wmeubank@ocp.kcmo.com
FULLER MONEY THE GLOBAL STRATEGY INVESTMENT LETTER
Prepared by Chart Analysis Limited
The Risk Of Global Deflation Has Increased
--Currency devaluations, weakening stock markets and slower economic growth emanating from the Far East are contributing to increasing deflationary pressures.
--Government bonds for developed countries offer safety relative to stock markets but the speculative narrowing of yield differentials is over as investors become more risk averse.
--All previously high-flying stock indices show evidence of top formation development and should weaken over the medium term, especially those of emerging markets.
--Asia's most depressed stock markets are, arguably, cheap but there is no conclusive evidence that they have bottomed and the eventual recovery process could be slow.
--The Japanese Yen remains a weak reserve currency but is becoming temporarily oversold.
--Renewed strength for the U.S. Dollar against the mark and Swiss Franc has been delayed by stock market jitters and also the selling of currency reserves by beleaguered central banks, but it should successfully challenge this year's highs in 1998.
--The Hong Kong Dollar's peg to the U.S.$ cannot survive beyond the medium term.
Cash Is King Once Again
The Art Of Denial--For another example of life imitating art...well, Hollywood at any rate, did you see that tabloid-style front page article in The Wall Street Journal on 3rd November? In case you missed it, the headline read: `How Six Real Pros Conquered the Chaos In Wild U.S. Market!' According to this story, six of Wall Street's bravest and truest fund managers and brokers rose in the dark early Tuesday morning 28th October, flipped on their at-home screens to a sea of red from Asian prices, and did what a man/woman has to do--spend hundreds of millions of other people's money `barking' buy orders to every dealer they could reach.
Move over Arnie, Bruce and Sly--the real American heroes today are the mutual fund managers and brokers. Is this a contrary indicator for the stock market? I fear so, recalling the old gag that probably came from 1929, which was revived after the 1973/74 bear market and again following the 1987 crash. Two boyhood acquaintances meet after many years and ask about their respective professions. One nervously admits to being a stockbroker and adds quickly `but don't tell my mother, she thinks I play the piano in a whorehouse.'
The point is, these folks were understandably, if unfairly, regarded as pariahs at the great buying opportunities throughout stock market history. Their current status as icons of financial probity may have been well earned in the recent great bull market but it is hardly reassuring as an indication of where share prices are heading.
Meanwhile, comforting words from the financial industry would have us believe that the stock market shake out is nothing to worry about. They mean well of course, but if everyone sits tight as the bubble bursts, today's reassurances may cause more financial harm than good. Panics should be prevented, if possible, but fundamentally overdue downward adjustments should not and cannot be postponed indefinitely. Encouraging everyone to hold on in the belief that overvalued stock markets will soon bounce back, when the Asian contagion (to use the new financial buzzword) is clearly spreading, risks far greater losses for the least wary. More practical advice might be--if you are going to panic, panic early!
Market bubbles occur throughout history because everyone participating gains more, at least for a while, through a collective denial of the risks. The bullish arguments that we have heard recently for overheated markets are facile. For a dose of common sense, I prefer one of Alan Greenspan's less publicized comments: `We should keep in mind,' he said not long ago, `that at these relatively low long-term interest rates small changes in long-term earnings expectations could have outsized impacts on equity prices.'
It is the height of complacency to think that Asia's economic problems will not affect corporate earnings in the United States and just about everywhere else. Where will it all lead? I think we should be prepared for at least medium-term bear markets. The risk of global deflation has increased considerably and could be compounded by significant falls for the world's stock markets.
Arguably, bonds are less risky than stocks today but they are not quite the safe haven that we have heard. Concern
over currencies and credit ratings can hit bond prices hard, as we have seen with some emerging market debt
recently. Moreover, deflation would reduce economic growth, increasing the supply of bonds. For safety, I prefer
cash, currently in U.S. Dollars and sterling. Last year's financial slogan was `Cash is trash.' I think we will see a
revival of `cash is king.'
Interest Rates And Bonds
Higher Short-Term Rates Despite Increasing Deflationary Pressures--until recently, global economic growth averaging 4.5% in 1997 (IMF estimate) represented the difference between a healthy disinflationary environment and destructive deflation. However, collapsing currencies, weak stock markets and slower growth--emanating from the Far East--have considerably increased the risk of global deflation. Meanwhile, central bankers are contributing to the problem by hiking short-term rates--in East Asia and other developing countries' failing attempts to prop up overvalued currencies, and also in the West's continued battle with the carcass of inflation. The latest increase by the Bank of England, the 5th consecutive 0.25% turn of the screw since the May election, has lifted the bank rate to 7.25%. This looks pedantic on domestic considerations and reveals little awareness of increasing global deflationary pressures.
