Days of 30%+ stock returns numbered:
Experts: Asia effect on U.S. still to come
Leading money managers participating in Pensions & Investments' 1998 Investment Outlook Roundtable expect low inflation and relatively strong growth in the U.S. economy next year but only modest returns in the stock market.
In fact, one participant predicted a zero return, although another said the market could advance 15% to 20%.
All of the panelists expected the Asian financial crisis to have a delayed effect on the U.S. economy.
The panelists were:
Peter J. Anderson, senior vice president investment operations, American Express Financial Advisors Inc.;
Gary L. Bergstrom, president, Acadian Asset Management Inc.;
Alan B. Bond, president and chief investment officer, Bond Procope Growth Equity Management;
John Y. Kim, president and chief investment officer, Aeltus Investment Management Inc.; and
James M. Weiss, senior vice president and deputy chief investment officer, State Street Research & Management Co.
PENSIONS & INVESTMENTS: What is your outlook for the U.S. economy for the next year?
PETER ANDERSON: First of all, we expect growth probably will surprise people and remain relatively strong during the first half. When I say "relatively strong" -- on the order of 3% to 3.5% in real terms.
Secondly, we believe inflationary pressures will emerge next year and we will be looking at something on the order of 3% to 3.5% inflation. By the way, in comparison, we expect this year will be about 1.9% on the CPI.
Corporate profits are going to be under pressure. We expect operating earnings on the S&P 500 to advance next year, probably to about $49 to $50 (per share). That would be a slower rate of growth, of course, than we experienced this year.
We expect interest rates at the short end in the first half of the year to advance. We expect the Fed to tighten, probably early in the second quarter, and we expect them to tighten more than once next year, probably a couple of times.
We will be looking at a 90-day T-bill rate on the order of 6% or higher. We expect a 30-year Treasury to advance from its approximately 6% level today to about 7%. That 7% level we expect will be reached sometime in the third quarter of next year. In the fourth quarter, we will see rates start to roll back over again.
Let me go back to the issue of economic growth. We expect relatively strong growth early in the year, in the first half of the year. We expect growth to begin to trail off in the second half of 1998.
In the first half, you will be looking at 3% to 3.5%. In the second half, we are looking at more on the order of 2% growth, as rising interest rates begin to bite and maybe we get a little bit of a delayed reaction to the Asian phenomenon.
P&I: Gary, your thoughts?
GARY BERGSTROM: I agree with a number of points that were just made. But having just spent a block of time in Asia looking pretty closely at the situation there, including certainly Japan as well as a number of the other countries in the region, our prediction is a little less sanguine for the U.S. economy.
I think there will be some delay, but I think there is a chance there can be some rather unanticipated and unpleasant surprises coming out of the events transpiring in Asia that we are not totally sure about in terms of how they are going to flow through the U.S. equity market. But certain of the multinationals that are counting on a lot of earnings growth out of that region I think may get some unpleasant surprises. I was in Bangkok a few weeks ago. That great source of local information, a taxi driver, was telling me, "Boy, you know, people just aren't paying a dollar for a Coke with lunch anymore because the recession is really starting to bite."
P&I: Can you give us your gross domestic product figure for next year and your figure for consumer price index expectations and things like that?
MR. BERGSTROM: I think our general growth forecast for the year might be a little bit lower than Peter's, probably more in the 2.5% to 3% range at most. Inflation forecast, probably around 3%, plus or minus, would be our best guess. I think that corporate profits, particularly on the larger multinationals, are going to be under a lot more pressure than we have seen in recent years and that could turn out to be one of the kinds of things that surprises folks.
P&I: How does this weaker outlook affect your expectation about what the Federal Reserve might do?
MR. BERGSTROM: Alan Green- span certainly is not unaware of these things, and Fed tightening here probably will be delayed somewhat and maybe be more muted than it might have been absent some of these developments in Asia.
The other obvious point about what is going on in Asia is that I expect there are going to be some surprises that we have not figured out yet because there is a lot of stress on some of these economies, a lot of political unknowns in many of these countries in terms of how they are going to deal all of a sudden with a period of recession as opposed to a period of 7%, 8%, 9% or even 10% real growth.
