The Asian fall-out may still be with us; it may be lift-off time for the euro, there may even be the stench of impeachment in the air, but the world's miracle economy refuses to acknowledge any problem. Crisis? What crisis?
With the Fed's steady hand on the tiller, and better than expected payroll and retail figures to end the year, analysts are cautiously optimistic for 1999. There are two drivers that concern us most, earnings and long-term interest rates," says Douglas Cliggott, US equity strategist with JP Morgan in New York.
Cliggott looks back on 1998 and sees a clear link between the market's rise and the contemporaneous rise in earnings and fall in interest rates. He feels that although the first half of 1999 will see equities move up slightly, the second six months should see the market make a significant move. "This time last year we were looking at a 10% return, made up almost equally between a rise in earnings and the P/E ratio. I would expect the latter to be unchanged, and for investors to see a modest price appreciation."
He highlights the sectors which have been performing well in the last quarter of 1998, such as cyclical consumer goods and high-tech, but warns against industrial holdings. "We are modestly overweight for the whole market, including energy in the short term, while remaining sceptical that crude oil prices can stay so low for too long." While not recommending taking a position in energy, Cliggott feels there could be some value in the sector, with exposure matched say by transport stock, which is bound to benefit from current low prices.
As for the euro, Cliggott will be keeping an eye on the dollar, as any forced move in interest rates will affect his calculations. Indeed this could be a major influence in the first half of the year. When the new European Central Bank cut interest rates across 11 European countries at the beginning of December, many analysts thought that this would boost the dollar against the deutschmark. However, a brief rally by the dollar proved unsustainable to the year end, with the dollar also failing to react to favourable government index figures.
Strategists suspect that the Fed may be reluctant to make further changes in rates until the economic numbers clearly deteriorate, the markets remaining focused on financial variables, as that is what normally prompts the Fed into a policy change.
Meanwhile, recent rate cuts have had an effect on spreads between US Treasury prices and other debt instruments. Treasury bonds fluctuated around the psychologically important 5% yield mark towards the year end, but even the benchmark 30-year bond continued to lose ground.
"Valuations on a spread basis are probably at a 15-year wide," agrees Dennis Adler, corporate bond strategist at Citibank in New York. There are a number of reasons for this, he argues. "People do think that the economy will slow down, but there is a serious bad debt problem, making investors very wary of the banks. Also the strength of the equity market, which itself is difficult to explain, means there is no reason to invest in government stock with a 4% return, or indeed commodity bonds yielding 6%."
Adler b elieves the Asian crisis has had a serious effect on the US debt market, but that we are seeing a "bottoming out" of Asian debt. "Unfortunately that is not the end of the bad news," he warns. "The focus is now turning to Latin America. We have had bad news for so long now, that it is almost entirely priced into the market. However, the real problems in Latin America may yet have to surface."
Accordingly, corporate bond sectors remain extremely important for investors, with consumer-based stock and commodities attractive due to their lower risk and exposure to outside influences. "We remain concerned about the energy companies for a number of reasons. Firstly the low oil price, but also the practice of downgrading assets. The current bearishness in the sector is almost entirely attributable to the warmer than usual weather in North America for this time of year. Finally the large mergers we have seen (and there may be more to come) have resulted in large movements in price, and we are still negative on this sector," says Adler.
Nonetheless, analysts are looking ahead with cautious optimism on most fronts. However, the word no one wants to mention is "euro". With nobody really certain what kind of impact the new currency will have on the dollar, investors may be in for a roller-coaster first six months before the US markets settle down for more, if not quite so much, of the same. Kevin Hal"