Eurodollars Continue To Encounter Resistance From Their 12-Month Highs--Most of the dynamics on this chart (large daily ranges) are downwards. This suggests that the overall upward trend is tiring. However, the main reaction lows are still rising and a close beneath 93.985 for the March contract is necessary to break this progression, indicating further technical erosion.
U.S. Treasury Bonds Steady To Range Near Their Early October High--The overall advance in U.S. long-dated bond prices has slowed since the end of July. However, they recovered quickly from last month's correction and are currently ranging near the October/November highs. While some erosion of support would commence under 117 (December), a close under 114 would be necessary to break the progression of rising lows and indicate significant deterioration.
UK Gilts Show Extended Top Formation Development--Gilts accelerated to a peak at 121-27 (December) on 3rd October and then fell back sharply. The subsequent rally was small and gilts have recently broken last month's reaction low. A close over 118-16 is required to suggest a higher phase of top development before a further retracement of this year's gains is seen.
German Bunds Continue To Encounter Resistance Near Their Historic Peaks--Bunds also fell back sharply from an early-October peak but have subsequently seen a somewhat better recovery than gilts. Nevertheless they have basically been marking time since July in a region of historic resistance. A close above 103 (December) is currently required to indicate a further test of the peak area rather than sideways to lower trading.
Italian Bonds Are Drifting Beneath Their October High--Italian bonds had been in an overall bull market since bottoming in March 1995. They also hit a high in early October, at 113.12 (December). A retest was unsuccessful and Italian bonds have been drifting subsequently. This type of broadening pattern is a potential top development characteristic and an upward dynamic is required to offset sideways to lower ranging.
Swedish Bond Yields Are Unlikely To Retest Their Low--Last month's strong rebound by Swedish bonds, starting with a breakaway gap, confirmed that an important low was established by the 10-year yield at 5.98 (December) on 3rd October. The rally encountered resistance from the first area of potential supply from the July/early-September range but there have been no downward dynamics recently. Consequently, Swedish bond yields should eventually push over last month's high at 6.55%, indicating additional upward scope.
Australian Bonds Have Backed Away From Their Latest High--Australian bonds are only one of two long-dated issues that I follow which were able to clear the early-October high, the other being JGBs. However, the move was not maintained and the December contract has subsequently been ranging near its earlier peak. A close under 93.80 (December) would reaffirm resistance near current levels.
Japanese Bonds Falter Within Their Uptrend--While JGBs extended their orderly uptrend following a pause in late
September-early October, the move has now become choppy. While the evidence is not yet conclusive, Japanese
bonds do appear to be losing upside momentum at long last. Below 129.40 (December) they would clearly be
eroding prior support for the first time in many months.
Conclusion On Bonds
The global bull market in long-dated government bonds looks tired, with many contracts ranging in regions of
historic resistance. This is occurring despite a so-called flight to quality in bonds and growing concern over
deflationary pressures. If that does not push bond prices higher, what will? Nevertheless, despite the October peaks
for most contracts and overall loss of momentum, none have broken their progression of rising reaction lows. Until
that occurs the previous uptrends remain, arguably, intact.
Global Stock Markets
Top Formations Predominate--Many pundits had hoped that western stock market strength would pull Far Eastern bourses higher. Instead, Asian contagion has spread to the west. Very few of the many uptrends evident at mid-year for world stock markets remain intact today. They have been capped by ranging top formation development. While these patterns may be extended, they represent distribution following significant and often accelerated advances. Consequently there is a very considerable risk that previously high-flying stock markets will fall further in coming weeks and months, perhaps significantly.
Watch The Charts--Many people still believe (hope) that, aside from Asia, stock markets are experiencing no more than a periodic correction before resuming their prior uptrends. If this is true, the first hint of improvement would occur on breaks in the progression of lower rally highs where these are evident. However, the size of the ranges forming make them unlikely upside continuation patterns, especially where strong prior advances had occurred. Nevertheless, sustained moves to new highs would at least open the door to further gains. As for Asia, failed downward breaks and rising lows are needed to provide preliminary evidence of sustainable floors. I have tried to be objective in assessing the technical facts as they appear on the charts and once again I eschew targets which are pure conjecture.
The Chart Analysis World Market Indicator (currently 1424) has fallen further and much faster than during its 1994 bearish phase. Consequently it now appears somewhat overextended. However, an impressive rebound is required to indicate a significant change in overall momentum. CAWMI is unweighted and calculated in local currencies every Monday.
MS Capital International's World Index (907) fell back sharply from its July peak near 980 to break the August reaction low. A move over 925 is required to indicate a steadier tone. The MSCIWI is capitalization weighted and calculated in U.S. Dollars.
The USA's Dow Jones Industrial Average (7401) slumped from its August peak and the subsequent rally has encountered resistance from the lower side of the overhanging top pattern. A close over 7700 is the minimum required to indicate some further test of that area. The Standard & Poor's 500 Index (906) recorded a failed upside break in October and subsequently fell under the August low near 900 before pushing back above that level. While a test of this churning pattern's upper region becomes possible on a close over 944, further deterioration is now apparent on the move under 920. The NASDAQ Index (1542) has seen a slightly larger numerical fall than its June/July 1996 and January-April slides. While a move to 1640 would suggest a further test of the peak area, the technical picture deteriorates progressively under 1600.
