"Intel's decision to cut capital spending by 40 percent"
December 6, 1998
MARKET INSIGHT
The Bubble Is Back, Compliments of the Fed
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By KENNETH N. GILPIN
his has been a very strange year. Consider these events:
A 24-year-old woman shakes the presidency.
A septuagenarian senator rockets into space.
Stocks plummet for a couple of months, then turn around and set new highs by the end of November, leaving many to wonder why they fell so far in the first place.
Charles I. Clough Jr., chief investment strategist at Merrill Lynch & Co., recently took some time to talk about developments in the financial markets, and to share what he sees happening in the year ahead.
Q: Based on the market's move over the last couple of months, it seems as if Asia, Russia, Long-Term Capital and Brazil never happened. Are the steps that have been taken to deal with these problems the reason markets seem so much healthier?
A: We have thrown a lot of money at a lot of problems, but throwing money at them doesn't necessarily solve them.
It is really hard to make the case that foreign events caused the mighty, powerful reserve currency capital market to collapse. It closed because American corporations are spending so much right now on investment they are running big cash deficits. And that led the Federal Reserve Board to throw a tremendous amount of money at the capital markets. It is that liquidity that is helping stocks.
Q: When they try to explain the source of the money that is flowing into the market, a lot of folks cite big cash balances in money market funds and at mutual funds. Do you buy that?
A: The stock market has seen its capitalization increase by at least $1.5 trillion in the last two months. You can't do that with normal savings. There is something powerful underneath this thing, and I would argue it is the Fed.
Q: This all sounds rather ominous. Is the market's recovery really that tenuous?
A: We are the biggest bulls in the world. But the real question the market is going to have to deal with is what happens when the economy slows. The Fed has now reflated the equity market bubble. The risk is that next spring they will be looking at an even bigger bubble at a time when the economy will be slowing and profits will still be declining.
Q: A lot of people have recently been talking more optimistically about profits, if not in the first half of the year, then later on. You seem to take issue with that view .
A: I think the argument is flawed. For the last five quarters, profits have been flat to down in the context of a Goldilocks economy. The basis for profits is fantastically positive, and yet they are weak.
I don't know if we will go into a recession or not next year. But I do know we will run that risk, and will go through a period of very, very sluggish growth, a time when investment spending will slow. When that happens, spending, income growth, profit growth and employment will all be weaker.
Q: Are the announcements of the Exxon-Mobil merger and Boeing's production cutbacks examples of that?
A: They sure are. So was Intel's decision to cut capital spending by 40 percent, which it announced a couple of weeks ago. I think we are going to see more of that. We have had the biggest capital spending boom in history. But after a while, there is too much of it.
Q: You have been a much bigger fan of the bond market than of the stock market for at least a year. Is that still the case?
A: Yes, it is. The best-kept secret in the world is how well the 30-year Treasury bond has done this year. It has had a return of about 18 percent so far, roughly in line with the Standard & Poor's index and much better than the average stock, which is down. I think by the end of the year it will beat the S&P. That's unheard of, for a bond to beat the stock market in a period of strong economic growth.
Q: Is 1999 a year to buy bonds?
A: I think bonds will outperform stocks by a country mile next year.
We think rates will fall, and could fall substantially, because there is no inflation out there. A year from now, we could see yields on the 30-year bond at 4.25 percent, possibly lower. I am not holding back.
Q: Is there more money to be made abroad than at home next year?
A: Today, nobody dares look outside the United States. But the theme for 1999 is that money will gravitate toward economies and markets that are running current account surpluses and are not heavily dependent on inflows of foreign capital.
That may point you to Asia, where countries like Korea and Thailand are already generating current account surpluses. Others will start doing the same soon. Asia could be the big story in 1999.
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