The Logic of Rally’s Continuing Longevity

Whenever stock and bond markets are on an extended roll--as they have been lately, worldwide--Wall Street analysts and financial journalists feel tremendous pressure to come up with a specific, and simple, explanation for the rallies.

“Mass hysteria” is always a good excuse, but it’s also the easiest one. Too easy.

“More buyers than sellers” is another popular explanation, except that market purists would say there’s one of each on either side of any transaction.

Much more plausible, at least on the surface, is the hypothesis that we’ve got a “global capital surplus” today--a huge sum of money sloshing around in the world economy, with nowhere else to go but into financial assets like stocks and bonds, indefinitely.

Of course, a surplus implies that, contrary to the long-held belief that you can’t be too rich or too thin, a lot of people, companies and/or nations must be too rich, because they have more capital than they know what to do with.

Last week some of those desperately rich global investors lined up to buy Russia’s first bond offering since the 1917 Bolshevik Revolution. Russia had expected to sell $500 million in five-year bonds, but so many buyers put in bids--despite the country’s ravaged economy and massive social problems--that the Russians happily doubled the offering, to $1 billion.

Yet there was still enough money left in the world last week to raise money market fund assets $6.6 billion to a record $898 billion, buy $30 billion in new U.S. Treasury notes, fund the $13.3-billion new stock offering from Germany’s Deutsche Telekom, send the Dow Jones industrial average up 123.73 points to a record 6,471.76 by Friday, and also to drive stock markets in Hong Kong, Madrid and Stockholm, among other places, to record highs.

Global capital surplus? It sounds like a good explanation. Except that it was only three years ago that talk of a global capital shortage was all the rage.

The fear was that if the newly post-communist, all-capitalist world economy continued to expand in the 1990s, there wouldn’t be enough money to go around. Interest rates would soar, stock market gains would be limited, and people would pine for the good old days when fewer options were competing for investors’ savings.

Could we really have gone from capital shortage to capital surplus so quickly?

Unlikely. Indeed, many experts reject the idea that capital is ever in shortage or in excess. “There’s no such thing,” says Michael Ivanovitch, economist at investment firm MSI Global in New York.

He and other economists argue that, by definition, total capital demands and total capital availability are always in equilibrium, at whatever the market clearing price happens to be. In other words, if you can pay the market rate of return--whatever it is at a given moment--you can lure capital.

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The reason that stocks, bonds and other financial assets have been and continue to be so popular in the 1990s is simply that investors perceive that the long-term rates of return on those assets will beat the returns on the alternatives--mainly “hard assets” such as commodities, real estate, gold, etc.

So it isn’t that capital has nowhere else to go except into stocks and bonds, but that they seem to most investors to offer the best chance for long-term growth.

(It’s not a coincidence that as the Dow index was streaking to new highs last week, the price of gold dropped to 20-month lows.)

The question on every investor’s mind, of course, is what finally stops the global bull market in financial assets? It has been temporarily halted several times in the past six years--in 1994, notably, and last summer. And individual sectors of stocks have boomed and busted. But circumstances have yet to develop that would deal the markets overall a true death blow.

Nor can many Wall Street pros see what would produce such a blow any time soon. To ruin investors’ appetite for financial assets would almost certainly require a dramatic shift in peoples’ expectations on at least two major fronts:

* Inflation. Rising inflation is the greatest enemy of financial assets because it erodes money’s future purchasing power. The fact that inflation rates have declined worldwide in the 1990s is perhaps the single biggest reason for financial assets’ boom, because price stability gives investors the confidence they need to buy and hold stocks and bonds.

Even in once hyper-inflation-ridden nations like Brazil and Israel inflation has fallen sharply in the ‘90s, notes C. Fred Bergsten, economist at the Institute for International Economics in Washington, D.C. “If you look around the world, there are not very many places you see inflation” as a serious problem, he says.

The reasons for inflation’s decline are well-known. Among them: burgeoning global competition among companies (keeping product prices down), cheap new labor in formerly communist countries, productivity gains thanks to technology, and few shortages among key commodities. One inflation scare--the big jump in grain prices in spring--has already been subdued, thanks to record harvests here and abroad.

