Right or Wrong, Wall Street Economists Generate Ideas and Trades

Right or Wrong, Wall Street Economists Generate Ideas and Trades
October 15, 1999
Right or Wrong, Wall Street Economists
Generate Ideas and Trades
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EW YORK -- If the forecasts of Wall Street economists are
often so wrong, how do they keep their jobs? How do they
make any money?
Those are fair questions after a string of years -- including 1999 -when many seers of Wall Street missed their calls on interest rates,
were wrong on the direction of Federal Reserve policy, and
substantially underestimated economic growth and even
overestimated inflation.
From 1996 through 1998, for example, the consensus economic
forecast at the start of the year turned out to be, on average, 1.4
percentage points below the actual annual growth rate, according to
the Blue Chip Economic Indicators. The consensus estimate for
1999 -- 2.4 percent as recently as January -- is well below the 3.4
percent growth rate in the nation's gross domestic product for the
first six months of the year. It is likely to be even further off the
mark for the full year.
The answer is that Wall Street economists forecast because they
have to. But their money-making product is a stream of, they hope,
good ideas about how the economy works that stimulates the
thinking of the money managers that make up much of their
"People wanting to read what you write and learn how you're
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thinking about substantive matters is more important than whether
you are precisely right in your macro forecasts of GDP or interest
rates," said Charley Ellis, managing partner at Greenwich
Associates, which assesses Wall Street performance by interviewing
institutional investors.
This research -- whether a long-term analysis of the surprising rise
in productivity or an instant interpretation of the newest employment
report -- plays an integral role in most Wall Street firms and smaller
boutiques. Research is the everyday grist for a firm's sales
representatives, who deal with clients on a regular basis. It is used to
attract clients who then trade through the firm or compensate it in
other ways, adding to profits.
"Research helps write trading tickets," said Donald H. Layton,
Chase Manhattan Bank's vice chairman in charge of overseeing its
global market business.
John Lipsky, the chief economist and the director of research at
Chase, and Robert J. Barbera, chief economist at Hoenig & Co., are
two such economists from the 50-odd firms constantly scrambling to
get the attention of money managers. Both, who themselves spend a
third of their time seeing clients, have to contend with the
economists at the Wall Street leaders in this business, including
Bruce Steinberg at Merrill Lynch and Stephen S. Roach at Morgan
Stanley Dean Witter.
It is a business whose top players have not changed very much in the
last several years, according to Greenwich Associates. But that only
intensifies the challenge to come up with the Next Big Idea.
One of the most attention-grabbing ideas this year came from
Edward Yardeni, chief economist at Deutsche Bank Securities. He
argued that year 2000 computer disruptions would cause a recession
in the beginning of next year. Even if it proves wrong, the idea
forced many money managers to address the issue.
But good ideas, right or wrong, are not easy to come by. "If we have
three great ideas in a year that is a home run year," said Richard
Berner, chief U. S. economist at Morgan Stanley Dean Witter.
Lipsky, 52, heads Chase's 120-person research team, which is
striving to become one of the major players on the Street. He was
chief economist at Salomon Brothers before coming to Chase in
1997. Before that he worked for Salomon in London and New York,
after a decade at the International Monetary Fund.
"No one is able to consistently foresee specific market developments
far into the future," said Lipsky, who speaks to hundreds of clients
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all over the world. "That is why forecasts are inevitably revised as
new facts emerge."
An economist's real job, he explained, is to "help our clients
organize their own thinking, even if they come to different
conclusions about market implications. We are doing the digging,
analysis and thinking that they would do if they had the time."
Chase's 1998 forecast, done by Lipsky and his research staff, shows
how a forecast can be off-base on growth but still contain crucial
insights. While predicting about 1.5 percent growth -- which was off
by 2.4 percentage points -- Chase said that long-term interest rates
would fall toward 5 percent, which was correct, and that inflation
would decline to about 1.5 percent, also correct. A forecast that the
Federal Reserve would cut interest rates, based in part on the
expected decline in inflation and helped by the deepening of the
world financial crisis, was also on the mark.
For 1999, Chase has gone astray again, missing on interest rates,
Federal Reserve policy and economic growth. On the other hand,
overall inflation, although slightly higher, is still contained -- one of
Lipsky's main themes. The forecast of a stronger than expected
dollar early in the year was a contrarian gem.
But Lee Thomas, senior international portfolio manager at the
Pacific Investment Management Co. in Newport Beach, Calif., the
world's largest active bond manager, brushes off the muffs. "His
forecast record changed from last year to this year," he said of
Lipsky, "but the quality of his ideas has not changed.
