5 Scenarios for 1995--and Tips for Investment

Wanted: A winning investment formula for 1995.

The near-term is looking like a stalemate to many Wall Streeters, who figure the markets may remain in a mode of backing and filling while waiting for the next Federal Reserve Board interest-rate hike, probably in November.

The more important issue is what happens after that. As some investors look ahead to 1995, they are increasingly intrigued both with the possibilities and potential pitfalls for stocks, bonds and short-term cash accounts.

With long-term bond yields already at 28-month highs, what if the Fed actually succeeds in engineering a “soft landing” for the economy? Could bond yields tumble?

What if economic growth remains strong in ’95 and inflation zooms? Would the markets find that a deadly combo?

And what if, despite all of the current evidence to the contrary, the surprise in ’95 is that the economy sinks into recession?

Financial markets would probably play out very differently under each of these scenarios. Here’s a look at five scripts for the economy in ‘95, and how investors might structure portfolios accordingly:

* A soft landing. This is the most optimistic bet on Wall Street today. It assumes that the Fed raises short-term interest rates two more times at most, that real economic growth moderates from the current 4% range to about 2.5% in ‘95, and that bond yields level off or fall back.

Executives of some of the nation’s biggest companies, meeting last week under the auspices of the Business Council, indicated their faith in a soft landing by projecting 2.6% economic growth in 1995.

They also expect the federal funds rate, a key short-term interest rate, to rise from 4.75% now to 5.5% in 1995. But long-term rates should hold steady, the council says.

If they’re right, bonds are a great buy today, Wall Streeters say. With 30-year Treasury bonds yielding just under 8% currently, and many corporate bonds yielding nearly 9%, the after-inflation return on long-term bonds is 5% to 6% if inflation stays around 3%.

“There haven’t been a lot of times in U.S. history when you’ve been able to earn 5% real returns,” says Jack Kallis, manager of the Met Life/State Street Government Securities bond fund in Boston.

John Williams, economist at Bankers Trust in New York, is even more optimistic: He thinks slower growth and modest inflation will allow 30-year T-bond yields to fall to 7.25% in ‘95, giving bond owners a capital gain on top of interest earnings.

For stocks, meanwhile, a soft landing would probably be the best possible scenario. Corporate earnings would continue to advance, while investors would no longer face the threat of ever-rising interest rates. The bull market could conceivably resume.

* Strong growth/low inflation. This is what we’ve enjoyed so far this year, and the only real winners have been investors who have dis- invested--that is, people who have stashed cash in money market funds or other short-term accounts, reaping the rewards of rising short-term interest rates.

If economic growth stays strong in 1995, it’s a sure bet that the Fed will continue to push short-term interest rates up sharply. Money market fund yields, now around 4.3% on average, could approach 6% by late-1995 if the Fed raises rates another 1.5 to 2 points.

So keeping hefty assets in short-term accounts would be a winning plan in ‘95, if you think the economy isn’t going to slow soon.

But if inflation remains moderate even though growth is strong, must long-term interest rates continue rising as well? Some pros don’t think so. They see a “flat yield curve” on the horizon: That is, short rates go higher, but long rates stay level or decline.

The result would be that short rates could nearly match long rates by late ‘95, or even exceed them. That has been a fairly common toward the end of economic booms.

“I think there will be an unmistakable tendency for the yield curve to flatten and eventually invert” next year, says Anthony Karydakis, economist at First Chicago Capital Markets.

The trick then would be to ride short rates up, then lock in long yields when it appears that rates overall have peaked. But such timing is no easy feat, naturally.

Art Steinmetz, manager of the Oppenheimer Strategic Income bond fund in New York, argues that investors who expect the Fed to keep pushing up short rates in 1995 should be in no hurry to grab long-term bonds. He is dubious that long rates can decline while short rates are rising, even if inflation remains tame.

Historically, “long-term bonds cannot rally until the Fed is done tightening,” Steinmetz says.

