U.S. institutional investors remain guardedly optimistic about economic forecasts for the second half of 1994 despite the precipitous fall of the U.S. dollar last week and the reaction of domestic stock and bond markets.
However, because they expect confusion to reign throughout the second half in all world markets, investors are buckling up for a rough-and-tumble ride, confident of investment gains to be made along the way.
"It's not going to be a smooth ride for the next year. We'll see a tremendous amount of volatility in the stock and bond markets as we move into the second half of the year," said Maureen F. Allen, chief economist at Scudder, Stevens & Clark Inc., New York.
"But I think a year out, the market will end up about the same level it's at now. It's just that it's going to be very, very uncomfortable for many investors."
U.S. investors have been busy trying to ride out the wave of market and currency volatility. The U.S. dollar last week slid to its weakest point against the yen since the modern exchange rate system went into effect after World War II.
At one point on June 21, the dollar dropped under the psychologically important mark of 100 against the yen, to 99.92 yen. It rallied slightly to close trading at 100.43. The previous dollar low against the yen was 100.40 on Aug. 17, 1993. The dollar has fallen more than 10% against the yen this year and more than 8.5% against the deutsche mark.
The U.S. stock markets reacted sharply to the dollar's decline on June 21, with the Dow Jones industrial average falling 33.93 to close at 3707.97. The Dow shed a hefty 103.37 points, or 2.7%, between June 16 and June 21.
Japanese stocks also fell in reaction to the dollar's movements, with the Nikkei Index dipping 1.6% on June 21 to 20813.6.
The dollar's plunge also affected domestic bond prices June 21, although they rallied later that day. The U.S. Treasury's 30-year issue lost three-eighths of a point to yield 7.49%.
The dollar rallied slightly June 22, closing at 101.55 against the yen. Bond prices moved up on the news and stock prices improved.
The dollar's woes are causing big headaches for U.S. money managers. "It changes the starting point. We have a lot of wound springs in the system. We've had a pretty sharp decline in the dollar, a pretty sharp decline in the bond market, a pretty sharp decline in the European bond market," said Richard Hoey, chief economist at Dreyfus Corp., New York, and portfolio manager of the $1.6 billion Dreyfus Growth and Income Fund.
"What it means is you go into the second half with a lot of asset prices sharply off their highs. It may create a buying opportunity. It depends on whether we get good luck or bad luck in terms of the fundamentals, notably oil prices. But we have a market here that has much more recognized the negatives in the fundamentals."
The Federal Reserve is expected to raise short-term interest rates to stabilize the value of the dollar, although investor opinion was mixed as to when such action might occur.
Managers largely agree that moves by the Fed will be more to shore up the value of the dollar by attracting foreign investors to U.S. bond markets than to control inflation.
"The Fed doesn't need to raise rates for the U.S. economy, but rather as a way to attract the foreign capital we need into the U.S. bond market," said Ms. Allen. "Foreign investors turned off the spigot into U.S. bonds and are waiting out there with cash to re-enter the market. They are waiting till they regain confidence in the Clinton administration and in the Fed to take appropriate action.
"When those two pieces fall into place, I think you'll see a bond rally, which will help stabilize the dollar and help reduce the huge deficit in the current account, which was announced the other day and is bigger than we expected ($31.9 billion)."
Notwithstanding a move to shore up the dollar, some fixed-income investors expect the Fed to monitor U.S. inflation indicators carefully and to make interest rate increases based on a perceived need to control inflation.
Bud Hoops, senior vice president and the director of investment teams managing 12 fixed-income mutual fund portfolios at Twentieth Century Investors Inc., Kansas City, Mo., said leading inflation indicators have been rising. "We're not in the camp which sees inflation dropping. Inflation won't be rising sharply, but we've already seen the best we're going to see. I think we're most likely to see an upward movement to 3.5% or 4% from the current 3%.
"We really think the Federal Reserve will act to defuse inflation. .*.*. There's a 50-50 chance that the Fed will increase short-term rates at its July meeting. The weak dollar might make it raise rates earlier than it would have otherwise, but I think the Fed will be vigilant and make pre-emptive strikes to control inflation."
Like most investors interviewed, Mr. Hoops expects the U.S. economy to continue its recovery, but at a slower pace, dropping from about 4.5% in the second quarter to between 3% and 4% in the third and fourth.
