What's Ahead? Abby's Advice

07/23/2004 12:00 am EST


Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

"Abby Joseph Cohen, chair of Goldman Sachs’ Investment Policy Committee, is one of Wall Street’s best known and thoughtful analysts," notes Dan Weiner, who recently interviewed her in his newsletter, The Independent Vanguard Investor. Here are highlights.

"Abby Cohen, the former Federal Reserve economist, is a world traveler, whose views are sought after around the globe. So, it was with no little luck that I was able to get her to once again share her views with me, and you, as we sat in her office high above New York harbor on a recent sunny, windblown day on the water, and on Wall Street:

Abby, let’s start with the big picture. What’s your view on the state of the economy?

"The economy is doing quite well. Clearly we are past the point of inflection, which was a year ago. This time a year ago there was grave concern about whether we would go back into a recession, would profit growth resume, would there be systemic deflation and so on. What we’ve clearly seen over the past year has been a dramatic economic recovery. The question going forward is not will we go into recession, because that’s not likely, but rather how vigorous will the expansion be?

But the speed of the recovery has to slow, right?

"Typically economic growth is at its fastest when you’re recovering from a recession because the year on year comparisons are easier. But since we’ve already made up that difference, we do expect there to be some deceleration. Even so, economic growth is probably going to be close to 4% over the next 12 to 18 months. And for an economy the size of the United States’ that’s quite an accomplishment.

What’s the fly in the ointment? What comes along and derails that growth?

"From quarter to quarter you just don’t know, and I think there’s going to be some variability depending upon what happens to inventories or capital spending in any particular quarter. On a long-term basis we monitor things like the budget deficit. It’s not just how big deficits are, but how long they last. If budget deficits last a very long time they create an impediment to economic growth because it’s something that’s taking capital away from the private sector, raising the cost of capital and leading to inefficient allocation. So that is a very big issue. The second issue is geo-political uncertainty. If you think back to a year ago, why was the economy staggering the way it was? The structural fundamentals were very good, but the economy couldn’t get out of its way. Investors were nervous but more importantly, business people were nervous.

Right. There was no hiring going on, no capital expenditures…

"No cap-ex. They were firing, not hiring. They were worried about cost-containment. There was extraordinary fear. So your question is, what could throw a monkey wrench into this? One is budget deficits that last too long and two would be something that makes business people really nervous.

We won’t really know if the budget deficit has lasted too long until we’re too long into it, though.

"You need to look at the budget deficit as a percentage of GDP because it’s a question of the ability to pay. It’s not how deep the deficit is in any particular year, but how long it lasts. The question for me and I think for investors will be have we seen the worst of the deficit as a percentage of GDP? As we go through the next several quarters, as the economy continues to grow, if tax revenues increase, and if countercyclical spending decreases, then the budget deficit gets under better control and it becomes less of a problem.

If you get GDP growing faster than the deficit, then presumably you would say we’re okay?

"It’s not just a question of GDP growing faster. If GDP is growing, you need less stimulus. And presumably there could be a policy adjustment. Also, the so-called automatic stabilizers kick in. When the economy does poorly there are some things that kick in like unemployment insurance that make the deficits larger. And then when the economy does better and unemployment declines, they kick in, in the opposite direction.

And the geo-political risk?

"This is an election year, so there will be some discussion about it and I think the discussion has to be a little more sophisticated than we’ve seen thus far. What we have to recognize is that we have been growing fairly rapidly while our key trading partners have not been. US GDP growth has been strong. The outlook for Japan, the world’s second largest single economy has dramatically improved because they seem to have really turned the corner. What they refer to as the ‘lost decade’ seems to be over. The concern we have relates primarily to the Eurozone. The Eurozone is actually larger now than the US. But we’re growing and they’re not, which means that there is a discrepancy in the major economies. But it’s worse than that, because the single fastest growing sector in the US has not been business fixed investment, but exports. And that’s something that lots of people forget about.

Exports as a portion of GDP?

"I’m not saying exports are the largest segment of GDP, it’s not. But it’s been the fastest growing. And if you look at where we do our trade you can see why Europe is so important. Outside North America, which is our natural trade partner, it’s Western Europe. And while there’s lots of discussion about China, the reality is that arithmetically there’s been more of a deterioration in our trade relationship with Europe than with China. In the early 1990s we had a trade surplus with Europe. We now have a trade deficit. We’ve almost always had a trade deficit with China, because it’s what we do. We import from China and take advantage of low-cost manufacturing and that trade model worked okay in the second half of the 1990s because we imported from low-cost nations then we exported our high value-added goods and services to other major, developed economies. But our major customer outside North America is Europe. Europe is growing at 1.5%, we’re growing at 4%, so we’re pulling in a lot more new import than we’re able to export. And if we could have one wish with regard to our Chinese trade it should not be to restrict imports—because many of our industries and many of our households benefit from imports that come from China—but that they buy more of our exports.