Canada's Toronto Composite Index (6648) failed to sustain September's upward break but found support on a closing basis at 6600 near the August low. Subsequently resistance has been encountered beneath the peak and 7000 is needed to indicate further pressure on that area. Conversely, the outlook deteriorates incrementally beneath 6840.
Chile's IPGA General Index (4945) accelerated to a low near the December/January floor before steadying around the psychological 5000 level. A move back over 5150 is the minimum needed to remove pressure from prior support levels.
Mexico's IPC Index (4335) plummeted following its failed nudge over its August high at 5200. The recent break of previous support near 4600 increased the top formation characteristics.
Brazil's Bovespa Index (7822) has seen an even bigger plunge and requires 10,500 to suggest an additional phase of top extension.
Japan's Nikkei Stock Average (15,434) has broken well clear of the year's earlier floor near 17,400 and needs a rally of over 1000 points, clearly exceeding any seen during the present decline, to check the downward momentum.
India's BSE Sensex Index (3633) is eroding prior trading and a move above 4160 is required to indicate a significant improvement.
Taiwan's Weighted Price Index (7712) steadied near the upper region of its old
base near 7100. However a move over 8100 is required to indicate a top extension phase.
Hong Kong's Hang Seng Index (9608) accelerated downwards before finding support near the psychological 10,000 level. A close over 11,300 is the minimum required to suggest somewhat higher trading.
Singapore's Straits Times Index (1686) has rebounded following its latest downward acceleration. While that move looks climactic for the short term to possibly intermediate term, supply above 1800 is unlikely to be challenged easily.
Malaysia's KLSE Composite Index (684) also rebounded following an accelerated decline towards the old base which launched its 1993 bull run. However, a move above 740 is required to indicate a test of overhead supply and a new base is probably required before more than a technical rally can be sustained.
South Korea's Composite Index (517) accelerated towards its important 1992 floor before steadying. A close over 560 is needed to break the progression of lower rally highs and indicate an additional technical rally.
Thailand's Bangkok SET Index (469) has not maintained its latest downward break. However a move above 575 is the minimum required to revive the base building hypothesis.
Australia's All Ordinaries Index (2511) plunged following its failed upward break and fall under lateral trading at 2600, before rebounding from dense trading evident under 2300. However, the rally has faltered beneath the top area and a push over 2600, which seems questionable, is needed to indicate a further test of the peak area rather than sideways to lower trading. The All Mining Index (631) has slumped back towards its important 1987 to 1993 floor area but the current pattern cannot support more than a technical rally at present.
New Zealand's Capital 40 Index (2416) collapsed, then rallied almost as strongly, before encountering resistance beneath the peak area. A close over 2500 is now required to indicate a further test of this region rather than sideways to lower trading.
South Africa's JSE Industrial Index (8042) plummeted but did not maintain the breach of the important 1996 lows near 7600. However the rally has faltered well beneath the peak area and a push over 8350 is needed to indicate an additional recovery rather than lower ranging. The JSE Gold Index (831) has fallen back to its recent lows and needs a move to 1100 to establish this as a floor area.
Belgium's BEL 20 Index (2282) is ranging lower in a volatile fashion and would need to push above 2400 to question lower trading and rather indicate a higher phase of top extension.
France's CAC 40 Index (2696) rallied from prior support within the February/early-June range centered on 2600, but has now encountered resistance from the overhanging top area. A move over 2820 is required to suggest somewhat higher trading within that pattern rather than a retest of last month's closing low near 2660, at least.
Germany's DAX Index (3659) plunged from its highs before experiencing a rebound which has faltered beneath the lower region of the top area. A push above 3860 is currently necessary to indicate top extension rather than sideways to lower trading.
The Netherlands' AEX Index (845) looks top heavy and a rally over 890 is needed to suggest an extension to this pattern rather than an additional retracement of the year's gains.
Spain's Madrid SE Index (542) fell sharply before rebounding from the January-April range centered on 475. However, resistance has been encountered beneath the top area and a move above 580 is needed to further test that area instead of sideways to lower trading.
Italy's BCI Index (927) fell back from the psychological 1000 level once again before bouncing from the August reaction low near 880. A move under this level would look like a completed top and 950 is needed to suggest a possible test of the pattern's upper boundary.
Sweden's Affaersvaerlden General Index (2888) slumped following a retest of its August high before bouncing from support within the February-May range between 2830 and 2620. However the rally has faltered beneath the top area above 3050. A move over this level, which appears unlikely, is needed to delay a further retracement of this year's prior gains in coming weeks.
