Last Updated July 1998

---

T'S BACK. IN FACT, IT NEVER really went away. Between the weakening currencies, Russia's 150% interest rates, and Japan's recession (depression?), the Asian crisis is not only still with us, but deepening. Investors -- especially those who jumped back into the Pacific Rim, are having a bad case of dásià vu. But really, this should be no surprise as we pointed out in March when we asked:

So what happened to this Asian crisis thing? Is it over?…Don't be fooled. This rally is more relief than prediction. Just as the Asian problem didn't appear overnight, it didn't disappear in a puff of fourth quarter earnings. The depth of the Asian crisis wasn't known until well into the fourth quarter at which time many companies had already booked the majority of their profits. The full impact of what's going on overseas won't be felt until the first few quarters of 1998. While lower interest rates and inflation will help damp its effects, the problem's still there.

This is one of those good news/bad news things. Obviously its bad for the suffering Asian economies and domestic businesses dependent upon them for sales; but there are certain pockets of the U.S. economy that will actually benefit.

Not Hot Commodities

While commodity inflation seems to be in check, wage inflation may be heating up. Roadway Express recently settled a contract dispute that will negatively impact earnings for the rest of the... As of late June, General Motors was struggling with not one, but two strikes. It's still too early to determine if this is the start of a trend, but even if it is, the full impact probably wouldn't hit until 1999. The Fed would probably tighten rates before wage inflation could really get a toehold, so barring any unforeseen events, the CPI will probably finish the year at about 2.5%. Asia may not be totally responsible for this, but it's doing its part to keep it at this remarkably low level.

Asia's Loss is the Bond Market's Gain

Believe it or not, at that nominal level and the CPI in the 2.5% range, the real return (what you keep after inflation) on the long bond is actually high by historical standards. This has led some analysts to speculate that its yield could fall into the 4.5 - 5% range over the next 12 months. But don't sell all your equities and buy bonds just yet. This estimate is probably far too optimistic. With the Federal Funds rate at 5.5%, any movement below that level for the 30-year bond would actually invert the yield curve. Now it's not that this hasn't happened before, it's just that it usually happens when the Fed is raising rates on the short end, not keeping them steady.

In their March meeting, the Fed did decide to lean towards tightening, but with Asia so unstable, it's highly unlikely there'll be any increases in the near future. You see, by raising rates here, U.S. investments would become even more attractive to foreign investors, thus draining more capital from their economies. Japan would be one of the hardest hit as it would be a no-brainer for Japanese investors to elect to take a 5.5% return in the U.S. vs. .5% domestically.

Unless wage inflation really does seem to be taking hold, the Fed will probably leave rates unchanged. The current Federal Funds rate will serve as a floor for any further rate decreases along the longer end of the yield curve. Bond investors will probably find only minimal capital gains available from the current price levels. While there may be periodic movements into the 5.5 - 5.6% levels, the long bond should probably spend the rest of the year in the 5.7 - 5.9% range of the past six months.

Under the Mask

Once again, all the news isn't bad. Some parts of the market have actually benefited. For example, low interest rates and continuing bond demand has stimulated interest in utilities. These issues which have lagged the market in the past two years, are usually viewed as bond substitutes by income investors. As bond yields fall, their dividends become more attractive. In addition, being in a capital-intensive industry, utilities have rather high borrowing needs. Market conditions are best for them when rates are down. Since equity markets are predictive, utilities' price performance usually runs pretty close to that of bonds. The accompanying chart illustrates this correlation by graphing the 30-year Treasury Bond yield on an inverse scale vs. the Dow Jones Industrial Average. If this relationship continues to hold, recent highs on the Dow Jones Utilities may signal a very good 1999 for bond investors.

Retailers have also had shown improvement in 1998. Remarkably, this has occurred at the same time that many suffered declining sales. How can this be? Well, it's Asia again. Net margins can increase even as sales decrease as long as costs fall more rapidly. Retailers selling goods manufactured or at least assembled overseas have benefited from the skyrocketing dollar. While (for obvious reasons) they don't want to publicize it, they haven't been passing these savings along to the consumer. Instead, they've used them to increase their margins.

Unfortunately, the outlook for the rest of 1998 isn't so rosy for most stocks. No, this doesn't mean a crash is imminent (although a correction is overdue). What it does mean though, is don't expect the across the board gains investors have enjoyed in the past several years. Instead, several things will conspire to hold stocks back:

• Increased inventories will have to be worked down. Until lowered, companies will find it hard to increase margins by raising prices, putting a lid on earnings.
   
• Analysts are already rushing to lower earnings estimates for the remainder of 1998. While most were too optimistic to begin with, any lowering is always perceived as a negative for the market.
   
• Many stock prices are presently based on the continuation of the "perfect" economy. Any problems (or perceived problems) will tend to bring them back to more realistic levels.
   
• While blue chip performance may continue to mask the turbulence in other sectors, small and mid-caps will continue to struggle until investors feel more comfortable about Asia and future earnings.

As inventories are drawn down and Asia (hopefully) begins to right itself, conditions may turn more favorable for stocks. This probably won't occur until late in the fourth quarter or in early 1999. When it does, small and mid-caps will represent the best value. On a relative basis to the blue chips, they presently offer the best value in over 20 years. In the meantime, the accompanying table shows the areas most likely to be affected and those which have been most resilient so far this year.

Not all economies enter recession at the same time, but they are interrelated. While this certainly isn't to say there isn't money to be made in the market, it does mean you've got to be selective. The problems in Asia won't go away in one quarter or even in one year. Just because they may lay dormant for a few weeks or a month or two, don't assume they've gone away. It takes time to get mismanaged economies back on their feet again. Investors who don't believe it are destined to suffer dásià vu all over again.