THE ECONOMY: ADJUSTING TO NEW REALITIES : A New Cycle: Real Estate Up, Mutuals Down

A new phase has begun in the economy and financial markets, and an age of disinflation and declining interest rates that began with Ronald Reagan in 1981 and continued through Bill Clinton’s first year in office is now over.

The next phase could see a drop in stock and bond prices but an expansion of jobs, public investment in education, police and fire departments, as well as business investment in plants and equipment. Indeed, business investment has already accelerated--orders in 1993 for heavy industrial equipment rose 12% and increased 28% for computers and other information technology--according to the latest government figures.

Significantly, the new era may not be inflationary, but interest rates will rise with economic activity.

The prospect is for increases in real estate prices but declines in prices for financial assets--stocks and bonds. In a nutshell, your house may go up but your mutual fund may go down.

That was the considered judgment of sophisticated investment people and economists from many sides of the philosophical and political spectrum Monday, despite the stock market’s rebound from Friday’s steep fall in prices.

That fall was not a fluke but an alarm bell, says Stanley Salvigsen of Comstock Partners, an investment firm based in Jersey City, N.J. Salvigsen is known for accurate predictions over the last decade that inflated oil, farmland and real estate prices would decline. Now, he says, stocks will follow.

“In recent years, stock prices have been rising two to three times faster than the economy, and that can’t continue,” Salvigsen says.

But it’s important to note that Salvigsen, and other investment seers, don’t see business and corporate profits declining along with stock prices. On the contrary, the dominant scenario is that the economy will pick up steam, helped by federal policy.

A change in direction is perceived. Byron Wien, investment strategist for Morgan Stanley, titles his weekly analysis “The End of Disinflation.” James Grant, editor of Grant’s Interest Rate Observer, has been saying for months that the economy has entered a new cycle.

“The policies of the federal government toward taxes and interest rates have changed, and that strongly influences returns on investment,” says John Rutledge, head of Rutledge & Co., an investment bank.

Through 1993, the policy of the Clinton Administration was to hold down interest rates, but now it has “tilted” toward encouraging jobs and tolerating some rise in rates. Last Friday’s action by the Federal Reserve Board to lift the short-term federal funds rate a quarter of a percentage point, to 3.25%, was seen as the first of many increases.

That reading of Administration policy is correct, says economist James Medoff of Harvard University, who last month provided analysis of America’s job picture to Clinton and the Democratic Party.

The problem is a lack of demand for workers, says Medoff, leaving unemployment and underemployment higher and more widespread in this economic recovery than in the past.

Jobs are not being created in sufficient number at a time when government policy most needs them. If Clinton is going to get people off welfare, he needs an active economy to provide jobs for them to go to; if he is going to step up education and training to equip high school graduates for a competitive world economy, he needs an abundance of jobs for the trainees to graduate into.

Declining interest rates didn’t swell the job rolls. As a result of low rates, money flowed into the stock market, observes Rutledge, who served in the Reagan Administration, and that set up a distorted situation in which corporate managers could lift the company stock price by cutting workers and expenses more easily than by expanding the business.

Money also flowed abroad in search of higher returns: Mutual funds, pension funds and corporate treasurers invested $32 billion more overseas than foreigners invested here in 1992, the latest year for which complete figures are available.

Now the Clinton Administration wants to reverse the trend. There is a provision in Clinton’s budget for job centers nationwide, where unemployed workers can not only file for benefits but also get counseling on jobs in the area.

Within the budget’s constraints, there will be a new emphasis on public investment in labor-intensive activities. “Spending on public safety is good because jobs for cops are better and higher-paying than retail clerk jobs,” Medoff says. The same goes for spending on fire departments and schools.

Surprisingly perhaps, there is little fear of renewed high inflation.

If business people pull money out of the stock market and invest in expanding their businesses, that should be productive, not inflationary, notes Salvigsen.

And with so little demand for workers, there is no pressure on wages, Medoff says.

And with just about every U.S. business now open to competitive world markets, there is no room for price hikes or cost inflation.

Yet interest rates will rise with economic activity. And it is logical that stock prices, which have risen with interruptions since 1982 on expectations of falling rates, would now decline. The least you can say is that stock prices and price-to-earnings ratios won’t expand from here, investment experts say.

Chances are stocks won’t fall dramatically. But smart investors know that a time of change demands new thinking.