Norway's Oslototal Index (2084) could not maintain last month's upward break but has bounced from previous support near 1265. However the previous uptrend momentum has been checked and a move under this level would indicate lower scope. Conversely, a close over 1400 is needed to suggest somewhat higher scope.
Denmark's Copenhagen SE Index (611) flopped back shortly after October's failed upward break, but did not maintain the slide beneath September's low near 606. However a sustained push over 662, which seems unlikely, is necessary to question the top building hypothesis. Additional weakness would be indicated under 600.
Switzerland's Swiss Market Index (5434) looks top heavy in the current churning pattern. A sustained move above 6000, which appears highly unlikely, is required to offset the bearish implications of this pattern which would deteriorate further under 5200.
Ireland's ISEQ Overall Index (3654) could not maintain September and early-October's additional surge and the sharpest fall in many years has broken the upward momentum. Renewed weakness would be indicated on completion of the top at 3540.
The UK's FTSE 100 Index (4720) more than reversed its September/early-October surge with the sharpest reaction
since 1987. This was also the biggest correction since the first half of 1994 and has therefore broken the erratic
overall upward momentum. Upward scope appears limited to some top formation extension prior to an additional
retracement of this year's gains.
Conclusion On Stock markets
We saw a mini crash in global stock markets towards the end of last month. This was immediately followed by some sharp rebounds, raising hopes that the shake out was over, leaving the bull market for previous high flyers intact. U.S. investors in particular have been conditioned to buy on every reaction. Needless to say that strategy will work splendidly until the bull market is over--then it compounds the eventual downside risk.
Stock market bull trends usually end on inflation, and we did see interest rates move somewhat higher in pre-emptive strikes against cost pressures, particularly in the UK. However, deflation fears have taken over, which
means that bond prices are no longer functioning as a lead indicator with the reliability of previous years. In fact,
U.S. long-dated bonds have been taking their cue from Wall Street recently, moving in the opposite direction as
investors seek refuge from a stock market sell off. Meanwhile, NIC and third-world debt, which had rallied sharply
earlier in the year on yield convergence speculation, has fallen even faster in recent weeks. This can only diminish
investor enthusiasm for financial assets. Today, the crucial questions for investors are, the length of time that it
will take for Asian stock markets to bottom out before they can stage significant recoveries, and the extent of
additional top development in other markets before they head lower. Given the financial problem and investor
disillusion, I suspect that it will take Far Eastern markets a long time to establish sustainable uptrends, perhaps
years. Meanwhile, most could move somewhat lower. The last lengthy top building process for Wall Street and
other western stock markets was in 1972/73. Could the culture of buying setbacks, corporate share repurchase
programs and takeovers hold off a serious decline for months? It is possible, but bear markets usually occur more
quickly.
Currencies
The U.S. Dollar Is Unlikely To Encounter More Than Temporary Resistance Near Its May Peak At <157>127.5 Against The Yen--Does lightning strike twice at the same spot? The possibility will cross all currency dealers' minds but they will probably conclude that it won't happen. Therefore the dollar, supported by its August-October range, should see no more than a temporary pause near the year's former high. However, watch for any clear acceleration, relative to the recent persistent move, which would suggest that another peak was imminent.
Sterling Surges Over Its May Peak Against The Yen But This Move Is Becoming Overstretched In The Short Term--A 675-basis-point interest rate differential among reserve currencies is a powerful magnet but the pound's latest move against the yen is becoming overextended. Watch for some unsustainable acceleration and a downward dynamic to signal the next corrective phase.
The Mark Is Testing Prior Resistance Against The Yen--Following its mid-September to October consolidation the mark has raced ahead against the yen once again. However, it is now in a region of previous resistance up to <157>75.92 established between September 1996 and April 1997. Any loss of momentum, let alone a downward dynamic, would indicate the onset of a reaction.
The U.S. Dollar Retreats Further Into Prior Support Against The Mark But Should Rebound Before Long--Last month's break of the short-term downward trend proved temporary and the dollar has drifted further into the broad February-June range centered on DM1.70. In the process of this long decline from the August peak at DM1.8905, sentiment readings have moved from nearly 90% bullish for the greenback at the high to less than 35% recently. This is a contrary indicator but a clear upward dynamic, at least over DM1.75, is required to establish a new floor and significantly higher scope. Meanwhile, dollar bears should consider all the technical evidence which indicates that when market corrections are clearly slower and more orderly than rallies to peaks, the high is retested, at least, far more often than not.
The U.S. Dollar Has Also Fallen Further Against The Swiss Franc But This Decline Appears Overextended--As against the mark, the dollar slumped to a new reaction low against the Swiss Franc late last month. However it is still holding near its intra-day floor at SF1.3772 on 21st May. The decline looks overstretched but a move over SF1.42, preferably on a dynamic, is needed to signal recovery scope.
