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Bill Sterling is Global Strategist for BEA Associates,
who are one of the fund managers for C.I. Mutual Funds. His reports are
interesting and timely, especially for anyone interested in the larger
global picture and how it may affect their investments. See our links
page for links to C.I. Mutual Funds and other featured mutual funds.
WHAT,
ME WORRY?
December 1997
By Bill Sterling It's official: the world didn't come to an
end on October 27, when many major stock markets plummeted in response
to Asian market turmoil. U.S. investors, who have been well-compensated
for "buying the dip" since October 1987, once again came to the rescue
and were rewarded for their nerves of steel. If we're lucky, the October
market break will end up as a nearly invisible footnote in the history
of a long bull market that began in 1982. In the meantime, chilly deflationary
winds from Asia have become even chillier. South Korea, with the world's
eleventh-largest economy, has been forced to apply for financial assistance
from the International Monetary Fund (IMF), which is tantamount to a national
version of a Chapter 11 bankruptcy filing. Japan, the number-two economy,
has experienced several major financial failures that have further undermined
confidence in the nation's entire financial system. The world's most sensitive
inflation barometer, the price of gold, has taken stock of the situation
and fallen to its lowest level since March 1985. 
International policy makers are running scared. They realize that a chain
reaction of bankruptcies and financial failures in Asia could leap the
firewall into Latin America and Eastern Europe and eventually into the
other developed markets. The history of such events, which was written
in the 1930s, is certainly sobering. Accordingly, there now is talk of
an Asian bailout package that may total nearly $100 billion, with the U.S.,
Europe, and Japan ready to augment the resources of the IMF if necessary.
Japan, too, seems increasingly prepared to do whatever it takes to prop
up its major banks with public money even as it lets its weaker institutions
slip into oblivion. Amidst such turmoil, the phrase of the day appears
to belong to Alfred E. Newman of Mad Magazine: "What, Me Worry?" Ironically,
the fact that policy makers are terrified can be viewed as a bullish factor.
We worried about the Fed raising interest rates just a few short weeks
ago, while now, the Fed can't even think about doing so. We also worried
about inflation, but with gold prices cracking $300, the market has crossed
that one off the list, too. 
Historically, U.S. bond and stock markets have responded well to financial
turmoil, since whatever damage was done to growth and earnings was usually
more than offset by declining interest rates. The nearby chart shows that
bond yields usually have declined sharply after banking crises. As we have
argued in recent months, 97-98% of economic activity in the U.S. and Europe
is independent of Asia, so the direct impact of Asia's slowdown is likely
to be muted. A recent report from Lehman Brothers argues that, even if
growth in all of Asia/Pacific plus Brazil were to fall to zero in 1998-
a worst-case scenario-the effect on the U.S. would be minimal. Under this
story line, Lehman brothers would shave, not slash, its 1998 earnings-per-share
forecast for the S&P 500 companies to $49 from $50. The message is,
don't jump out of any windows because of what's going on in Asia.
Reasons for Caution
Does this mean there is nothing to worry about at all? Not quite. To be
sure, if policy makers do not step in and try to contain the damage of
the Asian crisis, the global financial system could end up in deep kimchee.
But if they do respond with bailouts, as we expect, the collateral effect
of Asian weakness on the developed economies as well as other emerging
economies should remain reasonably modest. A more significant worry, in
my view, is that we end up with an odd mix of deflation and inflation.
Suppose pricing power for many manufactured goods collapses because of
excess capacity and competitive devaluations in Asia. At the same time,
suppose that wages and service-sector inflation in the U.S. finally accelerate
because of tight labor markets. Obviously, there would be scope both for
profit margins to compress and earnings to disappoint. There even could
be pressure on the Fed to tighten rates again, despite Asia's woes, if
the U.S. economy fails to return to growth in the 2-2.5% range, as is now
generally anticipated. From a sentiment perspective, I would also note
that there is a great deal of complacency in the markets. For example,
a recent survey of U.S. equity managers by New York-based International
Strategy & Investment shows a record low in cash positions, which can
be considered somewhat worrisome when seen from a contrarian point of view.