Other managers are not optimistic. "It's difficult to become too optimistic about the outlook for the economy and therefore for stock prices when there is so much restraint being built up - because of fiscal restraint, higher taxes, lower spending and the Clinton economic plan passed last August take a bigger bite out of the economy each successive year," said Hugh Johnson, chief investment officer, First Albany Corp., Albany, N.Y.
"So if you superimpose fiscal and monetary restraint on a highly leveraged economy, it's difficult to get very cheery about the economy and not hard to build a case for a very slow economy in 1995 (2.5% growth in gross national product at best). The market is likely to reflect a lot of nervousness as we get closer to the end of 1994."
The apparent slowdown in U.S. economic growth, coupled with slow, but steady recoveries in other markets, has some investors concerned that economic activity in international markets may be too similar to provide heightened returns and portfolio diversity.
Tom Carpenter, managing director and chief economist at ASB Capital Management Inc., Washington, said: "One of the things to understand here is (that) there is fear in the capital markets throughout the world of a global synchronization of growth.
"What markets fear is that the U.S. and Europe and Red China and India and Japan may all be in a strong upswing simultaneously. In that environment, there may be real cause to believe that commodity prices may rise, resource markets in general may be pressured and inflation may in fact build a head of steam.
"It's very important going forward to make sure that there is no synchronization of the international business cycle. (We can) prevent that by the Fed raising interest rates to make way (in U.S. markets) for Europe and Japan."
Focusing on equities, Byron Wien, U.S. investment strategist for Morgan Stanley & Co., New York, said "by the fall, interest rates will be headed down because inflation is not as serious a problem as people think.
"If inflation is under control and the economy slows down somewhat to 2.5% to 3% (growth rate of GNP), the stock market will do much better," he said. "I expect the market to do well in the fourth quarter, but it won't be until then that the market improves.
"I still think economically sensitive and interest rate sensitive stocks will do well - air freight, automobiles, semiconductors, rails, banks, some insurance, airlines, computer technology and smaller growth stocks."
According to ASB's Mr. Carpenter, the areas under pressure right now are clearly cyclical areas - housing and auto stocks. "Large cyclicals are not going to be adding anything to economic growth going forward," he said. "However, once the perception is that the economy is slowing and long-term interest rates begin coming down, those cyclicals will do well. It's a truism that the small-cap and medium-cap stocks tend to track interest rate movements, so if interest rates drop, they will do very well.
"At this point, we are remaining fully committed to the markets. We have in the last month taken 10% of our equity monies and put them into the bond market because we thought that real yields of 5% or more or nominal rates of 7.5% or more were quite appealing. We have minimal cash."
According to Scudder's Ms. Allen: "The key to U.S. equities is volume growth, which comes from strong export of goods.
"The investment sector looks good, because it is least affected by present conditions. We really like the basic materials companies - lumber, energy and smaller capital goods. We like consolidated industries like the semiconductor industry players.
"There are big volume plays to be had in companies providing outsourcing, such as employee benefit consultants that provide record keeping for pension plans or payroll companies, banks and financial service providers."
First Albany's Mr. Johnson noted this bull market is 44 months long - since the October 1990 trough. "When compared to all of the bull markets that have preceded us since 1890, it is clearly in its mature stages, so it's time to have a watchful eye (now) that the bear market is beginning.
"It's very hard for me to get cheery about stock prospects for the remainder of 1994."
Patrick Beimford, director of fixed income at Kemper Financial Services, Chicago, believes the bulk of the rise in interest rates has been seen.
"Rates could rise to 7.75%, but will establish a new trading range for 7.5% to 8% for the rest of the year, " he said.
"All this translates into an opportunity to buy the market, but we would still favor the longer end of the market in a barbell strategy.
" We don't think the Fed is finished tightening, and expect two or three more tightenings by the end of the year. We expect the Fed funds rate would tighten to 5% by the end of the year.
"But ultimately that will be constructive for the longer-end markets, because it will prevent inflation from moving up.
"We have been reasonably short for most of the year, but with any kind of meaningful backup to 7.75% in the next month or two, we would look as that as an opportunity to re-enter the market and purchase longer-dated Treasuries and mortgages (using the barbell strategy), with maturity in intermediate range, as opposed to a bullet strategy where you buy all five or seven years (durations)."
