"The worst is over. Probably."
That is the official outlook, somewhat truncated in verbiage and argumentation, of the various big institutions of the global economic policy and spin management league. Among the subscribers to this tentative point of view are the
International Monetary Fund
, the OECD (
Organization for Economic Cooperation and Development
, often referred to as "the club of rich nations"), the
, and the
(the club of rich CEOs).
You have to wonder whether any of them have a clue. The record of recent years is not particularly reassuring. The Fed, for example, has admitted to having habitually erred to the low side in its projections of U.S. economic growth and to the high side on its inflation call. The IMF, while admitting nothing, has done roughly the opposite at the global level. My point is not to criticize -- forecasting is very difficult, so the saying goes, especially about the future -- but to suggest that an investor's Big Call in here is a judgment on whether the big authorities got their Big Call right.
Stock, bond, and money markets have been pricing that judgment throughout 1999. The year opened with the prevailing mood being the one set last year amidst global financial panic. By February, however, a tendril of hopeful optimism was revealed in the shrinkage of emerging market and high yield credit spreads and the outperformance of value stocks. A majority of forecasters back then still expected that the Fed's next move would be an easing gambit. March saw growth styles reassert their dominance in U.S. equities, but then April produced the best-ever relative performance by value, according to
Frank Russell Company
style indexes. Credit spreads shrank throughout, but Treasury yields backed up. Meanwhile, the best thinking of Fed-watchers began to factor in the previously unimaginable possibility that a tightening could be in our future.
The pattern is one of ebbs and flows on the Big Call question of whether our eventual path into the economic future is an up-sloping one, or whether it will once again confront the abyss. Optimism is still tender and not well supported by the contemporary facts. Markets discount first one path and then the other; this angst, expressed in prices, has produced quite a bit of thrashing. "Maybe the worst is not, in fact, over. If the global bigfoots got it wrong, again, then forget about fear of the Fed, forget about cyclicals, and forget about spread product. But if it turns out that they got it right, then spreads will tend to tighten and cyclicals will look relatively good, but uh oh, watch out for the spoilsports on Independence Avenue."
Throughout April and into May, the scatter diagram of evidence, as I read it from market movements, showed an improving confidence in the Big Call. Market breadth improved dramatically as previously disregarded investment sectors came in for reconsideration: small caps, cyclicals and commodities, REITs. Money flowed back to emerging markets, including Latin America, and Asia, including Japan.
A Speculative Notion
But the Big Call is, in essence a speculative one. It is about the future. The current situation is not one of strong, or even strengthening, global growth. Markets must necessarily take, not on faith but at a price, the proposition that the worst is over. When commodity cyclicals are cheap enough, the reward-to-risk ratio for taking a long position on the Big Call is tempting. When those sorts of investments have rallied in price such that the potential future reward specs out as less attractive at the higher entry point, the old tried-and-true options regain the upper hand.
The recently increased frequency of the rotation from steady growth to deep value themes, and back, makes it appear that the market is fibrillating, or short-cycling, between them. A reasonable inference is that, at current prices, value plays are as fully priced, on a forward-looking, risk-adjusted basis, as steady growth stocks. The trade, then, may be not so much between these two stylistic approaches to U.S. equities as it is between U.S. equities and other asset classes.
Which brings us to bonds. The U.S. Treasury market has been less schizoid than cyclical stocks in pricing the global growth outlook: its trend year-to-date has been one of fairly steadily increasing dismay that the big institutions have got the Big Call right. Unlike for cyclical stocks, there is no mixed message for Treasuries in an environment in which stronger growth leads to higher yields.
It seems to me that the FOMC's decision to institute a tightening bias has caused a qualitative change in the nature of the rotation between investment strategies based upon positive or negative views on the Big Call. Prior to the bias directive, the rotation was
the idea that looked better at that particular moment, but since the Fed's announcement the rotation is
from the idea that looks worse. Said differently, the new monetary bias makes the risk assessment of investment options seem qualitatively more important than the calculation of potential reward. Fear is making inroads on greed.
Getting it right in calling the degree of vigor in future global growth, or even the timing, is probably less important right now than being right on the Big Call on eventual direction. The world has not yet established a growth trend that will drive financial and commodity market trends, but is struggling to do so. If the worst is indeed over -- if the Big Call was made properly by the big authorities -- then the Fed's next move is assured. The bond market right now seems less ambivalent than the stock market on that call, perhaps because its payout in a growth environment is less ambiguous.
Current relative prices among asset classes suggest that markets have fully worked out, and fully priced in, the best speculative estimates now available regarding the growth outlook. Markets are likely to fibrillate ineffectually between the opposite poles of the Big Call until new evidence produces a breakout in either direction.
For me, the greater risk to U.S. stocks and bonds continues to be in the sort of evidence that supports the case that the worst is over. The data that buttress that case will be exactly the evidence that will move the FOMC from its current stance of projecting its own most likely future behavior to acting on that projection.
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. While Griffin cannot provide investment advice or recommendations, he invites you to comment on his column at