in the currency and eventually the country experiences an export-led recovery.
In Asia, there is another serious problem however. The booming economies in the region are over built. Excess capacity abounds from China to Indonesia to Korea. Office vacancy rates in Shanghai are running at 35% and look to be at similar levels in Beijing. Official statistics on manufacturing capacity are not available, but there is clearly plenty of slack. Unemployment is clearly higher than the official numbers. And that is just China. Over building is evident all over the region, partly due to the rush of capital investment from the west which has often been done indiscriminately. Western business has believed that they “have to be in Asia” even if it is not particularly economical and even if it means tolerating corrupt business practices and lack of rule of law. The reason is, of course, that Asia. represents such as huge and rapidly growing consumer market and so investment capital has flowed in even though it has often been misdirected.
Eventually, the house of cards fell and now it looks like Asia is facing a fairly substantial slowdown over the next one to two years. The question is how widespread the impact will be on the rest of the world. The range of estimates runs the gamut from the gloom and doom scenario of global deflation to the expectation that the problems will remain fairly well contained. The truth is probably somewhere in the middle. Asia's problems will have an impact on the rest of the world economically just as they have in the markets. However, a decline into the darkness of global deflation seems unlikely.
FACTS AND FIGURES–The good news for the U.S. is that we have a fairly “closed” economy. Only about 13% of GDP is represented by net exports. Hence, economic events outside the U.S. tend to have a minor impact on our economy as compared to say, Australia where the system is far more open. Of those exports, the ASEAN four countries most affected by the problems are only a fraction. Exports to the region represent only about 6% of the total while imports are only about 9.5%. When the rest of Asia and the Pacific Rim are included the figures move up substantially because of the large amount of trade with Japan and Hong Kong as well as Australia and New Zealand. However, these countries have not recently devalued, so the impact of falling prices on the U.S. should be minor. There is a theory going around that the ASEAN countries will “dump” cheap goods on the market, imperiling U.S. jobs and causing “imported deflation.” However, it is useful to note that most of the goods imported from those countries are not the type to displace U.S. jobs. It has been a long time since U.S. workers made cheap toys or garments or did the piecemeal work in the computer industry. On the imported deflation theory, the level of imports is small enough to remain on the margin.
Where the real problem comes in will be how much the crisis slows growth globally and what impact they have on the financial sector in Japan. The ASEAN four countries represent only a fraction of global GDP–about 2%. Even including all non- Japan Asia, the total is still fairly small. In terms of the potential for a slowdown, assuming a pessimistic view that GDP growth slows from 6.9% in 1997 (OECD estimate) to half the pace in 1998, then the impact on growth in the developed world would be about 1% of GDP. So if we were assuming global growth in 1998 at 4.5%, we would cut that to 3.5% which is still fairly healthy. For the non-Asia developing world, the reduction would be about half that amount to a GDP growth rate of about 3% from 3.5% previously estimated.
The other major issue is how much the banking sector of the various countries will be affected. Japan is clearly the weak link as they are the major lender to the region. However, loans to the affected countries represent only about 4% of total loans outstanding and some of those are to subsidiaries of Japanese companies where default risk is low. It is only that Japan's banking system is already a mess that it becomes an issue for the markets. There are no other countries that appear to have such a large exposure to Asia. The issue for the markets is whether the extra blow to Japan's financial system will force them to repatriate capital. The banks need to maintain enough capital to meet Bank for International Settlements (BIS) requirements. If there is an increase in nonperforming loans, there is a risk that they would sell some of their U.S. Treasury holdings to raise the capital. Japan is the largest holder of U.S. Treasurys as of the second quarter, and probably continued to buy in the third quarter. With such substantial holdings, there is always a risk when repatriation is the issue. Right now, we don't see the need, but if the situation in Asia were to spiral downward, some selling would be possible.
RISK PREMIUM RETURNS–Of course, the problems in the credit markets extended well beyond Asia. Some of the worst carnage was in Latin America where credit spreads widened dramatically on fear that the devaluations would spread to the emerging markets. Brazil is usually cited as the most vulnerable because of its large current account deficit. Spreads between Latin American bonds and U.S. Treasurys moved out dramatically during the past two weeks. But credit spreads in the U.S. corporate sector also widened sharply, even though the risk would seem minimal. It looks like the whole event was really a sharp injection of the “risk premium” back into the markets.