P&I: John, your thoughts?
JOHN KIM: I tend to agree with Gary for slightly different reasons. If you look at the domestic economy, demand is going to be quite strong in '98. Absent the effects of the foreign economies, I would have predicted a GDP growth rate around 3%, slightly higher than I believe the Fed would like to have seen. But with the turmoil and the certain recession in the various Asian economies, I think that's going to shave the U.S. GDP growth rate by at least half a percentage point. We are back to the Goldilocks economy -- 2.5%, not too hot, not too cold -- and that is going to cause the Fed to hold off on its monetary policy, which is going to create a fair bit of stability for growth rates.
I do agree with Peter that we are going to see higher growth rates in the early part of '98. And as the effects of the weaker Asian economies emanate into the States, you are going to see lower or declining GDP growth rate in the second half.
On the CPI front, I am very bullish on inflation. Even without the effects of the deflationary environment in Asia, I am a big believer in the secular decline in inflation. There are clearly some wage pressures in the pipeline, but corporations seem to be doing a remarkable job of really not capturing that fully in the top line prices. In many respects they can't, and certainly now with the weaker overseas currencies and the competitive posture of the various Asian economies, you are going to see the importation of that deflation to the United States.
So CPI I think is clearly going to be below 2% and that's going to bode, again, very well for financial assets generally for '98.
P&I: What about earnings?
MR. KIM: Overall I think the earnings will do fine. Asia is only one component of the world economy. Latin America is still growing quite strongly. Europe looks incredibly robust from our vantage point, and again the domestic economy looks sound. Generally, I think earnings are going to grow in the 7% to 10% range, much more so on the smaller-cap issues. So I'm not really concerned about the negative impact that the Asian recession will have on U.S. corporate earnings.
P&I: Alan?
ALAN BOND: I think we face a very interesting scenario right now, given what has happened overseas and given the change that has taken place within our economy. I think you have to factor that into your expectations for GDP in 1998. First of all, I will give you the numbers: GDP of 3.5%; inflation, something between 1.75% and 2%.
Now, why so optimistic on the U.S. economy? I think the fundamental difference in our economy is that it's being driven by factors and forces we have not really seen before.
Unlike in other periods in our economy, you have the technology sector driving the productivity improvements that have really fueled today's major corporations. And technology represents a third of our GDP. The technology industry is one of the few industries where prices start high and come down. And that major factor pushing prices down and having such a big impact on our economy is overlooked to some extent. I don't think we can ignore what has happened in the Asian economy because it represents 30% of the global GDP, and I expect a financial crisis to continue to unfold. In addition, I think the issues in Latin America are beginning to surface. So I think the second half of 1998 will be the period where we experience some sluggishness as these events unfold.
P&I: Jim, what would you like to add or disagree with?
JAMES WEISS: I think when you look at the overall GDP, as always is the case, the net result is a combination of forces, some positive, some negative.
I do think we are going to see some impact in the United States from what is going on in Asia, but I think it's important to look at our economy and remember that 70% now roughly is service.
And the disinflation coming from Asia is going to have a limited impact, because you have the service part of the economy living a bit of a life of its own. We are kind of in the middle between my colleagues here at the table.
We see real GDP growth of about 2.25% to 2.5%. I think the pattern may well be a little weakness after the first of the year, as has been the case for three years now. We see a little bit of a boom maybe generating 2.5% to 2.8% in the second quarter and then settling down more in the low 2s as we move through the balance of the second half of the year.
On inflation, I think there is reason to continue to be optimistic. We do think the combination of all these factors probably will cause inflation to be a little higher next year than this year. We wouldn't be quite as concerned as Peter, but we see inflation probably in the low 2s after having been coming in under slightly 2% for this year.
That expectation is built off a combination of factors. We think productivity is going to continue to surprise people on the upside. It won't be as wildly surprising as the last number that came out at over 4%, but I think it will continue to be a source of good news. We do believe there will be cheaper Asian products, raw materials and subfinal goods coming in.