Okay, let’s turn to another topic, inflation.

"We’ve seen the bottom of inflation and the bottom of interest rates in the US. It doesn’t mean that inflation’s going to rise dramatically any time soon, but we are past the best news in that regard.

So bonds aren’t the best. But where are the values in the stock market, now? Most of the "gaps" seem to have disappeared.

"This time last year we argued that investors had become so nervous that when the stock market began to recover it was going to be in the securities investors were the most nervous about. The same was true within the fixed income community; the lowest quality bonds rallied the most. Within the equity community we have seen fabulous outperformance by smaller stocks. So you asked the right question— alright, what now? A lot of the easy discrepancies to identify have been taken care of. The small versus large discrepancy has re-converged, if you will. The high-beta/low-beta divergence has moved towards convergence, not totally, but the easy pickings that were out there last year for anybody who was willing to basically show some intestinal fortitude has been taken care of. So some of the very extreme recommendations that we had this time last year have become less extreme. For example, we were suggesting a dramatic overweight in economically sensitive names, including technology. We still like the economically sensitive names, but not as much. This time last year, we said we really didn’t like a lot of the so-called defensive names—we didn’t like utilities, we didn’t like consumer staples, we didn’t like stocks that investors own when they’re very nervous.


"Pharmaceuticals were certainly in that category. And so what we’re saying now is well, we’re going to look at all of these industry-specific and company- specific bases. But it’s no longer an easy valuation call. Over the last month we have seen a rotation away from some financial services as some investors are concerned about interest rates rising. And we’re saying we see some value in there so we’d be modestly overweight. Pharmaceuticals and health care, we like this area long-term. Technology, we’re suggesting an overweight position.

Someone listening to this conversation would say the gap between growth and value, large and small, well, that values have reached fair value across the board.

"Yes it absolutely means that you have to be more selective on individual stocks. You have to go for the alpha. You basically have to make sure you do the stock selection or the security selection very carefully, because there are still mispricings. Two, we’ve moved back into a period in which we can expect more normal returns—let’s call them low double-digit, which is certainly a lot better than a 1% cash return. The way to augment that is going to be through stock selection.

Where do you stand on investing in foreign markets? For over a decade it paid not to put a lot of money overseas.

"And for the last year it has been a worthwhile thing to do. But here too, people have to know what it is they’re doing. So this is not something that we recommend individual investors do by themselves, security by security. If there is an area that is very well suited for mutual funds it’s certainly the international investing arena. We believe the best returns for calendar 2004 will probably be Japan and then the US.

What about the emerging markets?

"The most attractive emerging markets are indeed in Asia. What we are watching very carefully though has been the enthusiasm that so many investors have already shown for these markets and what that’s done to valuations. One of the reasons why we’re enthusiastic about Japan is we think that as the world’s second largest equity market, it has more capacity to absorb foreign investment capital, number one. And number two, Japanese companies are in many instances a very good way to participate in growth elsewhere in Asia. They have operating facilities and a customer base in Asia.

I take it we’re talking about China.

"The numbers of potential consumers are huge. We have to recognize that China, nevertheless, has enormous impediments. There are hundreds of millions of people who are either unemployed or underemployed in China. And one reason the government has been anxious to stimulate growth is because they have to handle what is an enormous structural problem. These hundreds of millions of people have to be moved from an agrarian economy to a more modern economy. They have to be re-tooled and re-trained. My concern is not that we’re importing so much from China; my concern is that we’re not exporting as much as we should be. If we view China as an opportunity, I think it becomes a very interesting long-term prospect. Short-term, there’s going to be incredible volatility. There is this significant issue of hundreds of millions of people. There is the issue of bad bank loans. There are also issues in terms of bringing China into the community of major economies and what that means in terms of important issues like environmental liabilities, worker safety, and so on. They’ve got a ways to go.

So, the investment implications are…?

"The challenge for investors is to gain exposure in China, but to do it in a way that’s sensitive to the values. It’s one reason, for example, that investors are looking at investing through Japan or investing through Hong Kong or investing through other markets that are more seasoned and through companies where you understand the accounting.

Since we’re talking about issues of global economic imports, what’s your take on the Indian outsourcing issue?

"This is a global economy. You cannot artificially stop things at the borders. It’s better to think about how best to benefit from this.  There are some people who are going to have notable consequences as a result of it. But if we review economic history we can see it’s happened before. Each time there has been a major technological innovation in our economy there has been displacement. I think the question then becomes, What do we do about it? And in the past the answer has alwaysbeen related to education.

Abby, again, thank you for your time.

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