Prepared by

The Northern Trust Company

Q. What touched off the sharp decline in the Hong Kong stock market?

A. Fed Chairman Greenspan's comments to the House Budget Committee on October 8, in which he intimated that the Fed might raise short-term U.S. rates in the not-too- distant future might have had something to do with it. In reaction to these comments, our debt markets sold off.

Q. Why would a Fed hike in U.S. interest rates affect the Hong Kong stock market?

A. In 1983, the then British colonial government of Hong Kong decided to directly peg the Hong Kong Dollar to the U.S. Dollar. The implication of this is that if the fixed exchange rate between the two currencies were to be maintained, Hong Kong short-term interest rates would move in tandem with those of the U.S. So, if U.S. short-term interest rates were to move up on the expectation that the Fed would soon be raising the funds rate, which was the case on October 8, after Greenspan's testimony, then Hong Kong interest rates would move up in sympathy, which they did on the morning of October 9.

The Hong Kong stock market is heavily weighted by property-related shares. Property investments tend to be highly leveraged. So, the increase in Hong Kong interest rates made property investments less profitable. There also was a growing expectation that the Hong Kong government might increase the amount of land that it owned for auction in an effort to slow rising real estate prices. Thus, the rise in short-term Hong Kong interest rates and the expectation of an increased supply of land to be auctioned off by the Hong Kong government sent Hong Kong property- related share prices lower. In addition, there had recently been a sharp run-up in the prices of Hong Kong shares with ties to mainland China companies–so-called “red chip” stocks. It would be reasonable to assume that some of these red chips were bought on margin. If so, a rise in Hong Kong interest rates would be a negative for the red chips, too. Moreover, some of red chips had not turned the quick profits as expected. This was the combination of events that set in motion the recent slide in Hong Kong stock prices.

Q. So what did the sell-off in the Hong Kong market have to do with anything else?

A. Japanese share prices had been trending down before this because of a moribund Japanese economy and recent economic difficulties in Southeast Asia–a region of great significance to Japan in terms of commerce and lending. Hong Kong also is commercially important to Japan. Thus, the sell-off in Hong Kong share prices negatively affected Japanese share prices, too. The Nikkei 225 index fell 2.3% in the two trading sessions after Greenspan's October 8 testimony. In addition, sinking Hong Kong shares and questions about Hong Kong's commitment to the current peg of its currency to the U.S. Dollar created an environment for more volatility in the Southeast Asian financial markets.

Q. What was the linkage between this Asian financial market volatility and the U.S. stock market?

A. Last week in our commentary entitled “Cash and Bonds–The Rodney Dangerfields of Financial Assets?,” we argued that the U.S. stock market was “expensive” relative to inflation- adjusted yields on cash and bonds. A number of knowledgeable analysts have suggested that the U.S. stock market was fully valued, if not over valued. We think it is fair to say that “near perfection” was priced into the U.S. stock market. If some new information came along suggesting that something less than near perfection were likely to evolve, then the U.S. stock market would be vulnerable to a correction. A tightening by the Fed might qualify as something less than near perfection for the U.S. stock market. And, in fact, the U.S. stock market, just like the Hong Kong stock market, did not take kindly to Greenspan's October 8 comments. To wit, the S&P 500 index fell almost 1% on October 8.

But back to Hong Kong and Asia, in general. Asia, including Japan, accounts for about 29% of global output. Nearly every economy in Asia is now experiencing a slowing in economic activity. This has got to have dampening effect on economic activity with the rest of the world via a slowdown in exports to Asia. In 1996, 30% of nominal U.S. merchandise exports were bound for Asia, including Japan. The higher interest rates in Hong Kong and the sell-off in the Hong Kong stock market were just another reason to lower expectations about Asian economic growth. Slower-than-expected economic growth in Asia might imply slower-than-expected profit growth for some U.S. corporations with exposure to Asia because of reduced U.S. exports to the region. Slower exports to Asia might mean slower growth in U.S. production, employment and personal income. In turn, this might mean slower U.S. domestic spending and, thus, lower-than-expected earnings growth for U.S. corporations from their domestic operations, too. All of this, again, might be less than the near perfection priced into the U.S. stock market. As a result, some correction in U.S. stock prices could be expected.

Q. Some pundits are saying that U.S. stock prices could presently be in for more than a correction. Rather, this might be the start of a bear market in stocks. Could this be?

A. It is highly unlikely that this is the beginning of a bear market for U.S. stocks. Bear markets in stocks rarely occur unless a recession is imminent. We do not believe that a recession is imminent. Although there is a great deal of uncertainty about the negative effects of Asian developments on the U.S. economy, we currently estimate that about one-half of a percentage point will be knocked off of annual U.S. real GDP growth going forward. Even with this subtraction, we feel that growth will be in the 2-3/4% to 3% range over the next several quarters. So, the recent developments in Asia will moderate U.S. economic growth, but are unlikely to stop it in its tracks. This implies that corporate profit growth will likely slow, but stay positive. This might be the stuff of a correction in very high stock market valuations, but not of a bear market.