Likewise, a Merrill Lynch survey of Wall Street strategists showed a sharp
increase in allocations to equities after the October 27 sell-off. The
increase in bullish opinion was not enough to raise a red flag, but does
suggest that the markets are pricing in a lot of good news. When markets
are volatile and emotional, I like to consult coldly rational computer
models. My colleague Ian Borsook has developed a global asset allocation
model that looks at the relative valuations of cash, bonds, and equities
around the world (see "'Deep Green' vs. Global Markets" in the March 1996
Perspective). The model weighs these valuations against a number of forward-looking
indicators of inflation and earnings trends, and then makes an overall
recommendation on whether to favor equities over bonds. Its current bottom
line is that equities continue to be more attractive than bonds, since
interest rates remain low. That said, the model has become somewhat less
keen on equities in recent months, as valuations remain high while earnings
growth prospects have deteriorated at the margin. Rate hikes this year
in Canada, Germany, the U.S., and the U.K. haven't helped.
Still Bullish, But Trimming Risk
As Sherlock Holmes told Dr. Watson, "These are deep matters." Our conclusion
is to remain positive on equities, but to cut down on risk a bit. In our
international balanced funds, we have trimmed our targeted allocation to
equities to 65% from 70% in view of somewhat higher risks to corporate
earnings. We also have boosted our bond allocation to 15% from 10%, due
to lower risks of inflation. Our cash target has remained at 20%. 
We continue to tilt our geographic portfolio weightings toward the U.S.,
Europe, and Latin America, which are most immune to the Asian slowdown.
If an IMF bailout goes through in coming weeks, we would not be surprised
to see a trading bounce in Asian markets, including Japan. But IMF medicine
typically has the taste of castor oil and may not go down easily in nations
like South Korea. This suggests that the earnings outlook in Asia is likely
to remain poor for some time to come and, as a result, there should be
no hurry to re-enter Asian markets. That said, the relative valuations
of aggregate emerging markets are as cheap as they have been since the
late 1980s. Likewise, sentiment toward those markets is virtually the mirror
image of where it was in the 1993-94 period, when money was pouring in.
As they say about fund managers, "they're never as smart as you think when
they're hot, and they're never as dumb as you think when they're not".
A number of Asian countries may have been shown to be paper tigers in the
short run, but it probably is a mistake to write them off in the long run.
Accordingly, we'll be looking for opportunities to revisit Asian markets
over the course of the next six to 12 months.
Return To Top Of Page
This communication is published by C.I. Mutual Funds
Inc. Any commentaries contained in this communication are provided as a
general source of information and should not be considered personal investment
advice. Every effort has been made to ensure that the material contained
in this communication is accurate at the time of publication. However,
C.I. Mutual Funds Inc. cannot guarantee its accuracy or completeness and
accepts no responsibility for any loss arising from any use of or reliance
on the information contained herein.
International policy makers are running scared. They realize that a chain
reaction of bankruptcies and financial failures in Asia could leap the
firewall into Latin America and Eastern Europe and eventually into the
other developed markets. The history of such events, which was written
in the 1930s, is certainly sobering. Accordingly, there now is talk of
an Asian bailout package that may total nearly $100 billion, with the U.S.,
Europe, and Japan ready to augment the resources of the IMF if necessary.
Japan, too, seems increasingly prepared to do whatever it takes to prop
up its major banks with public money even as it lets its weaker institutions
slip into oblivion. Amidst such turmoil, the phrase of the day appears
to belong to Alfred E. Newman of Mad Magazine: "What, Me Worry?" Ironically,
the fact that policy makers are terrified can be viewed as a bullish factor.
We worried about the Fed raising interest rates just a few short weeks
ago, while now, the Fed can't even think about doing so. We also worried
about inflation, but with gold prices cracking $300, the market has crossed
that one off the list, too. 
Historically, U.S. bond and stock markets have responded well to financial
turmoil, since whatever damage was done to growth and earnings was usually
more than offset by declining interest rates. The nearby chart shows that
bond yields usually have declined sharply after banking crises. As we have
argued in recent months, 97-98% of economic activity in the U.S. and Europe
is independent of Asia, so the direct impact of Asia's slowdown is likely
to be muted. A recent report from Lehman Brothers argues that, even if
growth in all of Asia/Pacific plus Brazil were to fall to zero in 1998-
a worst-case scenario-the effect on the U.S. would be minimal. Under this
story line, Lehman brothers would shave, not slash, its 1998 earnings-per-share
forecast for the S&P 500 companies to $49 from $50. The message is,
don't jump out of any windows because of what's going on in Asia.