PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(December 12, 1997) FINANCIAL INSTRUMENTS: INTEREST RATES–Worries over Asia's parlous financial situation remain the driving force in the Treasury market. Yields fell below 6% in the long bond flattening the yield curve. As Japan floundered to put together a financial market repair package, Korea and Indonesia continued to see their currencies and stock markets plunge. With renewed worries over the state of Asian economies and the impact of their downturn on the rest of the world, the Treasury market rallied as investors from all other sectors sought out liquidity and safety.
There are two fundamental factors contributing to the rise in Treasury prices. The first is the risk aversion which has gripped the market since October. As the problems in Asia unfolded and spread from Thailand to Indonesia to Korea to Japan and onto emerging markets elsewhere, the bond markets of the world have experienced a tremendous increase in risk premia. Emerging markets bonds which were trading at 100-200 basis points over treasurys are in some cases trading as much as 600 to 700 basis points over. Some of these markets are arguably unrelated to the Asian problems. None-the-less, after several years of narrowing spreads and aggressive risk-taking the markets have now swung completely the other direction with even high quality corporate bonds suffering. In the second wave of panic, stock markets have tumbled making bonds look attractive. This aversion to risk or safe-haven buying will continue to support the U.S. treasury market.
The second fundamental factor supporting the market is the expectation of a further decline in inflation. There has already been a decline in inflation over the past year, largely the result of falling oil prices and a strong dollar. Since the dollar remains strong (especially against Asian currencies) and OPEC has indicated that oil production will increase, it is reasonable to assume ongoing good inflation. Add in the prospect that Asian goods will be priced competitively and put downward pressure on globally traded goods prices and the prospects for inflation are favorable for 1998. At sub-6% yields, a lot of good news on inflation is already priced into the market, but the good news is likely to contrite.
Last week's PPI decline of 0.2% was viewed by many as a sign of impending “deflation.” However, the fact is that PPI has been falling most of this year due to declining energy and computer prices. This month's drop reflected these factors as well as a modest decline in food prices. It is notable however, that the core crude and intermediate goods prices are actually edging higher. None-the-less, with the dollar rising strongly against many currencies this year and energy prices appearing to retreat further, the picture on wholesale inflation should continue to be quite favorable for most of 1998.
The major issue from current yields is how deeply the Asian problems impact the rest of the world. Next week will witness the final version (we hope) of Japan's economic and financial package designed to shore up the ailing banking sector and boost domestic demand. The market is looking for two things from Japan: 1) a tax cut coupled with deregulation to boost consumer spending and 2) a credible plan to use the proceeds of proposed bond sales to shore up the deposit insurance fund in order to prevent a systemic problem such as a run on the banks. If they actually come tip with a credible package, then the financial markets in Asia could find some degree of stability. However, at this stage, there is so much internal fighting about the package that the risk is it will produce too little, too late. If that is the case, then confidence will nose-dive again and funds will continue to flow into U.S. treasurys. The other area to watch will be Korea where the squabbling with the IMF continues to imperil the rescue plan and Moody's downgraded sovereign debt to near-junk status. A political backlash is a real possibility in Korea which could spiral down into a more serious decline in confidence in the region. Right now, Korea is still seen as the biggest risk to the region.
ECONOMIC DATA–The economic data are hardly worth reviewing since they are of so little significance. None-the-less, at some stage the market will return to the domestic situation. The figures show that the economy is continuing to grow at a healthy rate with little inflation. Although there is talk of a “slowing in demand” as evidenced by the slower pace of retail sales in the past two months, it is worth pointing out that retail sales are still rising, just not at the rapid pace of the third quarter. Figure 3 illustrates the trend in retail sales. Moreover, retail sales are only one component of overall consumption. Spending on housing and many goods and services don't show up in the retail sales figures. We are still forecasting a very healthy pace of consumption in the fourth quarter feeding into a GDP growth rate of 3.5% to 4.0%. This would represent a “slowing” from the hefty pace of growth in the fourth quarter, but it is far from a significant decline in economic activity.