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Has the world just been incredibly lucky? Maybe. Some economists, like Bankers Trust Co.’s John Williams in New York, argue that inflation cannot stay down for much longer. He notes that worker wages in the United States are on the upswing as the labor market continues to tighten. In theory, at least, higher wages can lead to higher prices if companies can pass through wage hikes.

“When I look at the economy now I think, ‘It can’t get any better than this.’ That’s the good news and the bad news,” Williams says.

But the idea that the inflation worm is turning has been put forth many times in recent years, and still price increases in the United States have remained relatively muted, holding consumer price inflation to the 3% range since 1991.

As long as low inflation remains the rule rather than the exception worldwide, it’s hard to imagine investors shifting massive amounts of capital from financial assets to hard assets such as real estate and gold--the things that normally attract money when expectations are for rising prices, and when investors thus turn hungry for assets that will better hold their value.

* Central banks’ monetary policies. The world’s major central banks--the U.S. Federal Reserve, the Bank of Japan and Germany’s Bundesbank, to name three--set the tone for world interest rates and capital availability with their monetary policies.

If the central banks follow tight-money policies--essentially making credit harder to get--they can force interest rates up and decrease the amount of capital flowing through markets. If the central banks are easier with money, credit is easier and capital flows more freely (including into stocks and bonds).

Economists debate just how easy monetary policy is in the world today. But with record low interest rates in Japan, certainly no one would call the Bank of Japan’s policy tight. In Europe, where central banks have cut rates consistently this year, it’s also a stretch to say money is tight.

And in the United States, while the Fed’s policy is unquestionably stingier than it was in 1993--when interest rates hit 30-year lows--few experts would describe credit availability overall as tight. (How many credit card applications did you get in the mail this week?)

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Allan Meltzer, economist at Carnegie-Mellon University in Pittsburgh, argues that even though “real” (after-inflation) interest rates are well above historical averages in the United States, money doesn’t feel all that expensive to most borrowers.

“It seems like money is cheap, even though real rates are not astonishingly low,” Meltzer says.

And to judge by the action of the U.S. stock market at least, investors have no problem with the current level of interest rates.

What has allowed central bankers to be mostly accommodative with money in the 1990s is the fact that world economic growth been moderate and inflation has remained low. The question now: Is there anything on the horizon that would force a dramatic tightening of central bank credit soon?

A tightening of policy would probably require a sudden significant pickup in world economic growth. Yet most economists doubt that that’s in the cards for 1997. The U.S. economy, they note, increasingly looks to be slowing, not accelerating. Consumers in Europe still show no willingness to freely spend money, and European governments are running ever-tighter fiscal policies as they work to reduce budget deficits. Japan, meanwhile, is still struggling with a huge banking crisis.

“I don’t see many signs that either the European or Japanese economies are going to do much in 1997,” says Bergsten.

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Without a change in the inflation outlook or central-bank-policy status quo, therefore, investors by and large continue to shovel capital in the same direction they’ve been shoveling for most of the ‘90s: toward stocks and bonds. They may overdo it from time to time--some U.S. blue-chip stocks are beginning to look frighteningly overvalued, for example--but the basic trend favoring financial assets remains in place.

Interestingly, perhaps one of the biggest votes of confidence for financial assets comes from foreign central banks themselves, which have increasingly chosen to hold their reserve capital in U.S. Treasury securities rather than in gold, the traditional store of value.

So large are those Treasury holdings now--$608 billion--that some Wall Streeters view them as a time bomb. What happens, they ask, if those central banks decide to begin dumping U.S. bonds?

But Bergsten and other economists turn that question around: “Why would they start selling?” Bergsten asks. “Only if they saw our economic policy going off track,” threatening soaring inflation, widening budget deficits and a collapsing dollar.

Until that day comes investors’ rationale for favoring financial assets over all others seems likely to remain unassailable.

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Foreign Hunger for Treasury Bonds

Individual investors haven’t been alone in hoarding financial assets in the 1990s. Foreign central banks have bought massive amounts of U.S. Treasury securities, and that total now far exceeds the sum held by the U.S. central bank, the Federal Reserve System. Quarterly figures and latest, in billions:

Source: Grant’s Interest Rate Observer