Sterling Should Retest Its Top Area Against The Mark--Following last month's upward dynamics, sterling consolidated initial gains against the mark before resuming its recovery. Underlying support now appears sufficient to test the late-July/early-August top area evident mostly above the psychological DM3.00 level and extending up to DM3.086. A fall back under DM2.85 is currently required to question this outlook.
Sterling Should Successfully Challenge Lateral Trading Above SF2.45 Against The Swiss Franc--The pound broke upwards against the Swissie last month before falling back to retest lateral trading near SF2.30. Hey, this happens! Anyway, the low has held and the additional build up of underlying support should now sustain a successful challenge of lateral trading near SF2.45 and an eventual clearance of the July peak at SF2.5362.
The U.S. Dollar Pauses Near The Psychological W1000 Level Against The Korean Won But This Move May Not
Be Over--The dollar's latest surge against an East Asian currency came with its upward spike against the Korean
Won in late October. In two quick steps it bounded to W999 before pausing in a probable consolidation beneath the
psychological W1000 level. While the dollar will probably now undergo a ranging phase, it would be surprising if
the overall upward scope out of the long prior range had been completed in only two-and-a-half weeks.
Commodities
Coffee Steadies Near Its June-August Lows--Coffee prices accelerated to a peak between January and the end of May before collapsing to a July low of 135<155> for the March contract. A secondary rally failed below 180<155> in early September and the price ranged back down to its June-August lows where support has been encountered once again. The short-term downtrend has been broken and a close under 140<155> is required to question current scope for some additional recovery.
Orange Juice Springs A Seasonal Rally--Everyone in commodities knows that you do not short orange juice in November, at least not if the price is low, as the frost season for the U.S. crop is December and January. The price reached an historic low at 69.1<155> (January) on 13th October and has rallied sharply recently, breaking the previous progression of lower rally highs. A downward dynamic is now required to check the recovery.
Natural Gas Peaks With A Key Day Reversal--Natural gas rallied from a 21st July low at U.S.$2.395 (January) to an accelerated peak at U.S.$3.465 on 26th September. However that only produced a two-week consolidation before the price surged once again. This move culminated in a key day reversal on 28th October, establishing a peak at U.S.$3.73, and considerably higher for the nearby contract. While the price has firmed following a correction, at least temporary resistance should be encountered as that high is more nearly approached. A close under U.S.$3.20 would suggest an additional retracement of gains.
Another New Low For Gold--Following a brief rally in late September, gold slumped to a new contract low on 24th October at U.S.$308.3 (December). While not far from psychological support at U.S.$300, the price is barely steady at present and a clear upward dynamic is required to signal a firmer tone.
Copper Is Falling Back Towards Prior Support From Its Trough--Copper has been trending lower since
accelerating to a peak on 18th June at 114.8<155> (December). The price is now re-entering the former trough
which extends down to 83.75<155> and was formed between June and November 1996. While that region should
eventually provide some support a clear upward dynamic will be needed to break the downward bias.
Where To Invest--The Big Picture
The Global Investment Scene
Do the deteriorating chart patterns evident since July for previously high-flying stock markets indicate that they are now reverting to a fundamental mean? I believe so, because recent equity valuations were exorbitant in many instances. Is the fundamental economic outlook also deteriorating? Yes, because in a global economy Asia's problems are certain to have some effect on other regions.
Moreover the recent psychological wrench has been considerable. Financial markets are often volatile, due to human nature, and sharp price moves will always influence fundamental perceptions as people search for explanations. Consequently opinions change much more frequently than the long-term economic trends which produce all bull and bear markets.
Consider the consensus earlier this year, up until August. Bearish forecasters, having been wrong for so long, had gone to ground. Meanwhile, sharply rising markets made it increasingly difficult for their bullish opposites to espouse the usual fundamental arguments for purchasing shares as valuations soared even more rapidly. The bulls increasingly resorted to analytical vagaries such as `economic sweet spot,' the `Goldilocks scenario' and a `paradigm change.' These do not offer much comfort when the trend changes, and most of the previously high-flying markets could fall considerably further before they no longer appeared overvalued on historic comparisons.
While a valuation correction within an ongoing bull market would normally produce reactions of 20% or less over the short to intermediate term, risks would obviously be much greater if the fundamental economic environment was also deteriorating. This appears to be the case since it is hard to argue that Asia's problems of non-performing loans, overbuilding and overproduction are of a short-term cyclical nature. These now threaten to turn a virtuous disinflationary trend into a dangerous deflation.
Consider the loans. Fast on the heels of Thailand's U.S.$17.2bn bailout led by the IMF, estimates of what Indonesia will require have climbed from the initial projection of U.S.$23bn up to U.S.$37.5bn. Unfortunately Asia's problems are not isolated to these two countries. South Korea may be forced into the IMF's hands. It is no longer alarmist to ask if other countries, including The Philippines and Brazil, could go the same route. Where would the IMF find the resources for additional bailouts?
