The upside of the downside (economic analysis)

Greg Nowell GN842 at CNSVAX.Albany.Edu
Wed Oct 7 11:26:43 PDT 1998

My brother and I are both natural pessimists. He's had a good silicon valley career and had money to invest. I was astounded to learn that for the past 9 years it had all been in money market funds. He kept waiting for the market to go south. We had a long discussion, and finally I said: It's easy to make the downside argument at this point--the 1929 meltdown scenario. What's more interesting, by way of contrarian exercise, is to make the up-side argument. Here are a few:

1. There has been a big hit in commodity prices (oil, frozen concentrated orange juice, wheat, copper, &c.). However, if one looks at futures contracts on a variety of commodities they all uniformly show increasing prices over the next 12-24 months. Natch, futures traders are not invincible. They can take a bath. But nonetheless, they have not priced a deflationary scenario into major world commodities; to the contrary, they have priced inflation. Unlike lenders, who anticipate inflation and try to protect themselves by wheedling an "extra margin" at the time a fixed-rate loan is made to protect themselves against unseen inflation, commodity traders get hammered on futures contracts that are priced north when prices go south. To the extent that "investor sentiment" is a self-fulfilling part of capitalism, the upward curve in pricing on major commodities is a signal not just to traders but to producers that "the market" is not anticipating deflation.

2. As of last wkend, the closed-end country funds for stocks (Japan fund, Indonesia fund, France fund, etc.) listed in Barron's were all (Asian, that is) priced at very low prices from their yearly highs. What was amazing, however, was the fact that all of the Asian funds except Korea were trading at *premiums* to the underlying asset value. This indicates that investors currently view Asian stocks as so undervalued that they are willing to pay more than their current market price. [A closed end fund is a company which holds, like a mutual fund, a portfolio of stocks (or bonds). Investors are invited to purchase shares in that fund, not from the fund itself, but where they are listed on an exchange. It is therefore possible for a fund to hold stocks in Asia which are valued at $1000 based on Asian closing prices, but for people in the US to value holding stocks in the fund at a price greater than the assets that the fund holds. This is called trading at a premium. When the opposite occurs, it is called trading at a discount.]

If investor sentiment was as bleak as could be, we would expect the closed end funds to be trading at par or at discounts to their underlying asset values.

3. The long bond at 4.7% is yielding about 3.2% relative to inflation (about 1.5%). The real rate of long interest is thus about where it was in late 19th century Britain. No one can say whether 4.7% is a "bottom" to the long bond but it seems unlikely that to me that it will be pushed lower than that for very long, especially if vestigal inflation remains (as anticipated by commodity traders).

Recent cuts by the Fed may not affect the long rate of interest, and I don't know whether the will succeed in narrowing the very large spread between the 30-yr treasury and other kinds of loans, such as mortgages. It is conceivable that the 30-year mortgage, if the "spread" between it and the long bond narrows, may go to 6.2% (as of today it was 6.5-6.625%. Rates are lower in places like California or Boston where loans are bigger. Avg rates listed in papers may be lower because they include people who pay points). However, I would not bet on this, for reasons which I need not enumerate here. In any case, the main point is this: changes in the discount &/or federal funds rate will weaken the dollar, which is good for Asian countries including Japan that have a problem with an appreciating greenback (appreciating US dollars increase reserve requirements in japanese banks, causing them to restrict lending, etc.). Lowering the federal funds &/or discount rate will also provoke inflation fears which may send US long bond prices lower (raising the interest rate). The prospect of losing money on the present value of long bonds may force investors into alternative forms of investment. At a minimum, a rising long rate would allow hedge funds to "unwind" short positions and would, in turn, decrease pressure to sell off other securities (especially foreign bonds and US junk) to raise capital to meet margin requirements. There is some argument that some of the buying pressure on long bonds is coming from speculators who think that by pushing the rate down now, they can force the hedge traders to "buy now, because it will be even worse later." This technique could particularly work if it forces hedged traders to pony up big time on margin calls, making holding out for a better position very expensive. But I think that the 4-trillion dollar treasury market is a bit to big to be manipulated in this way. Perhaps I am wrong, but that is my hunch.

To conclude. Certain of the conditions currently prevailing in world markets are strongly reminiscent of the 19th century style "busts" (cf. 1896, 1907) that wreaked a good deal of havoc and which were supposedly tamed by the advent of the welfare state, social security (both spurs to consumption) and deficit spending. And indeed it is *precisely* those states in which these redistributive mechanisms are *weakest* that the economic crisis is *worst*. So we cannot exclude calamity. However, there seem to be indications that grinding discomfort (including perhaps a recession) rather than calamity (1929 style meltdown) may be the exit solution from the current situation. However, it should be pointed out that in some countries of the world the situation is *exactly* that of a 1907-style bust, and that people are hungry and miserable as a consequence.

-- Gregory P. Nowell Associate Professor Department of Political Science, Milne 100 State University of New York 135 Western Ave. Albany, New York 12222

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