Among the many advantages of working at a big investment management company is that it is a valued client of all the major sell-side banks and brokerages. As a result, we get the benefit of perspective on a broad range of topics, from some of the best minds in the business. Many trees are felled in the delivery of these perspectives, and because there are so many and they are so diverse we have to tune our ears to hear the music that lurks in the cacophony. But it beats talking to yourself, as this market periodically drives you to do.
Bob Barbera, the
Hoenig & Company
economist, came through our offices last week. He and I see things so much alike that we may have been separated at birth. Among his key points: T-bond yields have bounced back up into the high fives because the global economy has recovered from the panic of the Russia and LTCM meltdowns of last year's third quarter. Treasuries were the primary beneficiary of the panic of '98, and U.S. corporate bonds were not, so spreads gapped. Now the "safe haven" money is slipping back to where it came from, so Treasuries are losing custom but corporates are not, so spreads are snugging. The information would appear to be in the volatility of Treasuries and not in the credit spread.
Bob's primary focus is, and has been, on Japanese developments. Like me, he believes that Japan is a much more important explanatory factor for global and U.S. conditions than many others seem to think. You've got to pay attention to what's happening over there even if your portfolio or your business interest is exclusively local.
And what is happening over there? One, the banks are being recapitalized. The requisite laws were passed and money was appropriated last year. After some reluctance on the part of bank managers to accept public capital because of the sanctions that accompanied the salvation, the regulatory authorities have managed to get through to them this year that they are being made an offer they can't refuse. As Japanese banks have begun to clean up their balance sheets, the Japan premium has evaporated in euro-currency markets. With access to credit again becoming a reasonable prospect for business owners, small business sentiment has turned sharply higher and business bankruptcies have fallen precipitously. The domestically oriented stocks that make up the over-the-counter market have begun to fly -- up 46% since the October low -- and the broader market is showing signs of a pulse.
All in all, it is an encouraging picture. But as you know, "Japanese recovery" translates into English as "false alarm." OK, so it doesn't -- but after the performance of the 1990s, it should. Barbera admits that he can't yet support the promise of these leading indicators with proof of performance in the growth of Japan's output, employment, or profitability. At this stage, it is still a matter of forecast, of prediction. But the basis for prediction now looks to be more on substance and less on faith than has been the case.
With something like normalcy beginning to reassert itself in the global economy, a more normal level and term structure of interest rates is likely to prevail. He doesn't read the recent U.S. Treasury market setback as derived from concerns about inflation or fear of
tightening, but merely as a return to normalcy. As such, he is less concerned about its effect on stocks than I have been. Many of the cyclicals and value plays that have underperfomed in the very weak global economy of 1998 may be setting up to do better as global conditions improve in 1999. A better Japanese economy in particular, through its positive effects on Asian and overall global demand, may enable our market to broaden out. It is too simple to say that the last shall be first, that those industries or sectors that have struggled will now soar, but a better Japan will be better for a lot of other folks, too.
In contrast, Greg Smith of
has stuck to a position he argued during his most recent visit, that Japan really doesn't have much hope of generating a robust recovery, and it doesn't matter much in any case. Its affluent-but-aging population can't be expected to be an effective engine of demand, but it can be an important source of funds, as it has been throughout the 1990s. The future is now, and the United States, not Japan, is at the center of it.
Not much harmony between these two points of view. I'm far more sympathetic to Barbera's analysis, but Smith's skepticism has stood him in good stead.
How about Byron Wien's recent change of tone? The
strategist took some money off the table, for many reasons. The higher level of bond rates is causing strain in his valuation model, and no immediate relief is in sight. Breadth is going from bad to worse. Sentiment seems a bit complacent. Inflows into equity mutual funds are relatively subdued. He sees no risk of recession and so a bear market is unlikely. But the case for a significant upward move from current levels is just so much harder to make than the case for a meaningful correction that he felt moved to raise his cash reserve.
Tom Galvin of
Donaldson, Lufkin & Jenrette
puts several of these themes together. He expects the market to broaden out because earnings will do better at more companies as the economy broadens out this year. Earnings breadth drives market breadth. He shows more interest in foreign flows into our markets than in mutual fund flows, and he sees those foreign purchases as an important explanatory factor in the outperformance of the high-profile, large-cap names that a foreign investor would recognize.
I'd tell you what I think in here, but I'm trying to forget. I suggested a month ago that the market was "hearing footsteps," that a rising trend in Treasury yields against a backdrop of extended valuation and terrible breadth meant that discretion should take precedence over valor. So of course the market lurches up toward a
10,000 on better breadth and better volume. Among the reasons for the better performance must be that the economy continues to amaze -- the
economists threw in the towel last week on their recession forecast -- and that earnings expectations are being marked up as a result.
Liquidity remains abundant, whether from foreign investors, mutual fund flows, or corporate activity. The inflation numbers are so good that
won't soon find the smoking gun required to tighten credit, so many investors apparently feel it is safe to put money to work in the market until the risk of unfriendly monetary policy looms more closely than it does now. Under these conditions, that feels to me like playing in traffic. But this is not a market that deals kindly with being dissed, however good the reasons may be.
As economists mark up their forecasts, whether for the U.S. or Japan, and as market psychology recovers from last year's raw fear, the risks line up on the high side: higher growth, higher earnings, and higher bond yields. I see that yield uptrend as the most important factor to keep an eye on -- but the market has enjoyed the uptick in earnings expectations instead.
Jim Griffin is the chief strategist at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. He welcomes your feedback.