Healthy Economy Could Bring Stocks, Bonds a Surprise

There are some things Wall Street would rather not talk about these days, and this one’s at the top of the list: What if the U.S. economy just keeps rolling along?

After Friday’s shockingly strong report on July job creation, which triggered a new surge in bond yields, the specter of another credit-tightening move by the Federal Reserve Board reared its Gorgonic head.

And as with each of the Fed’s four interest rate increases this year, many investors are already labeling the next boost as the one that will “do the job”: In other words, one more hike of half a percentage point and the economy will slow, inflation worries will evaporate and stocks will be off to the races again.

It’s curious that anyone could have such faith in the Fed’s gradualist approach to raising rates, given what happened between 1990 and 1993.

The Fed took a gradualist approach in that period, too, trimming interest rates in quarter- and half-point increments. And the continual surprise was that the economy failed to react significantly to the Fed’s steady stimuli. By late 1992, many economists were urging the Fed to abandon gradualism and jump-start the economy with a rate cut of a full percentage point.

Today, it seems few investors believe that the economy has momentum going for it. Many think it can be easily restrained. What most aren’t expecting is that the Fed will probably have to raise short-term interest rates continually well into 1995.

To be sure, some sectors of the economy do appear to be responding to higher rates. New home sales, for example, fell in June to the lowest level in two years, undoubtedly influenced by the rise in mortgage rates since winter.

But three powerful forces at work in the economy could ensure that growth stays stronger than the inflation-paranoid Fed would like, and thus that short-term rates will keep rising:

* Job creation is robust. Even with weakness in housing, the economy still managed to add 259,000 jobs in July, the Commerce Department said Friday. Year to date, the economy has created a net 2 million new jobs.

While some analysts fret about a buildup in product inventories at the wholesale and retail levels during the second quarter, they may be missing something important: Business owners sense that the economic outlook is terrific and thus they are unafraid to hire workers and restock shelves.

Every job added, in turn, means income for--and consumption by--that worker, adding fuel to the economy’s expansion. People who already have jobs, meanwhile, feel more secure in them as new hires come on, which also boosts prospects for consumer spending.

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David Hale, chief economist at Kemper Corp. in Chicago, calculates that the household sector will lose $3 billion to $5 billion in income this year from rising mortgage rates. “But such income losses will be modest compared to the income gains that would occur if employment growth held at the 2% to 2.5% range,” Hale says.

Every 1% increase in employee compensation, he estimates, is worth about $24 billion a year to the economy.

* Corporate profits are booming. Eric Miller, strategist at Donaldson Lufkin & Jenrette Securities in New York, notes that corporate profits have topped expectations for six straight quarters.

That surge in earnings, in large part because of the painful restructurings of the late 1980s and early ‘90s that slashed corporate break-even points, has given managers a windfall of dollars with which to expand their businesses.

And expansion, in the form of investment in new plants and equipment, is definitely happening, further bolstering the economy. For example, Cimtek Inc., which tracks new-plant announcements nationwide, counted 802 from January through May, up from 591 in the same period of 1993.

In the government’s report last week on June manufacturers’ activity, factory shipments of electrical machinery rose 1.1% in that month, the eighth straight gain.

* Europe and Japan are on the upswing. After deep recessions in 1993, the economies of Europe and Japan are showing unmistakable signs of improvement. That will almost certainly raise demand for U.S. exports and in general contribute to a stronger global economy all around heading into 1995.

Britain’s economy grew 3.3% in the second quarter, the fastest pace in five years, notes Joseph Quinlan, international economist at Dean Witter Reynolds in New York. Elsewhere, housing starts in France jumped 23% in May, he says, and German exports rose 11% that month.

And in Japan, an extreme heat wave this summer is driving a mini-boom in consumer spending (air conditioners, electricity, beer, bathing suits, etc.) while also guaranteeing a bumper crop in rice, Quinlan says.

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Given the ongoing boost to the U.S. economy from all of the above, can the Fed make a meaningful dent in growth with just one more half-point boost in short-term interest rates?

Many Wall Streeters doubt it.

“We think we’ll have another boost now (at the Fed’s Aug. 16 meeting) and one more by the end of the year,” says Marshall Acuff, investment strategist at Smith Barney in New York.

And maybe more after that?

Joseph Carson, domestic economist at Dean Witter, argues that the Fed-engineered increase in the federal funds rate (the overnight loan rate for banks) from 3% to 4.25% so far this year is still woefully inadequate if the Fed’s goal is to hold down growth and thus inflation.

“Historically, the average level of the inflation-adjusted fed funds rate has been about 2% to 2.25% during economic expansions,” Carson says. So if the Fed expects inflation to be around 3%, he says, the fed funds rate should rise to 5% to 5.25% at a minimum--well above the current 4.25%.

More important, if the Fed wants to get serious about capping inflation at around 3% a year, Carson says, the fed funds rate will have to rise to around 6%.

If he’s right, short-term interest rates will be pushing higher well into 1995 and maybe into 1996. For the bond market, that could mean a long, drawn-out bear market.

What about the stock market? If too many investors believe that the next Fed rate hike will be the last, the market will just be setting itself up for new disappointment later this year and in 1995, as the Fed keeps pushing up rates.

Thus, many Wall Street strategists continue to believe that it will be tough for the market overall to advance between now and the end of the year, short-term rallies aside.

“Concern about rates is going to overwhelm the equity market,” Acuff says. “Our guess is that rates are going to go higher than most people think.”

Even so, abandoning stocks completely isn’t a reasonable option for most investors. Long-term investors in diversified mutual funds, for example, have no compelling reason to walk away from this market.

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But if the question is putting new money to work, many Wall Streeters say investors should follow themes that mesh with the prospects for a stronger rather than weaker economy:

* Go with companies that have the most to gain, profit-wise, from U.S. economic growth. To Acuff, that list would include such names as machinery maker Emerson Electric, paper giant Kimberly-Clark and major lenders such as BancOne and Bank of Boston.

It’s worth noting that investors have been able to get excited about some stock groups this year--even as interest rates have risen--if the companies’ earnings outlook has improved radically. Steel stocks, which have surged in recent weeks, are the latest example.

* Keep thinking international. The recent blazing comeback of Mexican stocks demonstrates that opportunities can still abound in foreign markets, regardless of what’s happening in U.S. markets.

If world economic growth surprises, the biggest beneficiaries are likely to be foreign firms in the fastest-growing economies.

At the same time, don’t forget that many U.S. multinationals are also poised to reap the benefits of global expansion, says Howard Gleicher, portfolio manager at Palley-Needelman Asset Management in Newport Beach. He favors such names as General Motors, 3M Co. and Tenneco.