I have been expressing concern for some time that the markets did not provide much risk premium. However. I had thought that premium would be reintroduced into the market through Fed tightening over the course of the next six to twelve months rather than transmitting it from Asia through Latin America to the U.S. Nonetheless it is back and although the current spreads appear quite wide, it seems unlikely that the very narrow spreads will return in the near term simply because the markets are still so volatile and the outlook so uncertain.
IMPACT ON THE U.S.–As Fed Chairman Greenspan indicated earlier in the week, the impact on the U.S. economy is likely to be “salutary.” That is, with the economy running at over 3.0% growth for the past seven quarters and accelerating in recent months with a tight labor market, an event like this is welcome in the sense that it should slow growth on the margins. The real economic impact will be small, but at this juncture, it is likely to be enough to keep the Fed on hold a while longer. Moreover, it should mean that import prices continue to fall keeping inflation in check.
However, it is unlikely to mean a decline into global deflation, as some fear, unless every finance official and every central banker does the wrong thing at the same time. Falling asset prices in Asia don't have to mean falling asset prices in the U.S. After all, the U.S. did not experience deflation over the past six years when Japan was falling into recession and experiencing asset price deflation. Moreover, the leading indicators of inflation in the U.S. are still pointing upward, not downward. Money supply growth is rising at a rapid pace and accelerating. Even if imports pick up, the chances of “too many goods” from abroad chasing “too little money” seems unlikely. In addition, the Employment Cost Index indicated that wages and salaries are rising at the strongest pace in years, even if benefit costs are not, which implies ongoing strong demand to absorb supply.
Nonetheless, the picture for the bond market has changed. The Fed can remain on hold a while longer and inflation will likely be better behaved due to import prices than would otherwise have been the case. Domestically, demand would have to slow rather dramatically to prevent higher wages or the ongoing rise in service sector prices however. So on balance, the Fed is likely to continue to monitor growth and the labor markets quite closely. A rate hike early next year is probably still in the cards.
THE WEEK AHEAD–In the near term, the bond market is likely to remain buoyant as long as there continues to be turmoil in the world equity markets. The U.S. Treasury market is the largest and most liquid debt market in the world and that should mean that ongoing uncertainty will keep the capital flows strong.
There are a number of key reports due out next week however. Personal income and consumption should post healthy gains along with construction spending. The NAPM index is likely to edge down from last month's 54.2 reading to 53.0 but continue to indicate expansion in manufacturing. Moreover, commodity prices have been rising for three consecutive months and given the large rise seen in the Chicago report, the risk is to the upside in this figure. In fact, with the Durable Goods report indicating a large increases in core unfilled orders, it looks like manufacturing should remain robust well into 1998.
Auto sales are expected to decline for October from the pace of September. However, consumption continues to run strong even after the hefty 5.7% surge in the third quarter. Moreover, all signs are that business investment is continuing to grow at a healthy clip as well. At the end of the week, the unemployment figures for October are due to be released. It looks like the seasonal factors are looking for a large jump in employment which will mean if the raw numbers are on trend, the report will look weak. Hence, we are expecting a moderate 180,000 rise in nonfarm payrolls versus last month's 215,000 and a consensus estimate of 200.000. Hourly earnings will probably rise 0.2% and the unemployment rate will probably hold at 4.9%. If the figures are in line with expectations, they will probably be viewed as indicating a “slowdown” in employment growth, but chances are it will be a seasonal adjustment problem which is corrected in the next month's data.
Nonetheless, if the market has a chance to pay attention to the economic data, the numbers will likely be seen as supportive to the market. However, we still look for Q4 GDP to come in at 3.5% or above, but that is not likely to be the consensus view for the time being.
In this environment, the market can continue to stay strong but pushing yields at the long end of the curve through 6% may be a tall order unless there is evidence that Asia's problems are causing systemic problems in the rest of the world. The more likely outcome is that the markets will continue to be volatile for a few more weeks, keeping the Treasury market well bid and then the crisis will begin to abate and we can go back to the economic data. For now however, the market is priced for a “worst case” scenario which, if it actually materialized, would end with foreign selling of U.S. Treasurys.
Kathy Jones
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