As for U.S. stocks, strong growth and much higher short rates in 1995 might mean a repeat of ’94. Some stocks would be driven by rising corporate earnings, but overall the market would be fighting a vicious head wind. Note, however, that many foreign markets might not face the same rate pressures, and could thrive.

* Strong growth/higher inflation. It’s probably fair to say that most investors don’t believe inflation can surge dramatically in the ‘90s, because so much is working against higher prices: mainly, the forces of global competition and gains in productivity.

But what if those forces are overestimated? And how much is too much inflation, anyway?

Many economists expect only a moderate increase in inflation in 1995. The Business Council concurs, estimating that consumer prices will rise 3.3% next year, as opposed to 2.7% this year.

The question is whether investors have become so paranoid about inflation that even a 3.3% rate--or at least, the first signs of that kind of rate--might cause much more dislocation in markets.

Michael Ivanovitch, economist at MSI Global in New York, sees “12 months of strong growth and accelerating inflation” ahead, and continuing bear markets in stocks and bonds as well.

At Prudential Securities, economist Richard Rippe also worries about the propensity for inflation to surprise. He now projects that U.S. consumer prices will be rising at a 3.5% to 4% annual rate by late-1995 as the global economy expands, commodity prices climb and labor markets tighten.

“The risks in the inflation outlook (are) more on the the upside than the downside,” Rippe warns, especially if labor costs begin to rise as companies compete more aggressively to attract workers.

If you expect inflation shocks in 1995, you would probably want to steer clear of bonds now, even though the inflation “premium” in yields is arguably already high. Likewise, though some companies would undoubtedly benefit from higher prices--commodity producers, for example--stock-picking would also be a difficult game.

The only clear winners with strong growth and higher inflation would be “cash” investments like money funds, and perhaps gold and real estate. But foreign stock markets might also do well, especially in the case of commodity-producing smaller countries.

* Slow growth/higher inflation. Remember “stagflation”? That was the term used to describe the U.S. economy of the late-1970s, when growth was slow but inflation was high and rising.

Few Wall Streeters expect a repeat of stagflation in the ‘90s. The late-’70s case was primarily a result of the oil-price shock of that period, as oil exporters demanded higher prices, slowing many nations’ growth even as they paid more for energy.

But some market bears say stagflation is a real possibility for the United States in 1995 and 1996.

Charles LaLoggia, who writes the Special Situation Report market newsletter in Rochester, N.Y., argues that inflation is mostly a function of how much money the Fed has pumped into the economy in prior years. He believes that the Fed kept interest rates too low for too long in 1992 and 1993, setting the stage for higher prices as excess dollars now make their way into “real” things like cars, machine tools, real estate, etc.

Thus, LaLoggia says, even though the Fed will probably succeed in slowing the economy with higher interest rates next year, inflation will not be easily squashed. That will induce the Fed to go overboard, pushing short rates from 4.75% now to at least 7.5% by late-1995, he says.

Result: Long-term bond yields will shoot to at least 9%, LaLoggia says, and U.S. stocks will crash. “Cash” and gold will be king.

* Recession. You’d be hard-pressed to find a Wall Street pro who believes there’s much chance of outright recession beginning before late-1995, and most economists doubt we’ll have to worry about the R-word before mid-1996.

Historically, recessions are brought on when the Fed raises interest rates so high that economic growth halts. So far, the Fed’s five increases in short-term rates, from 3% to 4.75%, haven’t appeared to slow business activity except in the housing arena.

But what if the U.S. economy suddenly cracks early in 1995, and recession begins to look imminent?

By then, the stock market would most likely be well into a bear phase, as investors would be expecting a slump in corporate earnings ahead. So if you fear recession by mid-1995, you wouldn’t want to be a buyer of U.S. stocks now.

One usual side effect of recession, of course, is that interest rates begin to decline again. So short-term cash accounts would quickly lose their luster, if recession looms. And the hot investment, once again, would be bonds, as investors would rush to lock in yields.

“If you think there’s going to be a recession soon,” says Bankers Trust’s Williams, “you should be buying bonds like crazy.”