Message From The Marketsby
A currency crisis in Mexico. An earthquake in Japan. War in Russia. Rising political tensions in China. Mounting budget woes in Canada and Europe. Any one of these events might be enough to ruin a global investor's portfolio. But there's even more bad news in sight. In addition to all the other stresses on world markets, add one more concern: the specter of ascending interest rates around the globe. And that has traders fretting that economic growth will slow--or peter out altogether.
As a result, stock markets from Toronto to Taipei are getting whacked. In the past three months, European markets have suffered a steady decline. Bourses in other parts of the world are faring even worse. Mexico's stock market has fallen 54% in dollar terms. Japan's Nikkei stock average is off 11.1%, and Hong Kong's Hang Seng Index is down more than 21.7%. Trading on Moscow's fledgling stock market has dried up. And the Dow Jones industrial average is treading water. Around the world, says Morgan Stanley & Co. strategist Barton M. Biggs, "there's been a huge loss of faith" in equities.
INFLATION FEARS. What makes this failure of confidence so puzzling is the current good health of the global economy. After a robust 4% spurt last year, U.S. gross domestic product may expand a further 3.8% in 1995, estimates Morgan Guaranty Trust Co. Paced by a German recovery, Europe may grow by 3.2%, and Japan could expand more than 2% despite the shock of the Kobe quake. Even Mexico's peso collapse probably won't extinguish growth altogether in Latin America.
But stock traders are looking straight through the good news. Why? To Peter Sullivan, European strategist for Merrill Lynch & Co. in London, traders "have already taken account of a strong earnings recovery. Equities are pretty fully valued." That allows them to focus on their worst fears: The likelihood that the Federal Reserve will see the strong growth projections as justification for intensifying its year-long battle against inflation. Traders thus see a sharp hike in the federal funds rate--perhaps by 50 basis points--as soon as Jan. 31. Many investors also expect additional increases in the U.S. and across the industrial and emerging world stretching into next year.
By the time they peak, short-term U.S. rates alone could be as high as 8%, figures Morgan Guaranty economist William A. Brown. The prospect of
a global liquidity squeeze is already prompting some economists to erect
a new wall of worry as they tone down growth and earnings estimates for 1996 and beyond. Smith Barney Inc. international economist J. Paul Horne, for one, thinks the U.S. economy will brake to a 1.6%-a-year crawl by next year, followed in short order by a "modest" European recession stretching into 1997. Indeed, some economists think the next slowdown could feed upon itself with fierce determination.
Canada and Mexico, which absorb nearly a third of U.S. exports, are a good example. With interest rates rising steeply as central banks defend their embattled currencies, both nations' appetite for American goods is almost certain to wane. If U.S. exports start to fade, the entire economy likely will follow. That in turn will cool GDP in Europe and Asia, which rely on exports to the U.S. for a lot of their growth. "I've rarely seen a period when it's so difficult to discriminate among markets," says Christian Wignall, chief global equity investment officer for G.T. Global mutual funds. "There's no place to hide."
GOOD-NEWS BLUES. One result: In country after country, investors no longer are willing to forgive economic excesses as blithely as they did when U.S. interest rates were only 3%. That's especially true when they know they now can earn 7.6% on two-year U.S. Treasuries. "That may not be the best yield around," says Salomon Brothers Inc. chief equity strategist David Shulman. "But you know that at the end of two years, the money will be there." Yields on emerging-market debt, meanwhile, have reached incredible heights. Morgan Stanley's Biggs notes that dollar-denominated Eurobonds issued by Cemex, a fast-growing Mexican cement producer, have skyrocketed to 25% lately. Says Biggs: "I wonder how well emerging-market equities can do when the debt has such rich returns."
Amid heavy competition from bonds, equity traders seem intent on discounting the best of news as soon as it breaks. For example, traders hammered shares of both IBM and Compaq Computer Inc. after the computer makers announced excellent fourth-quarter profits. Traders figure profits have gotten about as good as they're likely to get any time soon.
It's much the same story in Japan, where the average price-earnings ratio of 76 reflected a strong belief that corporate profits would finally stage a healthy recovery this year. Then the Kobe earthquake struck, and analysts began tearing up earnings forecasts left and right. True, most expect profits and the economy to recover by 1996. But worries over consumers and companies liquidating massive quantities of stocks to finance reconstruction are now weighing heavily over the Nikkei.
The result may not be pretty. After slumping 5%, to 17,885, on Jan. 23, the average could be set to fall 1,000 more points, says James Capel Pacific Ltd. strategist Jason James. But Japan isn't the only major market that could be in jeopardy. Smith Barney's Horne says that as money tightens over the next six months, U.S. stock prices could retreat 15%. That, he adds, could spark "a further correction" in Europe.
TOUGH BATTLE. Declines in the industrial world are likely to cause new heartache for developing countries--even Asian ones with large pools of savings. Price-earnings ratios in these countries remain high by global standards and are thus vulnerable to further declines. Take Bombay. The average p-e ratio for major equities has fallen lately but is still hovering at 30--twice that for the U.S. "Investors will have to get used to lower p-e's," says Ashish Guha, head of investment banking at Bombay's Credit Capital Finance Corp.
One big reason: The collapse in Mexico has "increased risk premiums for the securities of all emerging-market economies," says Kemper Financial Services Inc. economist David D. Hale. With the easy money of the early 1990s rapidly evaporating in Latin America, Asia, and other regions, these markets are now settling down for a long, tough battle for credibility that may take years to win.
The sorry situation of Telefonos de Mexico, perhaps the bellwether for all emerging-market stocks, illustrates how far a reputation can fall. After dropping 50%, to $34, Telmex now trades at a mere seven times next year's estimated earnings. With profits still expected to grow by more than 20% annually in coming years, "that's completely stupid," says Oscar A. Castro, managing director of Montgomery Asset Management in San Francisco. So is he buying? "A year from now, the equities no one wants to hold will again be the darlings of international investors," he predicts. However, "I will not fight the market," he says. And right now, the market is forecasting coming economic bad news.