The
Weekly
Toyo-
Koizai

November 19, 1994

Insight into Global Trends of Exchange Rates, Interest Rates and Stocks

Commodity is the Next Target of International Money

Though the global economy is said to be recovering again, financial markets still look caught in a deeper quagmire. In our recent interview with a leading US investment consultant, he discloses his view of where the international investment money is heading for. He sees the next target is “Commodity.”

Princeton Institute of Economy, based in New Jersey, US, is one of the leading investment consulting institutions that delivers extensive reports on various areas of world markets and provides consulting services to governments, government agencies, central bands and institutional investors around the world. Mr. Martin A. Armstrong, head of the prestigious consulting institution, earned his reputation as a man who correctly predicted the “Black Monday” that led to the global collapse of stock markets in October, 1987. He later submitted a survey report on the process of the plunge of stock prices at the request of the special presidential research committee. His analysis is renowned for utilizing extensively the artificial intelligence computers to find market trends. At Mr. Armstrong’s recent visit to Japan, economic commentator Mr. Atsuo Mihara interviewed him on how he sees the future direction of the international money markets.

Exchange Rate is the Most Important Factor in Forecasting Market Trends

Mr. Mihara: Mr. Armstrong, you correctly predicted a number of financial events in the past, the Black Monday in October, 1987, the historical high of the Nikkei Dow-Jones Average at the Tokyo Stock Exchange in 1989, and the recent plunge of the Hansen Index at Hongkong early 1994 to name just a few. How did you get these ideas?

Mr. Armstrong: When you try to understand “where the markets are heading for,” the most important thing is to analyze a variety of events from the global view point. When you make a forecast of TSE’s Nikkei Average, for example, you would get nowhere by simply analyzing the collection of past data of the Nikkei Average. Bond markets in Japan, the Dow-Jones industrial average at the New York Stock Exchange, the Hansen Index at Hongkong, all of them are affecting each others. The 30-year US Treasury bonds that are rising for US investors could be falling for Japanese investors depending on the yen-dollar exchange rate.

M: That would be so, if the yen advances against the dollar.

A: The Black Monday happened when the 30-year US Treasury bond hit its historical low in terms of yen. At that time Japanese investors had heavily invested in the 30-year Treasury bond from the long-term view point, and before the Black Monday they were the largest bidder with successfully bidding as much as 40% of the total bid amount of the long-term bond.

M: That contributed to keep the dollar from falling further.

A: That should have been so theoretically, but the foreign exchange market did not respond that way, which led to the further appreciation of the yen. As a result, when the 30-year Treasury bond kept falling down in terms of yen, Japanese investors began to sell the Treasury bond to minimize the loss because almost all the newspapers around the world that time carried reports forecasting that the US dollar would fall further by 40% in the next year. When Japanese investors began selling the US Treasury bond the US dollar started falling along with it, which ignited the selling of US stocks by European investors. This process was all initiated not by the changes in the stock market but by the changes in the foreign exchange market.

M: Then European investors in the US started sending their money to their home countries.

A: That’s right. And that was how the global collapse of stock markets started. It was not caused by the stock market. It was caused by the foreign exchange market. Securities companies were inundated with calls by investors asking why the NYSE Dow-Jones average suddenly plunged by as large as 500 points, and all the answer they could get from the other end of the line was “we have no idea.”

M: But then securities companies did not know the exact cause of the stock market collapse.

A: They didn’t find anything wrong with the economic fundamentals that could account for the collapse. But in our institute we take up all aspects of a phenomenon when we analyze even one market. The foreign exchange market is the single most important factor. Because exchange rates fluctuate by 30% to 40% in the span of a few years. These fluctuations are much larger than those of stock prices and bond prices.

Therefore we would have advised our clients in the US to buy gold whereas our clients in Japan would have been told to sell gold one year prior to the plunge. We advised our Japanese clients that way because we thought the gold price would fall in terms of yen.

M: That sounds as if you were watching what happens on the Earth from the outer space.

A: One of the major pressures that could change trends of markets is always the one from the outside. Last year we forecasted that the Japanese stock market would start rising because we though foreign investors would buy Japanese stocks. We wouldn’t have reached that forecast if we had been looking at only the TSE Nikkei Dow-Jones Average. But as we always do we were closely watching changes in Europe and changes in money markets and that helped us a lot to get to that forecast.

Foreign investors tend to buy Japanese stocks when the yen is strong. This is not because they think Japanese stocks will make profit. That was why domestic Japanese investors didn’t buy Japanese stocks. So what actually happened was a twisted situation where the domestic investors sold stocks while the foreign investors bought them. The stocks in the Tokyo market cannot keep rising unless and until domestic investors start buying them. This is the reason the Tokyo market can not snap out of its adjusting phase yet.

M: So you always put exchange rates first when you make forecasts.

A: Exchange rates are always the most important factor. When the US stocks hit the new high back in 1929 they registered the high both in terms of US dollar and in terms of Swiss franc. In 1989 when the Japanese stocks hit their historical high their prices were the highest not only in terms of yen but also in terms of all the foreign currencies such as US dollar, Swiss franc, German mark and others. Foreign investors cause excess demands in the demand-supply relations of any market and push the market upward, while domestic investors just stay within their country’s market and simply follow the buying trend.

