If you asked institutional investors what they feared most as a possible threat to the U.S. equity market, how do you think they'd reply? Terrorism? Real estate fallout? Consumer debt? In fact, the leading source of worry among pension funds and other institutional overseers of money is inflation.
That, at least, is the result of Frank Russell Co.'s March survey of 209 institutional investors. Twenty-two percent of the managers ranked inflation as the greatest threat to the equity market, followed by 20% citing geopolitical instability as the primary risk and 15% pointing to a softening real estate market. Meanwhile, nearly two-thirds (64%) of the managers said that domestic stocks generally were fairly valued and 13% thought it's overvalued.
The broader context for such thinking is an equity market that seems intent on moving higher once more in an effort to reach its previous summit set back in the heady days of March 2000. Yes, the bulls seem to have regained the upper hand in recent trading sessions and one should be wary of underestimating momentum, which has been biased toward the upside for several years now. But there's enough doubt about the economy to keep the debate bubbling and the bears hopeful.
The inflation issue remains an open question too, as the latest Russell survey suggests. But if institutional money managers are worried about general price trends, there's not much follow-through in the bond market. The yield on the 10-year Treasury continues to trade in a range. Yesterday's close of 4.65% represents a middling level for 2007 so far.
Over in the trading pits for Fed funds futures, all's quiet as well. Looking out to the August contract, the market expects that the current Fed funds rate of 5.25% will hold until at least Labor Day.
From our vantage, it all looks like a standoff between those who think inflation's still a threat vs. investors expecting the economy will soften enough to nip any inflationary momentum in the bud. One side will eventually win, leaving the other to retreat and tend to the pain inflicted by financial loss and wounded ego. In the meantime, the back and forth continues. One day the word recession is in favor; the next brings inflation. There are even some who worry that both will arrive, delivering the dreaded stagflation.
The determining factor will be the data, of course, which continues to roll in. At some point the accumulating trend will favor one or the other side. Or, perhaps one economic report will be so dramatic as to clarify the situation once and for all.
Lesser mortals such as ourselves prefer to watch and wait, minimizing allocations to higher risk asset classes while keeping cash at the ready to exploit the fallen angels of the future. Yes, it could be a long wait. Of course, we're being paid to wait, with cash continuing to pay north of 5%. And with clues that the Fed's not about to cut rates any time soon, we fully expect that the waiting room will become increasingly crowded as the year progresses.