The plug-uglies had their day (actually five days) in the sun last week. Chemicals, papers, oils, metals, machinery, railroads - smelly stuff with dirty fingernails that nobody seemed to want until last week. The cyclicals popped as the realization crystallized that the rest of the world has done its worst and has not been able to derail the U.S. economy. In fact, our economy has lingered in the global sick ward for nearly two full years now and, far from contracting the malady, appears to be radiating a contagious health to the afflicted.
That's not good. Forgive the selfish perspective (perhaps you share it?) but what is good for the rest of the world is not likely to be good for investors in U.S. stocks and bonds - most stocks and bonds, anyway. From the onset of the global "Asian contagion" crisis in mid-1997 to today, it has seemed to me that the primary source of risk to our markets did not lie in the direction of a deflationary meltdown into a 1930s time warp. The real danger, then and now, lies in a global overheating. Indeed, a mere global heating, never mind overheating, may be enough to bring our kettle to a boil.
The simplest and most robust relationship between the economy and stock and bond markets that I can muster is that the markets do well when the economy does poorly, and vice versa. That may be a blunt rule, but if I can have only one tool, that's the one I'll take. How does it work? The economy does badly, the
eases, liquidity flows, and the markets do better. Bonds rally, multiples expand. Earnings may be lousy, but expanding multiples cover a multitude of quibbles. Eventually all that liquidity and wealth creation spurs an economic recovery, so the Fed tightens and the markets go south. It's a simple model and not elegant, but it's as robust as a three-pound hammer.
But our economy has done great and our markets have performed spectacularly in recent years, so the theory fails on the evidence, right? No. The economy is global and so are the markets. The 1990s have been a lost decade of global growth, except for a blessed few locales. The U.S. has enjoyed the exceptional confluence of solid local growth cooled by the chill environment in which it takes place, so our markets have been able to put those weak-economy fat multiples on cyclically strong earnings. Blessed indeed.
Last week saw the "global meltdown" school of forecasting throw in the towel. On Thursday,
the Wall Street Journal
reported that many economists were "rushing to revise their forecasts" upward. On Friday, it ran a front-page chin-scratcher that asked how long the US can remain an "oasis" amid global turmoil. That's a great question; it was especially interesting back in 1997, before events had produced an answer. Back then it was clear that the Asian meltdown would have a complex set of effects on the U.S. economy. You may recall that
opined at the time that the net effect would be "modest but not negligible." The question was whether the negatives of lost export sales and competition from imports would more than fully offset the positives of lower inflation and interest rates and better terms of trade. The reason that so many economists threw in the towel last week was that the data have finally satisfied them that they got it wrong.
The evidence is itself quite blunt. The U.S. economy soared out of 1998 and barreled into 1999 under a full head of steam. That 1997 question about the balance of positives and negatives has been answered by two consecutive years of nearly 4% GDP growth and almost a quarter million new jobs generated every month. And that's after accounting for a drag from the rest of the world equivalent to about 1.5 percent of our GDP.
There is an increasing suspicion among currency strategists that Brazil is the final act of the global financial crisis. The contractionary, i.e. deflationary, effects of the crisis may have peaked last year, blunted by exchange-rate adjustments that restored the competitiveness of resource-based economies, as well as by the easing initiatives of key monetary authorities and the locomotive pull of the mighty U.S. economy. Virtually everyone else has now devalued against the U.S. dollar, and the net competitive effect has slowed us down -- to a 4% growth rate.
If global turmoil did not hurt us much, then a more up-to-date chin scratching question might be, will global tranquility help us? My answer is no, probably not.
Marking up the economic forecast numbers is not a positive for our markets. Our economy is already operating at the fullest employment in a generation; it is not likely to be able to accelerate from this pace. If the rest of the world starts to recover, then we are likely to see better export orders. The U.S. trade sector may already have stopped getting worse. A net shrinkage in our current account deficit is a net addition to our GDP; that's accounting. More products sold abroad means more labor needed to produce it here. The exporters will have to bid that labor away from the homebuilders; that's overheating. The Fed is likely to find itself forced to help facilitate that transfer by beginning to ration the supply of credit, which in its current abundance is powering homebuilding and other domestic credit-sensitive sectors.
The U.S. domestic economy is already quite warm. Core services prices measured in the CPI are rising at a 3% inertial rate. This is cooled to a 1.7% overall rate by an outright drop in the price of energy and near stability in the prices of goods in general. Better global demand can quickly vitiate those cooling effects. The apparent top line inflation rate might bungee up toward 3% before economists have a chance to mark up their inflation forecasts.
Overheating is a negative for the currency. If better global conditions cause the ambient temperature of U.S. business conditions to rise, the dollar will come under selling pressure. It achieved the status of "last currency standing" over the past four years, but that bull run gives evidence of tiring. Any downtrend in the dollar will aggravate whatever inflation pressures may be in evidence domestically. The markets will throw down the gauntlet to a Federal Reserve that has had the luxury of only having to talk a good fight. The economy does well, the Fed tightens, and the markets do badly.
It's probably too simple to say that the last shall be first, to presume that whatever has done badly in the era of a strong U.S. economy within a weak globe will do well when global conditions improve. Too simple, maybe, but not a bad first approximation. The markets last week ran a pattern that suggests this outcome is rising in probability. Treasuries took a hiding, but credit spreads crept in. The yield curve steepened. Cyclicals rallied as consumer stocks sold off. Value outperformed growth at all levels, large-, small-, and mid-cap. The glorious tech stocks may have been a source of funds.
The soothsaying omens were mixed last week. The groundhog may not have seen his shadow, but the markets acted as if they had heard footsteps.
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.