This year's tight monetary conditions for East Asia's problem economies have only slowed their considerable devaluations. Slumping currencies and rapidly decelerating economies mean that more of their dollar loans, established when their currencies were pegged to the U.S. unit, are now at some risk. While it is impossible to know today the eventual extent of East Asia's loan problems, the situation will probably get worse before it improves. Meanwhile, according to David Hale, global chief economist at Zurich-Kemper Investments in Chicago, writing in the Financial Times on 7th November, East Asia's outstanding loans at the end of 1996 were about U.S.$752bn. The breakdown by country was Hong Kong U.S.$207bn, Singapore U.S.$189bn, South Korea U.S.$100bn, Thailand U.S.$70bn, Indonesia U.S.$55bn and Malaysia U.S.$22bn.
Japanese banks made a great many of these loans. It took the BoJ many years to recapitalize Japan's commercial banking sector through the yield curve, following the burst property and stock market bubbles, and now they are in trouble once again. European banks are next in line. According to The Wall Street Journal Europe on 7th November, a soon to be released report from Paribas, the Paris-based investment bank, will show that French banks' exposure to the region amounts to U.S.$96.5bn, Germany U.S.$74.9bn and British U.S.$58bn. Paribas' estimate for the U.S. is U.S.$34.2bn.
Aside from loan problems, Asia's devaluations will affect the west, perhaps more than has been initially estimated.
The consequences will be deflationary and can only slow global economic growth. East Asia will import much less--from luxury goods to financial services while cutting back sharply on infrastructure spending. With excess
manufacturing capacity and a shrinking regional market, these countries will hope to increase exports, using their
pricing advantage resulting from devaluation. This may cause some trade friction and other devaluations.
Government Bonds
The one obviously bullish point for long-dated bonds is the increasing deflationary pressures. However the risks should not be overlooked, starting with a very substantial fall in global bond yields over the last three years. This was accompanied by a significant narrowing of yield differentials among countries, due more to speculation than an objective assessment of the economic, currency or inflation risks. This trend has been thrown into reverse recently and investors are likely to be much more risk averse in future. If they start to experience losses in government bonds and their related stock markets, the enthusiasm for financial assets evident in recent years would wane.
The supply of new debt coming to the market is likely to remain high, due to requirements for capital, particularly
from developing countries. Slower GDP growth due to Asia's problems and their knock-on effect could reverse the
previous trend towards lower budget deficits for many developed countries, resulting in more bond issues. If global
deflation becomes a problem, many governments will combat it by printing money, sowing the seeds of future
inflation.
Stock Markets
The abundant liquidity that fuelled the recent great bull market for stocks continues to drain away. The process started in Asia as interest rates were ratcheted upwards in the defence of currencies. It spread westward as the Bank of England, and to a lesser extent, the U.S. Federal Reserve and Bundesbank moved to less accommodative monetary policies in anticipation of inflationary pressures. Interest rates have soared in Brazil recently, in defence of the real, and other currencies are under pressure.
Now falling stock markets are eroding the `feel good factor.' The benefits of margin leverage in a rising market have been thrown into reverse. Liquidity created by market bubbles can vanish quickly, once they are pierced, as we have seen recently.
Higher interest rates and falling share prices can only weigh on business and consumer confidence. This will cause those rosy estimates for 1998's global GDP growth--4.5% by the IMF not long ago--to be revised significantly downwards. Japan will be hit hard by East Asia's slowdown, in addition to continued consumer pessimism, and will probably slide back into recession. Asia's problems can only have a negative effect on the Australian and New Zealand economies.
The Bank of England's high interest rate policy risks an overkill for the UK economy. Government estimates of 3% GDP growth next year for Germany and France were always optimistic, influenced by the need to meet Maastricht criteria on budget deficits and debt as a percentage of GDP. Continental Europe's fiscal squeeze persists, unemployment is rising and the benefits of devaluation have been eroded. The U.S. economy remains a powerhouse by comparison, but it faces a weaker market for its exports, across the globe, and increased imports from Asia due to the region's devaluations.
The recent combination of disinflation, accommodative monetary policies, freer trade and more market oriented economies was good for stocks because it generated economic growth which increased corporate earnings. Tighter monetary conditions, sharp devaluations and slower growth now risk turning disinflation into deflation, which is bad for stocks because it squeezes corporate profits.
Once investors lose confidence in the ability of stock markets to bounce back, supply from government privatization, new issues and secondary offerings becomes a problem. Management and employee share options, so popular in the U.S. and which provided every incentive to boost equity prices through earnings growth, including stock buyback programs, become a double-edged sword in a falling market. An individual has no greater incentive to sell shares than the fear of profit erosion. As more of those who hold long-term share options are tempted to exercise them and sell, the supply of stock in the market increases. The latest data on insider activity shows that the process has begun. This will dilute earnings, unless offset by more share buyback programs, which are only possible when corporations are trading profitably.
