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MERRILL LYNCH & CO.
North Tower, 21st Floor, New York, New York
(November 13, 1997) FINANCIAL FUTURES: INTEREST RATES–The U.S. economy has recently been marching to a different drum than the economies of Japan and Germany. While unemployment is an increasing problem in the latter countries, the problem here is not enough labor. As evidenced by the higher-than-expected increase in October hourly earnings which came in at up 0.5% versus the more moderate up 0.3% that was anticipated, the prospect in the U.S. is for increasing wage pressures at a time when the world economy appears to be slowing.
In contrast to the need for Japan to stimulate domestic demand, the U.S., with its growing trade deficit, needs to promote more savings. Yet if Japan and Germany will not cooperate to offset the slowing of domestic demand in the U.S. by stimulating their own domestic demand, the result could be devastating for the world economy. This is especially true as the inordinate growth in Asia away from Japan slows, and possibly, depending on the financial problems, comes to a “screeching” halt.
The Fed prudently refrained from tightening at its November 12 meeting, despite the concern that the primary resource, labor, is being used up at what is becoming a potentially inflationary rate. At the same time, as indicated in the Economic Perspective and companion Currency Outlook, neither Japan nor Germany appears willing to adopt the stimulative policies that are needed to offset a U.S. growth slowdown. The danger, then, is that world growth, which has become dependent on (some might say addicted to), robust U.S. growth and a disproportionate import growth which accompanies that growth, will slow further, and countries already beset by chronically high unemployment will see their problems balloon.
While growth here, if continued, has the potential for driving up U.S. interest rates, we see little prospect for sufficient world growth to put upward pressure on rates in general. We have argued elsewhere that the recent rate rise by the Bundesbank was a mistake. Further the flattening of the U.S. yield curve (as well as curves elsewhere) warns us of the danger of slipping into a world recession. An Asia where growth does not remain robust to keep up with rapidly rising expectations will not be a “happy” Asia. Further, we would argue that the fall in longer-term rates is a somewhat passive response to the situation and in a time when over-investment may have occurred is unlikely to stimulate demand enough to overcome the impact of financial dislocations in Asia, and fiscal consolidation in Europe. Any caution by the U.S. consumer at this point could exacerbate the situation.
As a result or our concerns about world growth, the U.S. bond market becomes increasingly attractive. First, the general fall in world growth will put continued downward pressure on interest rates. Second, with financial concerns rising, the safety of U.S. Treasuries is compelling as the supply and demand for investment grade issues diminishes. Third, due to the rapid contraction of the U.S. budget deficit, issuance of new Treasury coupons has all but disappeared. Finally, with the U.S. stock market having been on a “tear” for several years, the potential for earnings growth to slow markedly as competition increases and world growth slows is increasing the relative attractiveness for bonds.
Until it becomes clear that the U.S. economy will slow to the point that reduces the concern that tight labor markets will ignite inflation, bonds may have trouble making further gains. However, longer-term secular positives that we have often referred to such as increased baby-boomer savings and prudent fiscal and monetary policies could soon be joined by the positive (for bonds) prospect of a world economy that is, if European and Japanese policies do not change, moving toward recession.
(Reprinted by permission. Copyright © 1997, Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
David Horner
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