The reason we still look for healthy domestic demand is that there are few reasons for the economy to slowdown. If and when a slowdown in exports affects orders and production and then job growth, demand may slow. However, with employment growth running strong, income growth picking up for the first time in years and interest rates at cycle lows, there isn't much restraint on the economy. Moreover, the Fed is not running a tight monetary policy. After all, money supply growth is accelerating rapidly and credit growth is expanding. These are not signs of restraint. So for now, the economy still looks to have a lot of fuel to keep it running.
GDP growth estimates are particularly important right now, since the markets focus is on how much the Asian problems will impact growth in the U.S. We continue to look for a GDP Impact on the order of 0.5% to 0.75%, but if it is coming off of a growth rate of 3.75% to 4.0%, it should not be a particularly, worrisome problem since growth would only slow to about 3%. If one assumes a worst case scenario that exports to Asia including Japan will drop by 15% in 1998, then GDP would decline 0.5%. This is worst case as the drop in exports to Mexico was only 10% after the peso devaluation and the peso fell by more than most of the Asian currencies have fallen. Moreover, although exports to Asia represent 27% of total U.S. exports, they have accounted for only 2.6 percentage points of the incremental growth in exports over the past few years as compared to exports to Europe, Latin America and Canada accounted for twice as much of the growth in exports. Given that domestic demand remains very healthy due to strong income and job growth and very low interest rates, the impact of Asia's problems in an economic sense, is still likely to be limited.
THE WEEK AHEAD–Amidst all of the euphoria about falling inflation (or deflation as it is popularly called right now) the CPI figures may disappoint next week. The reason is that service sector prices continue to rise. Service sector prices are rising largely the result of the upward push in wages. With hourly earnings rising to the highest level of the business cycle, it will be very difficult for service sector businesses to keel) costs down. Services comprise everything from hair cuts to legal and accounting services. The CPI figures to be released next week will probably reflect the dichotomy between goods prices and service prices. Falling energy prices will most likely mean an overall benign number, but CPI is more heavily weighted to services than goods as 57% of CPI reflects services while 43% reflects goods prices. Hence, there is likely to be more of an upward bias in this series than in the PPI. A modest rise of 0.2% overall and 0.2% ex food and energy is anticipated, but no deflation.
Housing starts meanwhile should continue to motor along at a healthy clip. Based on the Mortgage Bankers' Association index, demand for housing still looks good at low interest rates. We look for a rate of 1.5 million units, near the cycle highs. The trade figures are likely to indicate a deficit of about 10 billion, down from the $11.1 billion reading for September. We have noted before that September usually represents the peak level for the trade deficit each year, so a decline on a month-to-month basis for October is expected. Rounding out the week, the Philadelphia Fed index is due and should indicate that manufacturing in the mid-Atlantic region is still healthy.
Of course, there is an FOMC meeting next week on December 16th, but virtually no one expects a rate hike in this environment. There is talk that Greenspan and Rubin will be meeting earlier in the week with Finance Minister Theo Waigel and Bundesbank President Hans Tietmever to discuss the impact of Asia's problems on the financial sectors in Europe and the U.S. Some increase in the level of funds for the IMF or a separate stabilization fund is apparently being discussed, although it might be a very tough sale domestically in both countries. (Remember how difficult it was for the Treasury to get the $17 billion for Mexico? Imagine asking for another $40 or $50 billion for Asia.) Expect to hear a lot of rumors about what the G-7 might do to help stabilize the situation.
Finally, keep an eye on the stock market. If earnings expectations continue to decline then the bond market will continue to benefit from an inflow of capital from equity investors looking for a safe haven. It looks like bond yields are set to test the 5.85% level and possibly lower depending on how long Asia's problems linger. The yield curve should remain flat as the Fed stays on hold. The divergence between strong domestic growth and weak external growth will continue but the heavier weight is now on external factors. The next target in March bonds is the 122-00 region.
Down the road, the question is how sustainable rates are below 6% but that is not likely to be an issue until January.
Kathy Jones
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