On the other side of the equation, there will be some wage pressure, but we think not so much -- I should say employment cost pressure -- we think more on the benefit side where we had tremendously good news for the last couple of years and not quite so much on the wage side.
The one thing I would take note of on the wage side: it's going to be very complicated and I think important to identify where in the economy the wage pressure is coming from. For example, we know today to the degree there is wage pressure, we are seeing it in technology land. But, as Alan pointed out, technology companies probably are the best equipped through productivity enhancements and the learning curve to deal with wage pressure.
So we may find a lot of the wage pressure, not all of it, turns up in segments of the economy that are better equipped to deal with it. Therefore, maybe in the final analysis, it doesn't have quite the negative impact some think it will. So we would say a little bit above 2% -- maybe 2.3%, 2.4% -- CPI for the year and around 2.25% to 2.5% GDP growth.
P&I: What is your outlook for long-term interest rates, and what will the course of interest rates be through the year?
MR. WEISS: We think we are going to continue to be in a trading range environment as we have been for the last year and a half or so, but we think the trading range will drop down a notch or two. We look for something around 5.8% or 5.75% on the low side.
We are going to have a very skittish market, one that looks at every news event and tries to analyze it to death. And I am sure we are going to get periods where we get an employment cost index that looks bad in one month, or an employment number that looks bad, and we will see interest rates run to the upper end of the trading range, which is probably maybe 6.5%, 6.6% something in that range.
P&I: You are lower than Peter's peak?
MR. WEISS: A little bit lower, but we can cycle through that trading range three or four times next year.
P&I: Alan, what is your interest rate outlook?
MR. BOND: I'm not very far off from Jim. We have been in a very tight trading range on the fixed-income market for a while now. The band has gotten tighter. It was maybe 6.75%. Now it's more like 6.5% on the upside.
Everything we look at just does not indicate the lower level of rates of another 25 basis points is going to fuel this economy to the point we have to be really concerned about it.
P&I: John?
MR. KIM: I have a higher level of conviction on the volatility of interest rates. I think the entire group would agree we are in a very volatile environment, and I don't see -- with all the international forces creating additional volatility -- why U.S. interest rates should be range-bound at all. In classic interest rate theory, with greater volatility one should expect a greater risk premium. So even with my very optimistic inflation forecast, I have a hard time believing rates are going to decline much further from this level. So the range I would forecast for the 30-year Treasury would be something in the range of 7.75% and 6.5%.
P&I: Gary?
MR. BERGSTROM: I guess we don't have any terribly strong views on U.S. interest rates at the moment, other than to observe there hasn't been a whole lot of volatility, as we judge it, in the fixed-income market recently. But we are a little surprised that you have virtually a flat yield curve now starting from one month going out to roughly 100 years -- or however long that longest bond is that somebody floated -- which strikes us as something not too many people have been focusing on.
But I guess on balance from these levels, if we had to bet one way or the other, it probably would be that rates a year from now will be a little bit higher on the long end than they are now.
P&I: What level of returns do you expect, then, from the U.S. stock market as a whole in '98?
MR. ANDERSON: Zero.
P&I: Would you expand on that?
MR. ANDERSON: Zero within a range of, let's say, plus 10% to minus 10%. The reason I expect relatively little is, first of all, I am suspicious after three fabulous years. Of course, I was suspicious after two fabulous years. Now that we have had three, I am more suspicious.
But basically what we are looking at is an environment in which stocks simply are not cheap by any measure one would care to use. They are not cheap in terms of standard p/e measures. In our numbers, the market sells for roughly 20 times our 1998 estimate of operating earnings. If you use reported earnings, the multiple is more on the order of 22 times.
The market is yielding 1.6%, which we all know is an historically low level. The market is selling at 41/2 times book value, which we all know is the upper end of any band we have ever seen. If you use a standard dividend discount model, the market at current levels is modestly overvalued. Simply use the current long-term interest rate of 6%. Match that up against a $49 estimate for earnings, and what you come up with is a market that ought to be selling on the S&P at about 930. You have it today at 975 or 980. So even at today's prices, the market is very modestly overvalued.
