Key Worry Is Recession : Mixed Signals Stirring Fears Over Economy

The picture doesn’t seem that awful: Very low unemployment. Modest price increases. A seemingly stable dollar. Millions of Americans more affluent than they were a year ago. An economic recovery soon to celebrate its fifth birthday.

Yet, last week, investors glanced at the picture and--faster than an army of frenzied brokers can shout “sell!”--proceeded to drive the stock market into one of the deepest canyons in years. On Friday alone, U.S. stocks lost $145 billion in value, according to Wilshire Associates, investment managers in Santa Monica. The market value of all stocks has been slashed by $486 billion since late August.

Why, considering all the good things going on in the economy, is everyone so nervous? Is it all irrational? Or, is there something real to worry about?

Dollar, Inflation Worries

Economists say there are very real things to worry about: the persistently vast trade deficit, along with the budget deficit, raises the specter that the U.S. dollar will go lower and that inflation will go higher. The American economy already has grown dependent on cash from foreign investors, with the Japanese owning billions of dollars in U.S. Treasury bonds. If inflation rises, interest rates will have to go still higher to keep the Japanese and others willing to buy U.S. bonds in the future.

And if rates rise sharply, the economy could dive into a recession. “There’s nervousness that the whole house of cards is going to crumble--that the combination of large budget deficits and trade deficits isn’t going to work forever,” said Robert H. Chandross, chief North American economist for Lloyds Bank in New York.

Confusion about whether the economic picture is positive or negative is understandable--the economy is an endless jumble of good and bad news about employment, inflation, trade and deficits. Earlier this year, many experts predicted a lackluster performance with little inflation through 1988. The worrisome trade and budget deficits were expected to shrink slowly. Manufacturing, battered by foreign competition, was expected to recover somewhat. And unemployment, which had clung stubbornly in the 7% range, was decreasing.

By comparison with most economic recoveries, the current one has reached senior citizen status in its fifth year. It seemed unlikely that other countries such as Japan and West Germany were going to implement economic policies that would energize the U.S. economy still further.

This environment of low inflation and low interest rates made stocks attractive relative to bonds. Money flooded into the stock market.

By last summer, however, there were growing signs that the U.S. economy was healthier than the experts had projected. These signs included a lower-than-expected unemployment rate, growing demand for basic commodities and clear improvement in the trade picture during the early months of 1987.

And, perversely perhaps, that spawned the fears that became rampant in the markets last week. This seemingly favorable outlook provoked a skittishness in the financial community. As unemployment fell and labor markets tightened, fears grew that wages would exert added inflationary pressures. In particular, holders of bonds worried that the policies of the Reagan Administration and the Federal Reserve Board would unleash inflation, cutting into the value of their investments.

All the while concerns were growing about the U.S. trade deficit, which in 1986 meant that the country spent $166 billion more on foreign goods than foreign consumers spent here. Despite improvement in the first few months of this year, progress has slowed. And this has led to concerns in the financial community that go beyond the problem itself and to a possibly painful cure.

Encourages Lower Dollar

To combat the deficit, the Reagan Administration has encouraged a lower value for the dollar, an action that tends to force the price of imports upward, giving American producers a badly needed cost advantage. This contributes to inflation, however.

Meanwhile, the U.S. government continues to run a huge budget deficit, estimated at more than $150 billion for this year. Thus, the United States is enormously dependent on foreign investors, such as Japanese financial interests, to buy the bonds that finance these imbalances.

That is why the Wednesday release of the August trade figures, showing a $15.7-billion deficit, sent the markets into an uproar. The number suggested that the U.S. government might encourage a further decline in the dollar’s value, raising the price of imports. Because that would drive up inflation, the U.S. government would have to offer higher interest rates to keep its bonds attractive to investors.

And that is what is happening. As rates have gone up, bonds look better than stocks as a place to invest. “That (soaring stock market) was a bubble that was ready to burst the minute interest rates started to rise,” said John Hagens, an economist with the WEFA Group, economic forecasters in Bala Cynwyd, Pa.

But why did it all happen last week? The answer to that question must be found in the herd mentality that often grips financial markets that are now linked by worldwide communications and bombarded with instant information. “When the markets are nervous, they use anything to justify selling,” Kellner said.

The experts agree that last week’s trade deficit number, while disappointing, was not catastrophic. Both imports and exports were off, but imports were down further than exports.

But the numbers followed two previous months of disappointing trade figures, which the stock market had mostly shrugged off, blaming the imprecision and vicissitudes of monthly numbers. Then, with a third month of bad numbers, professional investors threw up their hands--and dumped their stocks--in exasperation.

“Rightly or wrongly, there comes a point where you look at things and say, ‘It’s just not going to work this way,’ ” said Lloyds’ Chandross of the Administration’s trade policy. “The third time is the charm,” Hagens said. “It was the third consecutive very bad monthly trade data report.”

The wild sell-off was propelled in part by panic, to be sure. “People in the markets are like a flock of birds you see flying around. One bird turns--and they all turn,” Kellner said.

And many clear-eyed investors expected some falloff from the dizzying heights the market had reached. “A lot of people just basically said, ‘Hey. We just can’t keep going,’ ” observed Thomas Stevens, chief investment officer for Wilshire Asset Management, a unit of Santa Monica’s Wilshire Associates. “I think an awful lot of people were happy to throw in the towel and protect their gains,” he added.

Slowdown Possible

Moreover, in the incredibly complicated U.S. economy, good news can often be found in the middle of bad. “The markets have run so far and so fast that we might just get an economic slowdown that takes pressure off the dollar,” said Jason Benderly, co-director of economics for Goldman, Sachs & Co. securities brokers in New York.

An economic dip could also help the U.S. trade balance, albeit painfully, because if Americans were less wealthy they would buy fewer imports.

Events in the stock market have a very real connection to the rest of the economy, with implications for the well-being of all Americans. A crashing market can become a self-fulfilling prophecy, sowing economic distress as much as reacting to it.

Most obviously, it hurts those who looked at their stock holdings as the basis of any financial moves, such as buying a house or car. Such investors’ net worth is now substantially diminished. “When you think in those terms, it’s awesome,” said Stevens of the $486 billion in lost equity.

But its effects go much further than stockholders. A collapsed market might erode confidence--and spending--by the majority of consumers who do not dabble on Wall Street, and it might cut into business investment as well. Ultimately, worries Kellner, a collapsed market is “the last piece in the puzzle that will display a recession.”

“I worry that there are going to be repercussions based on people being panicked,” Stevens said.

Treasury Secretary James A. Baker III warns West Germany on interest rate increases. Page 32.