Draining liquidity, slower economic growth and increasing deflationary pressures are a bad combination for stock markets, especially when many are coming off a period of speculation which kited valuations. Some of the Asian markets are, arguably, becoming undervalued, but they have the worst problems. Consequently their recovery prospects are likely to be delayed while other stock markets come under pressure. The risk of Asia's bear market becoming global now appears unacceptably high. If so, there are no safe havens among stock markets.
Normally bonds lead stocks, except when deflationary fears are paramount. This is increasingly the case today. As
covered in FMP27 (30th October), the usual debt/equity link has been broken recently, due to the change of
sentiment regarding stock markets, and bond prices are temporarily responding to gyrations in shares by moving
in the opposite direction. Therefore steadier bond prices are no longer a support for stock markets in the current
environment.
Currencies
The main trend recently has been the yen's continued weakness against all other reserve currencies. While this is approaching former resistance levels and will be seen as provocative by some U.S. manufacturers, it would probably take extensive jawboning to prevent the yen from extending its decline. That would probably have less effect today than we saw in May, and might not even occur near the year's earlier high of <157>127.5 against the U.S. Dollar. Confidence in Japan's economic recovery has been dented by East Asia's implosion and a new low for the year by the Nikkei Average.
Meanwhile, the BoJ will have to print a lot more yen to cope with the latest Japanese banking crisis. While it is theoretically possible that a large chunk of the trade-surplus dollars, insurance company and other Japanese overseas investments could be repatriated, it is hard to find a rational reason why that should occur anytime soon. Japan needs the overseas income because domestic short-term interest rates are negligible, 10-year bond yields are discounting a depression and the stock market remains weak.
When currency traders next take some of their profits on yen short positions, they will probably sell the mark and Swiss Franc against the U.S. Dollar and sterling. Presently they are short dollars against the Continental European currencies, judging from the recent trend and sentiment readings. These have reversed from near 90% bullish of the dollar at its August peak to only 35% bullish recently, the lowest figure since 1995. Sentiment readings are a contrary indicator, showing what people have done, not what the market will do.
The U.S. Dollar is still linked psychologically to global stock market weakness, partly due to the coincidence of the greenback's recovery from its 1995 lows as Wall Street was commencing its advance following a year of consolidation. The current fear is that if Wall Street falls, overseas investors will sell U.S. shares and repatriate the proceeds, weakening the dollar. While any widely held market perception can become self-feeding, for a while, this one does not hold up under analysis. There are probably at least as many U.S. investors holding foreign shares than the other way around. If U.S. investors sell, other markets will fall further, as we last saw in 1994. If conditions get panicky and there is a flight to cash, the U.S. Dollar offers liquidity, comparative safety and a better yield than most, including all reserve currencies except for sterling.
A more credible explanation for the dollar's weakness against the mark and Swiss Franc since August, other than an intermediate-term consolidation in response to earlier strong gains and Bundesbank jawboning, is the liquidation of reserves in the defence of currencies under siege. A high proportion of most government's reserves are held in U.S. Dollars. If they are trying to defend currencies pegged to the dollar, or to limit the fall through market intervention as we are currently seeing from Brazil to South Korea, they will have to liquidate reserves. This would also partially explain the yen's weakness as it too is held by Asian central banks as part of their reserves.
It is impossible to gage how much additional U.S. Dollar selling may be in the pipeline. However, it can only
increase the chance of another rate hike by the U.S. Federal Reserve, since dollar strength has been one of the
factors cited in helping to contain inflation. More importantly, any further dollar weakness against the mark and
Swiss Franc could quickly become a crisis for Continental Europe. Not only will these countries fail to reach their
optimistic forecasts for growth in 1998, currency appreciation threatens to throw their fledgling export-led
recoveries into reverse. Therefore if the dollar does not rebound shortly we can expect some European central bank
jawboning in an effort to talk it higher.
Commodities
All the talk of deflation has weighed on commodity prices recently, particularly the industrial sector. LME-traded base metals have continued to drift lower, with the help of speculative selling, punctuated briefly by occasional short-covering rallies within the downtrends. Gold continues to underperform, with the latest knock coming from a Swiss study concluding that the SNB should sell half of its considerable bullion reserves. Gold is cheap and the extremely bearish sentiment suggests that it may be close to a bottom. However there is no chart evidence of improvement and financial assets would probably have to reverse a lot more of their considerable gains of recent years before gold could become a fashionable investment once more.
Deflation sentiment has also curbed the speculative interest in agricultural commodities generated previously by El
Nino. However the U.S.-traded sugar contract has rebounded and we can expect periodic rallies in other markets
that could be affected by adverse weather patterns, particularly in the Southern Hemisphere. These would include
coffee and cocoa. Some short covering has occurred in orange juice, despite near record supplies, because prices
were trading near historic lows recently and the U.S. frost season is approaching.
