Returning to Right Side Up

Examining the re-establishment of optimism about global economic prospects.
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The Goldilocks economy has been a thing of beauty as well as mystery. No one has gotten it figured out to fullest satisfaction, as

Alan Greenspan

admitted last week on behalf of the

Federal Reserve

. The essential allure, however, is well understood: not too hot, not too cold, but

juuust

right. Therefore, the risk exposures are, on the one hand, that the economy gets too cold, and on the other, that it overheats. Elegantly straightforward, right?

The problem is that economists, policymakers and investors can't agree on which is the more threatening exposure. Last year's financial panic, set off by Russia's decision to default on part of its ruble-denominated domestic debt, had an effect like liquid nitrogen: It caused a sudden shocking chill that paralyzed Ms. Goldilocks. The effect was entirely out of proportion to the scale of Russia's debt, domestic or otherwise, in the overall scheme of things, but the prevailing latency must have been a fear of global chill. The fourth quarter resounded with gloomy prognostications about the coming worldwide depression. That perspective has disappeared now, like April snow. Markets now reflect a dramatic shift in risk perception, turning away from a fear of too-cold conditions in order to keep a closer eye on the chance of overheating.

In U.S. equity markets, this change in perspective has resulted in a rally in economically sensitive cyclical stocks, and a rebound in "value" relative to "growth." In effect, this performance reflects a sorta, kinda, maybe capitulation on the part of those who had been worried about "too cold" and its attendant scarcity of growth. But it is a soft capitulation at this stage, one that permits a rebound in cyclicals to coexist with the maintenance of high price-to-earnings multiples on growth stocks. A hard full capitulation might look like a mirror image of last year's panic: fear of overheating, rising commodity prices, a weakening in the currencies of commodity-importing nations, and a generalized trend of tighter monetary polices.

All sorts of markets are in the process of adjusting to changes in current and prospective global economic conditions. The cuts in interest rates that took place in response to fourth-quarter fears were a starting point. The stabilization, finally, at deep new lows for emerging-market exchange rates provided them with much-improved competitiveness in pricing for their commoditylike products and the prospect of export-led recovery.

The more important changes, however, may have been, and may be, taking place elsewhere: Japan's economy is to that of the rest of Asia as the dog is to the tail. If there was any real usefulness to the financial terror that struck last year, it is that it apparently has shaken Japan's authorities from their insular complacency. Legal and political changes have begun to cause changes in corporate behavior: write-offs and layoffs are now seen as feasible. Such restructuring may finally ignite the world's second-largest economic engine.

Evidence to that point is seen in forward-looking indicators such as market prices. The

Nikkei

has more than doubled the

S&P 500's

year-to-date return and Japan's index of over-the-counter stocks, oriented to the domestic economy, has nearly doubled since the pit of depression fears last year.

It took some time for evidence to accumulate that last year's financial heart attacks would not prove fatal. Improving credit flow to Japan's domestic economy was an early indicator. By the end of January this year, the emerging markets' blood flow was starting to look better, as reflected in the peaking and reversal of the spread over Treasuries required to attract or retain capital in those markets. At 875 basis points currently, this spread has retraced roughly three-quarters of the gap that opened up during the third-quarter panic.

The price of oil, that ultimate commodity, has acted as if it were a constituent of the .com universe. Whether this is because of supply-side restraints on production as organized by

OPEC

, or whether it is due to a rebound in global demand as a result of recovery in the energy-intensive economies of East Asia, this kind of price performance tends to catch the eye. Arguing for a demand-side interpretation of this move are OPEC's past ineffectiveness, and the fact that metals prices too are coming on.

By early February, these ambiguous hints had begun to crystallize and cyclical stocks began to show a bit of life. By mid-March they had levitated to the point that they overtook the performance of the Nifty Fifty growth stocks that had seemed like the wiser bet as the fourth quarter opened. But this year, it has been the energy, metals, papers, chemicals and transports that have been among the leading groups in the S&P 500. In most of these cases, the year-to-date outperformance has been such that it has pulled the six-month performance record up to rank ahead of those of the former growth leadership. Investors who bought cyclicals at relatively dirt-cheap prices in the midst of last year's meltdown look a lot smarter today than they did at the time of purchase.

The same holds true in the case of small-caps. The performance of this asset class has been dragged along behind that of the mega-cap leaders for so long -- as had that of other classes, such as international equities, bonds, real estate, commodities and cash -- that it had begun to appear as if diversification and the entire fundamental premises of modern portfolio theory were quaint, outdated notions.

The scope of evidence across commodity and asset markets makes a strong case for the re-emergence of global economic vigor. The rally of emerging markets' currencies against the dollar, the easing of interest rates abroad, and the steepening of the yield curve at home supplement the relative improvement in cyclicals and small-caps in foreshadowing a global growth pickup.

It is not yet an entirely convincing case, however. All of these arguments are, jointly and severally, interdependent. Their current readings amount to a reversal of the signal they were sending, in unison, last year. Now they have decided, all together, that they had it wrong last year. This sort of equivocation is not quite enough to put to rout the growth-at-any-price strategy that has worked so well for so long.

So we are likely to see a volatile give-and-take between the newly emergent cyclical, breadth and value themes and those of the established growth leadership. It seems unlikely that so great a divergence as that which opened up between growth and value in recent years can be stopped and reversed in a quiet and peaceful passing of the crown.

The re-establishment of optimism about global economic prospects may have turned the markets upside down in the last several weeks, but perhaps it should be seen as a return to right side up. In April, for example, looking for bargains on Wall Street was rewarded -- in stark contrast to last year, when the purchase of cheap stocks was punished by the market.

For now, economic growth is seen as good. It is still too new an idea, and too fragile, to be a threat to the regime of easy money, fiscal stimulus and other encouragement as provided by the world's policymakers. For now, growth and value themes can coexist uneasily.

But if market signals begin to suggest a future pace that is too frisky to maintain Goldilocks' balance, the policy regime may change. In the wake of that development is likely to come a much harder capitulation than we have yet seen to the effects of strong economic growth on stock market returns. A critical key to those returns is accommodative monetary policy -- which goes out the window when vigorous growth comes in.

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

GriffinJ@aeltus.com.

Mike Farrell is Griffin's colleague.