Jay Pelosky is the global strategist for Morgan Stanley. His outlook on the market and the economy is generally more bullish than that of Morgan Stanley's perpetually pessimistic chief economist, Stephen Roach. All the same, the firm advocates a "constructive dissonance" in forming its economic and strategic policy, Pelosky says.
He believes the going-nowhere stock market is trapped within a trading range that is underpinned by consumer spending on the bottom and held down by lousy corporate earnings at the top. BusinessWeek Online's Margaret Popper spoke recently with Pelosky about his view of the market and the economy through the rest of 2001. Here are edited excerpts of that conversation:
Q: What's your outlook for the stock market between now and the end of 2001?
A:It continues to be a stock-picker's market and continues to be a market where broadly diversified portfolios make sense. It's an environment where you don't have to chase -- you want to be a buyer on weakness. As an example, we added to U.S. equities in March. At the time, it seemed like a very risky thing to do. March was very weak. But it has been born out that it was better to buy in March than to buy in late April.
As it becomes clear there is some economic stabilization and recovery ahead, equity prices, at least, will be modestly higher. We would expect the Standard & Poor's 500 index to actually have a shot at getting up towards 1,400, which is a pretty decent move from here. (The S&P was 1180 on July 11). You're talking about, maybe 15% [upside]....We expect the rest of the world markets being up somewhere in that kind of range -- a 10% move -- give or take a little bit.
Q: What about the bond markets?
A:We would expect the 10-year Treasury bond to continue to oscillate in a 5% to 5½% yield range. That is why we have a slight bias to equities in our balanced portfolio. There's a risk bond prices will be lower. When you have these range-bound markets, the risk of buying high, or after you've seen a bit of a run, is that markets come back in. All of a sudden, a month later, you're under water.
Q: Should investors buy bonds as a safety net during the economic slowdown?
A:It's hard to identify significant macro-mispricings that would encourage one to take big positions on betting either for significant economic recovery or significant economic weakness. Bonds do not seem to be really cheap if you want to take a big bet on bonds, thinking that the economy would weaken and bonds would fall. It's hard to say there's a real opportunity in high yield, for example, as there was, six or nine months ago. Big parts of the high-yield market have already had a significant rally.
Q: Are you worried about inflation?
A:We do not think inflation is about to rear its head. In fact, we expect industrial-world inflation to decline a half percentage point in 2002. Headline inflation in Europe and the U.S. this year has been distorted to some extent by dramatic increases in energy prices and food prices, and we expect those to come in next year.
Historically, inflation is a lagging indicator. Typically, 12 months after economies slow, inflation is lower than it was the year before. The kind of wage gains that have been driving up economic activity would also be likely to become much more muted.
Q: Could the Federal Reserve sow the seeds for inflation by cutting too deeply?
A:No, I don't think that is a big risk, although one could question the potential for dollar weakness 6 to 12 months down the road. To date, people are very happy to hold the dollar. Over the past couple of years, capital flows into the U.S. have been very robust, in part driven by mergers-and-acquisition demand coming out of Europe, i.e., European corporates recognizing they need to become significant players in the U.S. That coupled with some portfolio reallocation out of Europe and the U.K. into the U.S. -- in part driven by globalization of investment portfolios in Europe -- has created a very strong dollar.
Yet the dollar has remained strong over the course of 2001, when the M&A boom has clearly abated. Over the past quarter or so has come the realization that the U.S. policy mix is the most pro-growth, and that's what investors want in a growth-short world.
Now, the question [concerns] 12 months from now, let's say, when the world economy has stabilized and the dollar doesn't represent [the] best, or only, hope for growth. Then, maybe, it starts to become less sought after at the same time as you have a big supply of dollars washing around the world.
Q: What's your outlook for corporate earnings?
A:We're actually in what we would call the fourth big earning cycle of the past 20 years, which peaked in the spring of 2000. In a very short period of time, year-on-year earnings growth has fallen from peak to negative. I'm talking here about world equity earnings, not just the U.S. Typically, the cycle takes about two years for earnings growth to go from peak to trough. And the question we are wrestling with at the moment is whether we are going to have a shorter time frame for that to develop, in part, driven by the current cycle. We went from peak to negative in 11 months, vs. 16 months in the prior three cycles.
Q: Do you think the earnings recovery might be quicker, then?
A:It may well be quicker, but it's fair to say that earnings expectations for 2001 are quite muted. For 2002, we have on a global basis, earnings growth expectations of about 8% to 12% compared to 3% plus or minus for 2001. Probably more likely to be minus.
Q: When do you think earnings will bottom? Do you think the second quarter was the worst of it?
A:In the U.S., we're debating about whether the second quarter or the third quarter will be the worst. We think probably more toward the third quarter. But the rate of decline, I would imagine, would be starting to really moderate.
And elsewhere, it's a little tougher to say. Probably later than that, we would expect in Europe, and probably in Japan as well, because they're lagging, particularly Europe.
Q: Since consumer spending defines the bottom of your "range-bound markets", what's your projection for unemployment?
A:We have a view that in December, we will have an unemployment rate of about 5%. Typically, from a bottom in unemployment, you have a full percentage point gain in the next 12 months. We bottomed, in terms of unemployment, at 3.9% [seasonally adjusted in September and October] of 2001. Five percent is a fairly natural rate of unemployment and would be consistent with a growth rate in the U.S. economy of roughly 2½%.
Q: Any sense of when we're going to have bad days in the stock market again?
A:The summer's probably going to be fairly dull. The fall may be the real testing period, because by then, guys like myself, people who are somewhat more positively disposed, will be expecting to see confirmation of the Fed's actions having effect.
Popper covers financial markets and the economy for BW Online in New York
Edited by Beth Belton