wmeubank@ocp.kcmo.com
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(November 10, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–RISK TAKERS TURN RISK AVERSE–The U.S. Treasury market continued to benefit from the turmoil in the world's financial markets. Equity markets and currencies are tumbling in Asia and Latin America, causing investors to flee to the safest, most liquid market in the world: U.S. Treasurys. Investors are fleeing anything that looks risky, even traditionally safe corporate bonds. The market has gone full circle from chasing yields at any risk to chasing safety at any price.
The dynamic of the market is now one of tug of war. The economic fundamentals suggest the economy is growing at a robust pace with rising wage pressures, circumstances that would normally cause the Fed to tighten monetary policy. However, the problems in Asia and more recently in Latin America suggest that economic growth might slow and inflation decline which would mean that the Fed has no reason to raise rates. Looking at these two opposing forces, we continue to believe that the market is probably too pessimistic about U.S. growth prospects.
Growth in 1998 will undoubtedly be affected by the problems in Asia, but the U.S. economy continues to be driven largely by domestic demand. In fact, even after years of strong growth in exports, net exports only account for about 13.4% of GDP. Moreover, comparing the current problems to the Mexican Peso crisis suggests that fears of an export-induced slowdown are probably overdone. After the peso devaluation in December 1994, exports to Mexico slowed by just over 10%. which is fairly mild considering the peso fell 55% during the following year. In fact, exports to all of Latin America were down by about 8% during that year. The Asian tigers represent a smaller trading bloc for the U.S. than Latin America. In addition, Canada and the UK which represent huge trading partners continue to grow at very healthy rates which suggests that overall exports will probably only subtract a few tenths of one percent from GDP growth next year, all else being equal.
What is less certain however, is the impact of the Asian problems on inflation. There is a strong belief in the markets that Asia will export deflation around the world due to excess capacity and their growing share of the consumer goods markets. Since Asia relies on cheap labor as their major resource, the currency devaluations suggest some mark down in the cost of intermediate goods. However, those goods are often finished elsewhere and reexported, so cheap labor is only one component of the process. It is only if the crisis causes the northern Asian countries to tip over into recession that the case for a significant economic impact becomes real. That is where the market is now focusing. Korea's banking problems appear to have gained attention with the won the next currency to fall as a result of the downgrading of the banks.
Now the question is how Japan holds up in all this turmoil. Japan's banking problems are well known but with the Nikkei sliding below 16,000 there is a risk that the banks will have to liquidate cross holdings of shares. It is estimated that the situation becomes critical below the 14,000 level in the Nikkei. If that were to happen then Japanese banks would be under severe pressure which in turn could lead to renewed recession and a deepening of the downturn in global equity markets. The irony is that the whole situation can eventually become circular. If Japan's banking problems really accelerate to the downside, then they may be forced to sell their U.S. Treasurys–the very asset that investors are rushing to buy as a safe haven. There are no easy answers, but the markets appear likely to price in the worst case scenario near term.
DOMESTIC CONSIDERATIONS–Meanwhile, the U.S. economy is without question very strong. Consumption is holding up well in the fourth quarter as evidenced by the rebound in chain store sales in October. Sales appear to have risen by 4.5% on a year-over-year basis, after a lackluster 2.3% rate of growth in September. Auto sales were weaker, but the pattern of softness every four to five months has been seen over the past three years without yet portending a sustained downtrend. The underlying reason for healthy consumption continues to be strength in income growth. Real disposable income and real spending are trending higher, which is the normal pattern of things.
In addition, the manufacturing sector continues to post robust growth. The NAPM index surprised the market by rising sharply from an already-high level to 56 indicating a strong expansion. The underlying indicators were all strong. New orders rose to 59, production rose to 60 and the order backlog jumped to 56.5. Vendor delivery time slowed to 54.7 and inventories declined to 46.5 indicating some difficulty in meeting demand. Employment rose to 52.4 as well indicating ongoing hiring in the factory sector. The price index also rose, coming in at 55.9 in October, marking the fifth consecutive monthly increase and the fourth month above the 50% level. These data were corroborated by a huge jump in factory payrolls in the October report. No sign of a slowdown here.
The employment report was an eye-opener. The unemployment rate fell to 4.7% and nonfarm payrolls jumped 284,000, well above the range of expectations. Moreover, the underlying figures in the report were all quite strong. The August and September reports both witnessed upward revisions to new job creation. Moreover, all sectors posted job gains with the exception of government hiring. The factory workweek rose to 42 hours which is close to the recent record and overtime was high as well. Average hourly earnings jumped 0.5% to a 4.2% year-over-year rate, the highest since July 1989. The figures are clearly consistent with all the other evidence of a tightening labor market and the inevitable rise in wages which goes with it.
FED POLICY–Clearly the Fed is in a tough spot. Domestic economic considerations suggest that they should be tightening policy even though measured inflation has yet to pick up. Inflation is a lagging indicator and given the distortions to the measurement of CPI as a result of the recent changes to the index and the over weighting of computer prices, the risks are clearly to the upside. However, given that the financial markets globally are in turmoil and the Fed has no way of determining what the impact will be on growth and inflation, the most prudent course of action is to hold policy steady for the time being. They are under no obligation to support the stock market or to assure that investors achieve a positive rate of return. However, stability in the financial markets is something they prize.
However, once the markets settle down, the Fed is likely to drain liquidity from the economy by pushing up the funds rate target. If the Mexican Peso crisis is any guide, then the Fed will not wait all that long to hike rates once things settle down. They waited less than six weeks after the peso devaluation to raise interest rates.
STRATEGY–For the near term, the Treasury market is likely to remain strong reflecting ongoing flight to safety and general asset allocation out of riskier investments. How long the uptrend lasts and how far it extends will be a function solely of the degree to which other asset markets deteriorate. It is possible that bond yields will fall below 6% over the course of the next few weeks, but if problems abate sooner then a range of 6.10% to 6.25% is more likely. The short end of the curve is likely to remain well bid as well. We initiated long positions in December T-bonds with close stops in anticipation of another move to the upside in the market near term. We would not want to hold short positions in bonds over the weekend, given the fragile state of the Asian equity markets. Longer term however, when the dust settles, bond yields are more likely to back towards the 6.5% level.
Kathy Jones
Hosted by:
One Crossroads Place
610 West Maple Ave, Suite WWW
Independence, MO 64050
(816) 252-4080
sysop@kcmo.com