Portfolio Strategy
Government Bonds
With all the talk of deflation bonds have been pushed as a safe investment by many strategists. I will readily grant that they are a lot less risky than stocks right now, but the value is relative rather than absolute. I continue to prefer minimum exposure to long-dated bonds, especially the more risky developed country debt where the speculative bubble has now burst. From an investment perspective, my preference is for short-dated contracts only, such as U.S. Treasury bills and UK sterling deposits, which offer a good real return and are underpinned by solid currencies.
For speculation, I am waiting on a chart signal to increase a small short position in Japanese 10-year bonds, which
is costing me at the moment. If I did anything else it would probably be to lightly short some of the yield
convergence plays, such as Italian bonds and UK gilts, on a sell-high-buy-low baby steps jobbing basis.
Stock Markets
I continue to maintain the very defensive strategy first advocated in FM159 (15th August 1997). Today, this means a very high degree of liquidity. Fortunately churning top formation extension has provided several opportunities to reduce equity exposure in previously high-flying stock markets during recent months. Where markets are already very depressed, one might as well hold on for the next upswing even though that could be a long way off.
From an institutional perspective, I would persist with the rewarding policy of hedging by writing covered calls and shorting index futures during rallies in the previously performing markets, taking at least partial profits on the shorts during accelerated sell offs. I think investors should be prepared for at least medium-term bear markets. Consequently I am not yet the least bit tempted to bottom pick in depressed Asian shares. I favor no `off the beaten path' emerging markets or recently fashionable small capitalization shares. They are illiquid and fall further than mature markets or most household name shares when sentiment really deteriorates.
For speculative opportunities, I remain very active in stock market futures, now concentrating almost entirely on
positions traded within my time zone, which means the European and U.S. contracts. I only short these, and only
on good rallies during the top development stage which has been ideal for my baby steps sell-high-buy-low jobbing
strategy. The late-October/early-November rebounds were strong but failed just where they should, to remain
consistent with a bearish hypothesis, right under or within the overhanging July-October trading ranges. I will
switch to a combination of trend running augmented with baby steps if/when the volatility decreases and the
technical rallies are clearly much smaller. Closes above the early-November reaction highs are now necessary to
question the scale-up selling strategy and indicate a higher phase of top development, let alone something stronger.
Currencies
I maintain that the opportunities relative to risks in reserve currency trades are less attractive today, compared with a year or two ago, when the U.S. Dollar and sterling were clearly undervalued. Nevertheless some good moves have been signalled on the charts and others currently beckon.
Staying with the five reserve currencies, short yen positions have obviously been the most profitable. Since many people have joined the action, I would now have a much reduced dollar and sterling long position against the yen, in line with the baby steps buy-low-sell-high jobbing strategy, even though there has been no clear evidence to date that another important top is at hand. I have not played the mark and Swiss Franc yen crosses in recent months, but many people have. Consequently, the yen is becoming temporarily oversold and is due for a technical rebound before long. Nothing would compel me to go long yen, except for a technical rally against the similarly low-yielding Swiss Franc.
The yen's next technical rally could be particularly strong against the mark and Swiss Franc, because the U.S.
Dollar's correction looks overstretched against these two currencies. I continue to like the dollar in the low DM1.70
region, trading it on the baby steps basis, at least until there is clear technical evidence that the intermediate-term
correction from August's high has been completed. While I did not anticipate the extent of the dollar's correction
against the Swiss Franc, there has been just enough volatility for baby steps traders to reduce average costs while
establishing a significant long position. I look for a major recovery in coming months, perhaps from current levels,
although this is not yet clear on the charts. With concerns over Asia's slowdown casting a shadow over the
Australian and New Zealand currencies, high-yielding sterling remains the best U.S. Dollar proxy by far.
Commodities
Deflation fears have understandably weighed on commodity prices recently, having pushed El Nino out of the headlines. We are currently playing the deflation story with a lead (LME) short and there will probably be other opportunities in metals, particularly after any technical rallies lose momentum. Deflation sentiment has helped to push some agricultural commodities to potentially interesting levels recently. Accordingly, I opened a small long position in coffee (March CSCE), on 7th Nov. I'm hoping for at least a short-covering rally.
Buy recommendations were also issued for orange juice (January NCTN) on 5th November. This is a short-covering and weather punt as the U.S. crop approaches its frost-risk season. Statistically, there is realistically no
more than a 1 in 5 chance of a serious threat to the crop, at most. However, any scare is usually good for a sharp
rally. Meanwhile, ample supplies of frozen OJ drove prices down to historic lows recently.
Cash
Cash remains my preferred investment in the current nervous environment. Once again I am narrowing my
selections down to just two currencies for yield and safety--the U.S. Dollar and sterling as its best proxy.
November 14, 1997
David Fuller, Chairman
Chart Analysis Limited
7 Swallow Street, London, W1R 7HD, United Kingdom
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