Interest Payment Pressure Mounting upon the US Government

M: The United States has been still suffering from the deep-rooted fiscal deficit. Recent interest hikes seem to move the situation of the Clinton Administration for the worse.

A: That is exactly right. In 1981 when the Federal Fund rate was raised to as high as 14%, 70% of the budget deficit was covered by the long-term interest rate debts. But now 70% of the budget deficit depends on the Treasury notes and bills which mature in five years or earlier. That is, when President Clinton first converted the long-term national debts into the short-term debts, the budget deficit decreased in amount for a while because the short-term interest rates lowered at that time. But when the short-term interest rates rise, so does the interest payment by the government buy only dramatically. (One percentage point rise of the short-term interest rates would translate into a 33% increase in the interest payment by the government.) This means that the recent fluctuation of the short-term interest rates has immediately been affecting the fiscal outlay. Present interest payment eats up as much as 15% of the national budget, but that number would climb to 20% by 1996. What the US Administration is doing is exactly the same as wheat a real estate investor does when he borrows a short-term loan and put it into a long-term investment.

M: The US government reduced its long-term debt to cut the immediate interest payment and shifted it finance to the short-term bond. But there is a limit to what they can do with it, and in addition foreign investors are no longer interested in the long-term bonds as before.

You place greater importance to the international flow of capital as one of those fundamental elements when you make forecast of a market. What would describe the reason?

A: The international flow of capital is affected by five factors, that is:

1. Confidence in a particular currency (or currencies),
2. Difference in the labor costs,
3. Geopolitical security,
4. Taxation systems, and
5. Inflation.

As a matter of fact, different firms or investors see different factor(s) more important than others do, but principally these are the most important elements for anybody.

M: Foreign establishments, in particular foreign financial institutions and foreign capitals have recently been withdrawing from the Japanese market. This could be one aspect of the so-called de-industrialization phenomena, Japan seems to have become an uncomfortable market for foreign investors to stay and keep operation. How do you see these trends?

A: That is precisely because of the same reason Japanese manufactures are shifting their investments to foreign countries disfavoring higher domestic labor costs. In the US a lot of companies have moved away from New York to Princeton, New Jersey, where I have my office, for tax advantages. Companies are quick to move. American constituents as a whole have lost confidence in the Administration and are still seeking change, in particular, in the taxation system. In the 1960s the average tax rate per capita in the US was a moderate 12%, which allowed a household to pay the home mortgage and car loan with the income of either of the spouses. That has completely changed by now because the average tax rate is higher than 40%, and both spouses are forced to work to make ends meet. The standard has been caused by “the big government”with its growing bureaucracy. The same could be said with the business giants like IBM that have lost their growth power.

New Focuses on Commodity and Australia

A: With all these changes in the backdrop the volatility of international capital has significantly increased since 1987. Investors could be compared to constituents who vote in an election called market and their attitudes change dramatically and quickly. First they picked up real estates, then moved to stocks and then turned the wheel towards bonds. When these booms have gone there inevitably follows a market plunge. Capital is always moving and looking for a next target to play on.

M: Does that mean the international money is presently focusing on stocks rather than on bonds?

A: Commodity is what they are looking at now. They are looking at raw materials, metals, agricultural products, gold and then the stock market. As for real estate the boom will continue in the residential market sector. Banks in the US and Australia are wary of financing commercial real estate buy they are quite active in home mortgage investments. In Princeton, where I live, or down south in Dallas and Nevada, or in Seattle and Vancouver up north, real estate investments have been booming, while companies are fleeing from New York and California.

M: The yen still looks staying around is high. What is the next development that you would expect to come?

A: The yen might try it s new high of 93% to 94% yen level to the dollar next January. In the worst scenario I can not rule out a possibility that the yen might hit the next 83 to 84 yen level. However this rate would be too high to be natural. By 1996, the yen may drop down to 120 to the US dollar. So after it touched the new high the yen should ease sooner or later. But I believe that the yen still continues to be strong against the European currencies. As for the US dollar, it will weaken against the Australian dollar. Eventually the Australian dollar will become the strongest currency in the world.

M: Because investors focus on its abundance of natural resources?

A: That’s right. There are a lot of businesses opening now in Perth, Australia, and one of the reasons is its advantage of easy access to Asian markets. Perth is really a livable place full of energy. If you are buying commercial real estate now, that should be in Perth, not in Sidney.

Japanese Stocks may Rebound Sharply after a Plunge

M: The Japanese stock market has been stagnant for quite a while. What would you see in the future?

A: I believe that the Nikkei Average will never go down below the supporting level of 18,525 yen. However, if that happens it could further go down toward as low as the 11,000 to 13,000 yen level. This could be the case when the yen soars to the high of 83 yen to the dollar. But when the Nikkei plunges to that level it is sure that the rebounding pressure accumulates in the market and the Nikkei could recover at least the 28,000 to 32,000 yen level in a short time, I believe.

M: In any case it seems the market will become more interesting next year than it is this year.