"It is your job," Thomas said of money managers like himself, "to sit
down and decide which idea makes sense and construct your own
world view." It is the economist's job, he said, "to explain a theme
that catalyzes my thinking."
Barbera, 47, left the heart of Wall Street after seven years at Lehman
Brothers to become a sole practitioner at Hoenig & Co., a small
brokerage firm based in Rye Brook, N.Y.
He scored this year with his contention that Japan's economy would
rebound and, even more strikingly, last year with his contrarian
theme that the pain in Asia would be a gain for the United States.
Barbera reasoned, correctly, that the recession in Asia would lead to
lower inflation, lower interest rates and more growth in the United
"I get paid for looking out for what might change the conventional
view," Barbera said. "There is a small list of portfolio managers who
think I have something to deliver and we talk."
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Paul DeRosa, a partner at Mount Lucas Management, an asset
management company in Princeton, N.J., and one of Barbera's 60
clients, said: "The money is made and lost in interpreting situations
as they develop."
This is what he counts on from Barbera. In the summer of 1998, as
the Asian economic crisis spread to Russia and Latin America,
DeRosa said that Barbera was quick to say that the situation would
force the Federal Reserve to cut interest rates, which it did three
While getting this right, DeRosa said that Barbera did not foresee
the big rally in the bond market that occurred the previous year.
The de-emphasis on economic forecasting, obviously, is partly the
result of being wrong so often. But it also reflects how the
once-revered job of forecasting has become little more than a basic
commodity in a world where just about everybody has access to his
own black box.
"I can decide what way interest rates are going," said Rob Kapito,
vice chairman of Black Rock Management, an asset management
company, and a client of Lipsky.
The decline of forecasting is reflected in the name change of the
National Association of Business Economists to the National
Association for Business Economics. The association's membership
has fallen substantially as many corporations turned from reliance
on teams of macro-economists who were supposed to predict the
overall economy to smaller groups of micro-economists focused on
specific markets.
In addition, forecasts, even when they are right, are no longer
enough for most clients. With just a forecast, Barbera said, "you are
simply asking clients to bet on your black box and good portfolio
managers won't do that."
What portfolio managers do want instead is easy access to good idea
Thomas of Pacific Investment, who sees Lipsky three to five times a
year, said that he narrows the choice of who he trades through based
on the quality of the ideas from the economists he talks to. Despite
Lipsky's forecasting misses, Chase is being called as often as last
On the other end of the trade, Peter Frey, the head of credit market
sales at J.P. Morgan Securities, said: "It is not clear that there is a
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good correlation between how precise our forecasting calls are and
our pay back," he said. "The correlation between the access and
dialogue we give our clients and our pay back is clearer."
Firms also rely, at least in part, on their economists' views when
they bet their own money on movements in the market.
Lipsky's views are considered, for example, when Chase stress tests
its own bets in the financial markets to assess the amount of risk it is
taking. His sense that the world's economic crisis was deepening in
the summer of 1998 played a role in Chase's decision to count on
interest rates to decline as investors ran to the safety of the bond
"We act with even more conviction when the views of the economist
are aligned with those of the traders," said Ina Drew, head of the
domestic treasury at Chase. That successful bet was one reason why
Chase reported record earnings in the fourth quarter last year even as
some of its rivals reported profit declines for the same period.
Layton also said that Lipsky's connections to international financial
leaders around the world can help in getting underwriting business
for the bank when countries, especially in emerging markets, issue
new debt or privatize a state-owned company.
Economists are also useful to money managers who disagree with
their views. Kapito of Black Rock Management, for instance, said
that although he disputed Lipsky's argument that inflation would
remain contained, the reasoning helped Black Rock form its own
view that inflation was at a bottom and likely to move higher, even
if only modestly. On this basis, Black Rock decided to buy more of
the Treasury's bonds that are indexed to inflation and rise in value
when inflation expectations rise.
Barbera likes to provide his clients with what he calls signposts. For
example, as early as February this year he was writing that the
Japanese economy would recover this year. Along with his reasons
for the recovery, he listed developments money managers could
watch on their own to see if the recovery was developing along the
lines he predicted. For example, Barbera said that the confidence
level among the executives of smaller Japanese companies would
rise and that the bankruptcy rate would fall.
"I happened to agree with that and so we made a small play in
Nikkei futures that have done very well," said DeRosa of Mount
Lucas Management.
"You cast a wide net," Barbera said, "and try to catch on to one or
two things that have changed in a specific fashion that could have an
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impact on things. But you never catch it all."
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