The other side of the coin, I see no reason the market should collapse. I don't see the economic environment out there that would produce a collapse. I think earnings will be in reasonably good shape. We don't see soaring interest rates. I don't see the phenomena that drive you into a market environment in which we collapse.
Rather, what I expect is a lot of volatility, but when we draw a line through the volatility, we come up with very little. In effect, it will be a repeat of what we experienced in 1994, where the market returned to basically nothing. We had a lot of frustration in 1994, we had a lot of scares in 1994, but in the end we earned nothing. And I think that would actually be almost healthy for the market.
The second thing I would say is as we move further into 1998, I believe obviously people will begin to focus on 1999's economic environment. At the moment we think we are likely to experience even slower growth in '99 than in '98, and as a result corporate profits in 1999 are really going to be a little on the sickly side. So with all of that, boring. "Boring" wouldn't be the word; there will be lots of volatility. In the end, we will look back at it and we will have been scared four times during the course of the year, but in the end we will be OK.
P&I: Jim, what are your thoughts?
MR. WEISS: We look at really the three underpinnings of the equity market: Corporate profits; p/es; of course related interest rates and money flows, cash flows into the market or not into the market. When we look at corporate profits, we see the profits going up maybe around 7% next year. It's clearly slower than has been the case this year, but I think we have to ask a very important question of ourselves as investors: "What sort of corporate profit growth is necessary?" And you can get a little pessimistic when you look at the great growth we had the last couple of years. I don't think 7%, although it would be a 30% in the rate of growth, would be disappointing at all.
Pete is quite correct that p/es are at the upper end of the range. When you look at the economic environment, they ought to be. Not that anything in life is based on one statistic, but if I am going to reduce it to one statistic, I am impressed that back in '87, which has been a year of comparison for 1997, return on equity was about 8%; it's now 16%. That has to be worth something, and that 16% isn't going away any time soon; certainly not going back to 8%. I think we can hold the p/es kind of where they are.
Then I look at cash flow and I think there is every reason to believe there is going to be money still coming in, real support from the cash flow part of the equation. I think individuals will continue to plow money in, and there is potential for confusion as we watch that.
Secondly, I think we will continue to see stock buybacks. Maybe not at the torrid pace of recent times, but that's going to be a support to the market, net net. International flows will be interesting. I suspect, as we wade through the continuing volatility in Asia, the U.S. economy and therefore the U.S. market may be a beneficiary of the flight to quality. You have a certain amount of money that is going to stay in equities permanently on a worldwide basis. That money doesn't hunt for cash occasionally, it hunts for the best equity market. We may be a source of stability on the world scene.
Going back to the individual, just to comment, we watch these mutual fund flow numbers every time they are announced. We have to understand one thing:
The significant portion of the money that has come into the mutual funds in the last six or seven years was substitution of mutual fund ownership of equity for direct ownership of equity. We don't know when that runs its course, but it will. At some point you will see the monthly flows come down.
The knee-jerk interpretation will be the individual is pulling back. It might simply be the disappearance of the substitution component of that prior flow. So there is a potential to be confused there.
MR. ANDERSON: I think the real test will come after we have a couple of corrections; not a single one, but a couple of corrections in the marketplace and investors go through a prolonged period of time where they earn a zero rate of return or maybe for brief periods of time even negative rates of return. Then it will be interesting to watch what happens to cash flows.
P&I: Jim? Tell me where you think the market is going to be.
MR. WEISS: We are going to get price appreciation roughly equal to earnings growth of about 7% and a yield of roughly 2% round numbers, probably looking at a high single-digit return. But I think the pattern will be that the peak in return will be hit before the end of the year.
I don't think we are going to finish on the high point at the end, and I am concerned what 1999 is going to look like.
MR. ANDERSON: If earnings growth slows -- and I think everybody around this table seems to be in that camp -- then the odds of negative earning surprises begin to grow in quantum fashion, and I think we all fully recognize how the market reacts to disappointing earnings, particularly when they come in technology stocks.