Twentieth Century's Mr. Hoops said bonds do run the risk of getting hit further. "We are worried about short-term rates rising sharply. We believe the yield curve will flatten for short-term bonds," he said.
"Long-term rates will rise somewhat, but not dramatically, about half as much as short rates will.
"Bond investors are in a situation of greater-than-usual uncertainty and rising rates, and we'd recommend a more conservative approach and a shortening of duration."
Brad Tank, principal with Strong/Corneliuson Capital Management Inc., Menomonee Falls, Wis., and portfolio manager of the Strong Government Securities and the Strong Short-term Bond Funds, said: "There will be a bond rally. The worst is behind us now. 1994 won't necessarily finish with really strong bond prices, but this market is nothing to be afraid of.
"We think bonds are in the trading range and that volatility will subside. There will be some price movement in 1994, but significant price increases aren't likely to occur until 1995. The bond market simply hasn't known how to deal with three quarters of growth."
The dollar disruptions of last week also affected non-U.S. markets and may affect international strategies going forward.
Michael Perelstein, managing director, global and international Investing, MacKay-Shields Financial, New York, said there aren't strongly upbeat opinions right now on the international markets, "but we do think they will outperform the U.S. market."
Mr. Perelstein said MacKay-Shields has a counter-conventional view of Japan.
"We don't think it's overhyped or oversold. Overall, we think Japan will cushion the decline in other international equity markets. We think it's stronger than any other market and have increased our weighting to 40% now.
"Besides Japan, we also like the commodity-based markets and want to be exposed to them. Canada and Australia are good examples, with strong metals, minerals, and timber.
"We are avoiding places like Hong Kong and Malaysia. We sold off our positions there and in Southeast Asia in November and December."
Joshua Feuerman, vice president and portfolio manager, State Street Global Advisors, Boston, still believes the international markets will remain the best performers for the rest of the year.
"We first noticed in February the phenomenon of the exportation of U.S. interest rate policy to the international stock markets. Many markets, like Mexico for example, had a stronger correlation to U.S. long-bond rates than to their own interest rates and fundamentals," he said.
"But this effect is subsiding ... and the international markets are beginning to react individually again.
"I really think Norway, Singapore and France look very good. Spain has not had a lot of good news lately and doesn't have a lot of room to pull itself out of its mess, due to EC regulations. Austria and Hong Kong also look to be poor performers.
" Japan is looking a lot better on a valuation basis and we expect it to do much better in late 1994 and 1995."
Robert G. Heisterberg, senior vice president and global economic and policy analyst at Alliance Capital Management L.P., New York, said the good news is that the second half will be a lot better than the first.
"There is increasing evidence that there is no place in the world where there is not an economic recovery underway and that means investors have to rethink about fixed income and equity markets. You get not only more stable, but better performing markets.
"So, wherever you were or whatever your benchmark, I'd make that asset change and become much more aggressive. In global, I would take 15% out of cash, and put 10% in equities globally and 5% into bonds."
Jarrod Wilcox, director of international equity at Batterymarch Financial Management, Boston, said his firm forecasts lower returns for the U.S. market than for the average equity market. "Our spread between top and bottom is not so great - around 7% for the U.S. on an annualized rate. At the high end, we have a fair number of countries that we would forecast at a 10% to 11% rate. For places like Spain and Singapore, we are forecasting on the order of 11% to 12% annualized return at the high end. We'd predict a place like Germany at about 9% and Japan about 9.5%. So that's a pretty dull forecast."
"Places we would like qualitatively would be some of the peripheral countries that were beaten down during the recession, such as all four Scandinavian countries, including Denmark.
"We also see this as a good buying opportunity for intermediate level emerging markets; they have come down quite a lot partly due to their own problems, but also because of higher U.S. interest rates."
George A. Murnaghan, vice president of Rowe Price-Fleming International, Baltimore, said his firm believes the Japanese economy will have a muted recovery. "We would expect a recovery of between 1% and 1.5% GDP for the economy in second half as the best we can expect," he said.
"That will be supportive for company profits and stock prices, however, we are not expecting the Japanese market to be a relatively good performer, especially relative to Europe.
'Our emphasis in Europe is on France, the Netherlands and Switzerland. ... We underweight the smaller markets in Latin America and the Pacific.
Patricia B. Limbacher contributed to this story.