Q. Suppose that price declines in the U.S. stock market take on larger proportions than just a normal correction because of an underestimation of the negative effects of Asian developments on the U.S. economy. What then?

A. In that case, the Fed will likely cut interest rates. U.S. inflation is low. The events in Asia work in the direction of lower, not higher U.S. inflation going forward. Under these circumstances, the Fed has enormous latitude to cut interest rates to prevent a recession in the unlikely case that one might be evolving. The Fed realizes that a bear market in U.S. stocks now would risk putting additional stress on a global financial system already frayed at the edges. Again, with U.S. inflation as low as it is, the Fed, in all likelihood, would not hesitate to cut interest rates to stabilize our stock market and impart a cushion of stability to the global financial system. Remember, the Fed cut interest rates quickly in the wake of the 1987 stock market downdraft–a time when inflationary pressures were considerably greater than they are now.

It is highly unlikely that fiscal policy would need to be called on to stabilize the U.S. economy. But if it were, here too, Congress and the administration have policy leeway. Because the U.S. federal budget is almost in balance, if need be, tax rates could be cut and/or government spending could be increased to preempt a recession.

Q. There is increased talk about deflation setting in because of alleged excess global capacity. Is this something stock investors should be worried about?

A. In general, no. An excess supply of goods and services is not a tough issue for policymakers to deal with. To paraphrase a line from the movie “Field of Dreams,” if you print it, they will spend it. If there is a situation of excess global capacity or excess supply of goods and services, there will be a tendency for inflation to fall. With inflation already low in the U.S.–and most everywhere else, too–the Fed could and most likely would pump up the broad money supply by lowering interest rates. This would create the increased demand to eliminate the excess supply. In his October 29 testimony before the Joint Economic Committee, Fed Chairman Greenspan said that the Fed would respond to the prospects of deflation just as it would to the prospects of inflation. Greenspan added that he viewed higher inflation rather than deflation as the greater risk right now.

Q. Why the big fear about deflation?

A. If people come to expect lower prices tomorrow, they might delay the purchases of things today in order to take advantage of tomorrow's expected lower prices. Acting on these deflationary expectations–i.e., not making purchases today because of expected lower prices tomorrow–can cause the deflationary expectations to become the actual deflationary outcome. So, the concern with regard to deflation is that current period demand would dry up, forcing businesses to cut prices to move their merchandise. Profit margins would suffer unless costs, including labor costs were to go down. The fear is that a downward wage-price spiral might develop.

Although we are not currently experiencing general price level deflation, we are experiencing falling prices for some goods. Computers immediately come to mind. But computer sales have boomed. Silicon Valley labor compensation has been growing rapidly. And up until the recent Asian developments, tech stocks have been stellar performers. So, the stocks of companies that can cut their selling prices because of productivity increases would seem to perform well.

Suppose inflation were 0.5% one year. The next year deflation of 0.5% occurred. Do horrible things happen economically because the zero line is crossed? We think the likelihood of general deflation is low for two reasons. First, prices of services, which account for over half of the CPI, are unlikely to decline. Second, we do not believe that the Fed would sit idly by if deflation were imminent.

Q. Given all of the global financial market volatility in recent weeks, the anxiety level of investors is understandably higher now. What should long- term investors in U.S. equity markets keep in mind?

A. The value of stocks relates critically to the behavior of corporate profits. The behavior of corporate profits depends critically on the behavior of the economy. The behavior of the economy depends critically on the behavior of the Fed. The behavior of the Fed depends critically on the behavior of inflation. The U.S. economy currently is very sound, with little evidence of imbalance. What has transpired recently in Asia will likely moderate U.S. economic growth. If this external shock had not occurred, the Fed was poised to raise interest rates in order to moderate the pace of U.S. economic activity. The external shock has obviated the need for Fed snugging. With the moderation in economic activity as a result of the Asian situation, corporate profit growth also is likely to moderate, but still remain positive. Inflation currently is low in the U.S. and the events in Asia argue in the direction of keeping it low. Therefore, the Fed is likely to keep interest rates steady in the near term. If U.S. economic activity should appear as though it is stalling, which also would have negative implications for corporate profits, the Fed, against a backdrop of low inflation, would most likely cut interest rates in order to preempt a stalling out of the U.S. economy and corporate profits. This would seem to be an environment conducive to a return on stocks at least equal to its long-run trend.

October 30, 1997Paul L. Kasriel

The Northern Trust Company

50 South LaSalle Street, Chicago, Illinois

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