As the number of disappointments picks up, which I think inevitably it will, I wonder if that will shake investor confidence. I am not bearish. It's just that I think we are going to struggle.
P&I: Alan?
MR. BOND: The lessons that were learned in October of just this year really sent a strong message to people. It's a message that Chairman Greenspan has been trying to send to people continuously. We have seen these pullbacks that make the individual investor kind of take a step back and say, "Well, is this it? Maybe it is over this time. Is this going to be that 10% correct or 20% correction" and "should I pull my money out?" It's almost like the boxer who gets knocked back a couple of steps but he comes back even stronger and, as we have said, people have become conditioned to buy on weakness. That's true. That in its blanket statement is probably not the right thing to do. And I think investors are becoming more sophisticated and it has a lot to do with their access to information. Just in the last seven years, individual investors have gained as much access to information as quickly as many institutional managers. So the playing field has gotten a lot more level.
With that in mind, I think the market can advance 15% to 20% next year. I think it will continue to be volatile as people learn how to use all this newfound information power that they have, that they buy in the morning and sell in the afternoon.
Now, why a 15% to 20% advance? I think as long as I see companies buying back billions of dollars of their stock, I am encouraged. As long as I continue to see the consolidation wave that has plagued so many of these industries, such as the financial industry, there are reasons to be optimistic, selectively optimistic. If you isolate the right sectors you can still do well in this market.
P&I: John?
MR. KIM: Alan mentioned that each successive year of the last three years have been more difficult. But Alan, I will take 30% year-to-date return any day. Valuation is not the issue. The market is clearly overvalued. I think the issue going forward, as Jim actually mentioned, is the earnings growth and what that might imply in terms of either multiple expansion or compression.
I think corporate earnings growth will be in the 8% to 10% range so, without any expansion and with the modest 1.6% dividend yield on the S&P, you are going to see a low double-digit return environment.
The big watchout for me is Fed policy. If the domestic economy heats up, the Fed is forced to tighten. I think that could rain on the party fairly severely, and that's my biggest concern. The other factor, though, is that in the final analysis, investors have to put their money somewhere. Do you want to put your money in a 6% 30-year Treasury with all the interest rate volatility? I think not. Do you want to go into a 51/4% overseas, with the exception of Europe? Very, very unpleasant. So I think the U.S. equity markets will be again the asset class or the market of choice almost de facto, and that's going to continue to create the good funds flow that you have seen.
Mutual fund equity flows will range $20 billion to $22 billion every month next year, and that's a very powerful dynamic that's secular in nature that's not going to cease in '98.
MR. BERGSTROM: Our view, broadly speaking, is that a lot of the overvaluation tends to be concentrated in the big multinational corporations, along the S&P 500 stocks. In fact, there are not such bad values at all in some of the midcaps and smaller-cap companies.
So our view is that, as a broad generalization again, the better opportunities -- both in evaluation sense and growth sense -- tend to be concentrated at the lower end of the capitalization spectrum.
P&I: What do you expect for the broad market next year? And then we will get into specific sectors.
MR. BERGSTROM: In terms of the broad market, if you define it as the S&P 500, it's a little hard to project more than high single-digit kinds of numbers. On the other hand, you could very well have an environment like you had for a few years in the late '70s. For example, you had the S&P down 7% in 1977 and then up 6% in 1978. Not exactly an exciting environment.
On the other hand, U.S. small-cap stocks, were up 25% and 23% respectively in those two years. If you were in that sector, you did just fine. If you were in the S&P 500, you just treaded water.
P&I: Do you prefer small-capitalization growth or small-cap value? Which do you think is likely to do better?
MR. BERGSTROM: The short answer is we generally see the better opportunities in small-cap value.
But we take some umbrage with the definitions most people use of "growth" and "value" as being a little too simplistic. Generally speaking we have three value measures -- that are our own proprietary creations based on a huge amount of empirical database work -- that we tend to focus on. We find things like saying, "It's a high p/e company, therefore it's a growth company" excessively simplistic.
[continued in pt. 2]
