Keeping a Steady Eye on a Great Global Imbalance

Will the market remain resilient in the new year?
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What was that all about? From the exalted height of pre-Christmas new highs on the

S&P 500


Nasdaq Composite

indices, the market meltdown of the third quarter has a surreal quality about it. Can it really have been as bad as it felt at the time? From the current vantage point, the memory of that cave-in is somewhat elusive, as is common with bad dreams. The record shows that the crash was fact, not nightmare, but it offers little guidance as to what such a dramatic discontinuity signifies for the future. Was it a warning shot across the bow of a bull market, an omen of worse to come, as some seem to fear? Or was it the climax of the "Asian contagion" that began a year earlier?


Federal Reserve

, through repeated easing actions, triggered the history-making, fourth-quarter market rebound. The fact that it chose to stand pat at its Dec. 22 meeting hints at a "thank goodness that's over" attitude.

What is the meaning of the big backup in the Japanese bond market? With

Ministry of Finance


Bank of Japan

sharply reducing support for the long end of the Japanese government bond market, each for its own reasons, yields have soared -- from a worm's eye view -- to the 1.9% level. This will undermine economic recovery, according to one headline. But recall that analysts had been monitoring the JGB market for evidence of a turn in the world's second largest economy -- before they gave up on it entirely earlier this year. Yields would back up dramatically, it was deduced, when the market smelled out a recovery.

While lower yields are normally considered necessary to initiate an economic rebound, that hasn't worked in Japan; higher yields there, in their special circumstances, are perhaps more in the nature of effect than cause. They are partly a result of an anticipated avalanche of government borrowing pressures on the market in order to fund a 24 trillion yen stimulus package.

The steeper yield curve -- the Bank of Japan is standing pat on the overnight call money rate at 0.25% -- will enable banks there to book nearly 175 basis points of yield pickup on "risk free" government debt with no BIS (Bank for International Settlements) capital strain. That's how U.S. banks got healthy in the early 1990s. Japanese banks have yet to overcome fully the embarrassment of having to avail themselves of the trillions in capital support made available by the Diet this year, but with a more aggressive regulator now reviewing their books, their resistance may give way suddenly. Those institutions that got by on bond market capital gains may have to get better more slowly through the net interest accruals made possible by a steeper curve. Those that can't tolerate a slow convalescence may find themselves nationalized, merged, or closed down. Such a result will be stressful but cathartic; the system needs this sort of pruning for its long-term health. I believe it is reasonable to put a positive face on recent developments in the JGB market, but they are very recent and deserving of further observation.

Another positive argument, though, is the "mix of policy" case. Which is the better strategy for economic recovery? Very easy monetary policy, together with cautious fiscal stimulus? Or moderation in monetary policy accompanied by aggressive fiscal thrust? There can be no pat answer -- but the former approach hasn't worked in Japan's case. The alternative can hardly do worse. The latter policy mix would tend to be associated with higher market clearing yields than would the former.

The basic underlying fact of life in global markets for much of the 1990s, one that will color 1999's results, is the imbalance in economic performance between the United States (or the "Anglo-Saxon" economies, more generally), on the one hand, and virtually everyone else, on the other. The result, for us, has been a strong currency, low and falling commodity prices, declining inflation and interest rates, and a surging market multiple. I've attributed these results to a mix of U.S. virtues (cultural openness and political flexibility, wise macroeconomic policy choices, bottom line oriented corporate governance) and foreign vices (a long list). Maybe at this time of year this should be restyled as a "naughty or nice" analysis.

The global imbalance has generated effects other than the nice ones so far enumerated, among them the record U.S. trade deficit and the apparent negative rate of personal saving. It has also strongly influenced other circumstances, such as the divergences in welfare between commodity producers and commodity consumers: crafters of code in Seattle have done much better than butchers of hogs in Carl Sandburg's Chicago.

The basic issue in the 1999 outlook, it seems to me, is whether the great global economic imbalance will improve, or deteriorate further. If it worsens, it is likely to result in a still deeper U.S. trade deficit, a still heavier drag from abroad on U.S. domestic demand and therefore probably a slower GDP growth rate and worse corporate earnings results. The initial impact on the dollar is indeterminate; a stronger dollar grew out of similar conditions in the 1995-98 period, but dollar strength has become more vague of late, and in any case a deeper trade deficit implies a potentially painful adjustment process at some point in the future.

If the global imbalance improves, due to a bottoming in Asia generally and Japan most particularly, as well as helpful contributions from an integrating Euroland, then some of the negative effects of that imbalance will be mitigated. But so too will some of the positives; if the world economy should, by miraculous convergence, begin to look robust, we might logically expect a reversal of the falling commodity prices, declining inflation and interest rates, and booming market multiples with which we have been so pleasurably anointed. The dollar might come under pressure in a world that offers opportunity outside of the United States, and the Fed might have to defend it. Commodity producers, Russia, and value managers may all get off the mat.

Naughty or nice in '99? It is too soon to have any conviction about an improvement in global economic performance next year, but some of the pre-conditions for better future balance may be falling into place.

In the meantime, in an environment of great complexity, and by the principle of Occam's razor (in which the simplest answer is preferred to the more complex), I will come down on the side of a nice beginning to the year for the market. The simple answer is that the Fed has shown itself to be on that side. Whether it has staved off a bust or re-inflated a bubble is yet to be determined, but until the Fed is no longer our friend, this market is likely to remain resilient.

Here's wishing you the same in the new year.

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