The economic and corporate outlook for the U.S. has been extremely murky since last month's terrorist attacks. But if history has its say, some things can still be counted upon, says Subodh Kumar, chief investment strategist for CIBC World Markets. One's the dictum, "Don't Fight the Fed." While Kumar acknowledges that the events of Sept. 11 will take an uncertain toll, the chief strategist believes the Federal Reserve's aggressive easing will help bring the U.S. economy back to its feet. And he's advising investors to exercise foresight: There are reasons to believe a new business cycle will start next year. Kumar spoke to TheStreet.com associate editor Justin Lahart and staff reporters Kristen French, Yi Ping Ho, Lee Barney and Chris Frankie on Oct. 2, 2001.
It's hard to separate anything from the events of Sept. 11. One problem now is there aren't any accurate data points to judge from. We sort of think we know what the world looks like ... but how do you move forward? How are you advising investors to deal with the lingering uncertainty?
The market has obviously been upset by the tragic events of Sept. 11. The way I think of the market, you have to look at both the quantitative part and then the emotional part. If you had the same thing happening in 1999 and 2000, when the Federal Reserve was tightening rather than loosening, it would be a very different situation. If we leave emotion aside, I'm looking at Fed policy, earnings and margins.
I think that there's every incentive for the Fed to continue easing. Inflation's low, and energy prices are contained. I happen to think they'll do whatever it takes, and there's no inflation reason to hold back. They still have a lot of flexibility at this point.
If you look at the market, what's interesting is that as the Fed was cutting rates, long Treasury yields haven't moved to new lows. It's quite noteworthy that that's happened even when people are worried about the economy. To me, that's a plus sign. The bond market is essentially behaving as if the economy is stabilizing.
"I think that there's every incentive for the Fed to continue easing. Inflation's low, and energy prices are contained. I happen to think they'll do whatever it takes, and there's no inflation reason to hold back."
When we come to the stock side of things, the next important factor for equity markets, even before the events of last month, is what happens to the earnings cycle, particularly what the earnings cycle looks like next year. In the last three or four years, people have gotten too used to what I'd call "coincident indicator investing." In other words, at the peak of the earnings cycle in March 2000, or before, people were investing as if the earnings recovery would go on forever.
We're now worried that recovery will not come. I think to make money you need to have a slightly contrarian bias. The basic thing to remember is that earnings are coincident numbers. If you keep focusing on third-quarter earnings, which are going to be weak,
you will miss the turn. The key thing is to look at how earnings in the next 12 to 18 months will move upward.
We've seen flattening industrial production since the summer of 2000. Companies have already been in cost-cutting mode for 18 months, so it's high time we started to see some results. I'd be very surprised if companies still see no improvement. I think the earnings low was seen in the second quarter and the third quarter of this year.
The scenario I favor is that, with no obvious mistakes from the Fed, an aggressive ease, plus companies cutting costs since mid-2000, a new earnings cycle will start next year. And usually when a new earnings cycle starts, the first leg is a lot more dynamic. If the Fed succeeds and a new earnings cycle starts from this year's earnings, we'll be looking at a recovery next year of at least 25% if not more, which is standard cyclical-earnings behavior.
We had one of the lowest asset allocation of equities of 55% stocks and the balance in other investments, until early April, when we shifted to 75% stocks, lower bonds and lower cash. We've made a switch from a balanced-portfolio view to an equity skew, and we're staying that way.
If my scenario comes through, and it's more likely to come through, I think the most leveraged earnings recovery for stocks will be in technology and cyclical stocks. Until April this year, my overweights were in things like utilities, financials, energy and big-cap pharmaceuticals. But I've made a switch to earnings momentum
stocks. And taking into account more aggressive Fed eases, I've gone back into banking stocks, especially the regional banks that will be beneficiaries.
" If the Fed succeeds and a new earnings cycle starts from this year's earnings, we'll be looking at a recovery next year of at least 25% if not more, which is standard cyclical-earnings behavior."
There are questions whether the tech-capacity overhang will really get worked off. In the tech arena, there'll be a lot of companies that won't survive. How would you sort through the wheat from the chaff?
Capital spending dried up in the first half of this year when companies were worried about the economy. But if they think the economy has kind of stabilized, companies will be forced to look for efficiency-driven capital spending, and not just cost-cutting. From that angle, the revenue line for tech companies is going to start improving as corporate America has no choice but to focus on improving efficiency. Communications is part of that.
Tech as an industry is probably going to see some revenue growth. A company can see direct benefits from investing in technology in areas like enterprise software or supply-chain management. There are a number of companies in
this area that I think makes sense for companies to start spending their money on.
If tech recovers, you have to start off by having a relatively good position in strong and big companies like
. It's unlikely that tech will recover without big companies moving up. Maybe
AOL Time Warner
on the content side, and then smaller, second-tier software companies.
Even if tech recovers, it doesn't mean that a lot of companies won't go under. But tech is being restructured without a safety net, and that means that the restructuring will be more vicious and more complete. Companies with good products will be bought up, and others with weak products and weak financials will disappear. But the tech industry will come out much stronger than before.
"We've made a switch from a balanced-portfolio view
to an equity skew, and we're staying that way."
Are there signs that Fed easing, which started in January 2000, has kicked in?
In my opinion, it was premature for people to say that by the summer, Fed policy should have some effect. I still maintain that leads and lags of central bank policy range from nine to 12 months. So the first effects of the Fed ease in January should be felt in the fourth quarter, meaning September and onward.
There are at least three episodes where markets have bet against the Fed and have been disappointed. The first came after the Asian crisis in 1997 and 1998 when the Fed eased and had no effect
on the market. The second one was during the market euphoria in late 1999 and 2000. The Fed started to tighten in late 1999, but if you opened up
The Wall Street Journal
or other papers, lots of companies were saying, "Who cares about the Fed! Our business model is so good." They misjudged the Fed then, and I think they're misjudging the Fed now.
One concern has been the unwillingness of consumers and investors to take on risk, as well as the worry that such unwillingness is going to last for a long time. Are you worried?
Lower interest rates mean that refinancing costs and mortgages are lower, and the affordability of housing and autos is good. The Fed aims to keep the average consumer relatively confident. You had people talking about similar things in 1997 and 1998. At that time, Asia was supposed to
be the big magnet of growth. And with the Asian financial crisis, people said this is the end of world growth. And who cares what the Fed is doing. But in the last three or four years, people have been underestimating Fed policy.
The unemployment rate could rise to 7%, which in 1989 and 1990 was one of the reasons why the U.S. had a lengthy recession. But back then companies felt, and rightly so, that they had to reduce costs. However, companies have currently been in cost-cutting mode for a long time. I think the consumer will hang in. We may not see a buoyant consumer,
but a more careful consumer.
When I say people will hang in, a lot of people think I mean that
gross domestic product will go back to 4% or 5%
growth. That is an unstable number for the U.S., which is what we had in 1999 and 2000. But if we go from zero growth and close to that, to 2.5%
growth next year, I think that kind of spending by the consumer is doable.