PRUDENTIAL SECURITIES, INC.
One New York, New York, New York
(November 21, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–Asia continued to play a major role in the U.S. treasury market during the past week, keeping the market strong and flattening the yield curve. Worries about a global meltdown into deflation continued to circulate, with particular attention on Korea and Japan. Despite all of the evidence to the contrary, the market continues to discount a worst- case scenario.
As the Asian crisis rolls from one country to the next, the market for U.S. traceries has remained firm. The price structure continues to reflect the expectation of slower growth and declining inflation and the slope of the curve even implies easier monetary policy by the Fed going forward. Yet, although it is quite likely that on the margins U.S. growth will slow due to Asia's problems, it is very difficult to make the case for a serious decline. The direct effect on the U.S. will be transmitted through the trade sector which represents about 12% of U.S. GDP. Even in a worst case scenario where exports to the Asia/Pacific region are cut in half by the crisis and imports rise sharply, it would be hard to subtract any more than one-half of one percent from GDP. Moreover, consider that this analysis would represent a far greater economic response to Asia in the trade sector than to Mexico's devaluation in 1994-95. So, a further deterioration in the trade balance is likely and will have a negative impact on GDP, the impact may be limited.
It is worth keeping in mind that the U.S. economy is still largely determined by domestic factors. In that light, consider the past week's economic data. Housing starts rose to 1.53 million units in October, approaching the peak of the cycle. With mortgage applications still running at a fast pace, employment growth still strong, interest rates low and a jump in construction jobs seen last month, the signals from the housing market point to strong demand going forward. There were few signs of weakness in the manufacturing sector either. Industrial production and capacity utilization are climbing at a rapid pace and approaching the cyclical highs. Moreover, the signals from the Philadelphia Fed index point to ongoing strength. There is no inventory imbalance to slow production, either. Despite a pick up in inventories in the past few months, the inventory/sales ratio remains near all-time lows, suggesting no need to cut back production in the near term.
On the demand side, consumer confidence remain strong despite the stock market's volatility in the past few months. Moreover, future expectations are actually nearing an all time high indicating that consumers are feeling quite confident about the future as well as their current circumstances. So, despite the press stories about the slowdown in consumer spending and the expectations for a dismal holiday shopping season, everything looks on track for a reasonably healthy pace of retail sales going forward.
The Fed is doing little to slow the economy either. There is an argument that the rise in the real Fed funds rate over the past year is acting as a constraint on growth. That is, that as inflation has edged lower and the funds rate has remained at 5.5%, tile increase in the real cost of capital is exerting restraint on the economy. Yet, it is awfully hard to see where that is happening. After all, the money supply figures are showing rapid growth and even acceleration in the creation of money. The credit statistics indicate that bank lending is running at a healthy pace of 7% with strong growth in commercial and real estate loans. Given that personal consumption expenditures rose at a 5.7% annualized pace in the second quarter and seem likely to come close to that level in the third quarter, it is hard to see where the restraint is showing up. Moreover, the markets have not exerted much restraint. Yields are low across the curve and equity prices are up 19% year to date.
Next week's third-quarter GDP figures will most likely indicate that the economy continues to grow at a rate well in excess of its “potential.” A third-quarter GDP figure of 3.5% is likely to be confirmed with very little change to the flash estimate released earlier. The fourth quarter is sizing up to be in the same vicinity but driven by different sectors of the economy. Personal consumption expenditures are not expected to continue at the hefty pace of the past quarter, but remain buoyant while fixed investment will stay strong. Overall, the U.S. economy is likely to continue to grow at a healthy pace because there aren't a lot of things to stop it from growing.
DEFLATION: HOW REAL IS THE RISK?–Deflation continues to be a buzzword in the markets. The belief is that excess capacity in Asia and competitive currency devaluations will lead to a “global glut” of goods which will sink the world into deflation. Yet, there are obvious problems with this analysis. The first and foremost is that deflation, like inflation, is a monetary phenomenon. Hence, the precursors of deflation are falling money supply growth and contracting credit. Yet, in the U.S., the U.K. and Canada, money- supply growth is expanding quite rapidly. In the broad aggregates, it is rising at a double-digit pace. In the U.S. M3 growth is rising at a 12% rate, the highest in a decade. Bank credit is expanding at a smart pace as well. The latest data for the U.S. indicate an expansion of 8% in bank credit and 7% in commercial loans. Money growth in Europe is expanding moderately, on average at a 5% to 6% rate on the continent. Even in countries mired in extremely weak growth such as Japan, there has been no decline in money supply. Japan's M2+CDs series indicates an increase at a 2.7% annualized pace over the past several months. So the monetary conditions for deflation are not in place.
Secondly, deflation would be characterized by falling overall prices. This has caused some confusion, because those calling for “deflation” often cite declines in computer prices or some other commodity as evidence that it is happening. But that analysts is really a matter of confusing low inflation with deflation. This week's CPI data once again indicated that pattern of low price increases in goods and rising prices in the service sector. Year-over-year inflation in goods is running at 1.0% while in services excluding energy, it is rising at a 3% rate. This pattern is likely to continue as competitive pressures will likely keep prices for globally traded goods low while a strong domestic economy and rising wages will keep service sector prices rising at a stronger pace. Notice however, that neither of these series is indicating falling prices. They are only indicating rising prices at different rates.
Third, it is difficult to buy the idea that rising production is going to be detrimental to the world economy. After all, increases in output are associated with increasing wages and employment which in turn, feed demand. If the worry was simply that inventories were too high and had to be worked down, that would be reasonable. The excess inventory in Asia will most likely have to be worked down in the next year, but that implies falling production as the supply-demand imbalance is addressed. Moreover, demand from the rest of the world still looks strong. The U.S., the U.K. and Canada are all growing at rates well in excess of potential which is why imports to those countries are running at very high levels. Continental Europe is witnessing a widening out of their recovery which will mean rising demand as well. Moreover, monetary policies are generally expansionary. Even in the U.K. where the yield curve is inverted, there is little evidence that monetary policy is restraining demand. It is quite likely that strong demand from the rest of the world will help sustain Asia during what is likely to be a growth recession in 1998.
Much of the talk of deflation seems to rely on the same sorts of logic which circulated in 1994. In that year, there was a fear of a “global capital shortage” induced by tightening monetary policy and huge demand for capital from the developing countries. That analysis proved wrong because it ignored the fact that economic growth generates its own savings and capital and therefore that the global capital markets did not represent a finite pool of money. This time around, the argument is just put on its head. Now the worry is that there is a finite demand for goods which will be met with a huge onslaught of production regardless of the economic losses that would be generated. The argument ignores the fact that (as anyone with children knows) demand is not finite and growth generates its own economic benefits.
So although the Asian problems will likely keep import prices down and help contain overall inflation in the U.S. it seems quite unlikely to produce deflation in the current environment of strong money growth, expanding credit and growing world trade.
THE WEEK AHEAD–No doubt Asia's problems will continue to be a feature for U.S. trading next week, particularly since the economic calendar is sparse and it will be a holiday-shortened week. The bond market may continue to hold at high levels on worries over Japan's banking problems. However, Japan has little choice but to shore up its banking system.
The market continues to be priced for a very negative economic scenario globally. Right now, the risk is that the worst case scenario does not play out and the market has to return to economic fundamentals. Those fundamentals don't point to sub-6% bond yields.
Kathy Jones
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