1994-95: REVIEW AND OUTLOOK : Thrills, Chills : Economy’s Strength Is a Fed-Defying Feat

This will be the year we realize that the proper perspective for viewing the U.S. economy is not the nation but the world. The global business cycle--not the local--will be the determining factor for economic growth.

And so while U.S. interest rates will be higher than forecast, they won’t deter industry’s plans for hiring or capital investments. That means conventional predictions of a slowing U.S. economy in 1995 will be incorrect.

But to understand why, you have to enlarge your focus.

Europe’s economies will be growing again, led by a solid expansion in Germany. Asia’s economies continue to surge, although Japan remains hobbled by inflated real estate and artificially puffed-up stock prices in the aftermath of its financial bubble of the 1980s. Japan’s growth this year may be only 1.4%, “less than half the gains likely in Europe and the United States,” predicts economist Stephen Roach of Morgan Stanley.

Meanwhile, Latin America is expanding solidly, despite Mexico’s troubles. Mexico was forced to devalue the peso at the end of December, which hurt foreign investors and its own credit standing. The Mexican economy will struggle in ‘95, but support from the United States and Canada and access to their markets will help as its new government strives to rebuild international confidence.

The world’s economies will be more synchronized in 1995 than in recent years. But not because the U.S. economy will slow. On the contrary, 3.5% to 4% growth is the likely outlook for 1995--just about equal to 1994.

What will that do to interest rates and bonds? To stocks?

Interest rates will go higher. At its next meeting in February, the Federal Reserve Board may raise rates a full percentage point, says Patricia Klink, president of Advisers Capital Management, a firm that invests pension money in bonds and other fixed-interest securities.

Klink believes that Fed Chairman Alan Greenspan will be reappointed now that the Republicans control Congress and that he will keep interest rates relatively high to forestall inflation.

Will that stall the economy? Possibly no more than six rate increases totaling 2.5 percentage points stalled it in 1994. To be sure, housing will suffer, and consumers may pull back as monthly charges on their credit cards increase--although the promise of tax cuts from the new Congress could change that outlook somewhat.

But industry sees strong earnings ahead and no real inflation in wages. That should support stock prices, with U.S. manufacturers, engineering firms and banks that have major international business among the year’s big winners.

“Until they suffer a profit squeeze, business firms will not be much deterred in their hiring or capital spending by higher interest rates,” says Albert M. Wojnilower, economist and veteran interest rate watcher at CS First Boston Investment Management. Wojnilower believes that short-term rates will go over 6% this year and that long-term bond rates will be close to 9%, but that the economy won’t slow until 1996.

That outlook doesn’t apply to Southern California, where the five-county economy will grow 2% this year, according to economist Jack Kyser of Los Angeles County’s Economic Development Corp. Interest rates will hurt home building, but the local economy will be buoyed by foreign trade. Traffic through the Ports of Los Angeles and Long Beach will grow 12% to $161 billion, surpassing New York as the largest port complex in the United States.

Still, you can’t grasp the immensity of the global economy by looking only at merchandise trade. U.S. trade in services, at more than $300 billion, now totals almost one-fourth of all U.S. trade and is growing rapidly. Worldwide investment--the money flowing into shares and loans as well as factories and businesses from New York to New Delhi--now totals $5 trillion in a given year and outpaces the $4 trillion in world merchandise trade, according to Felix Rohatyn, the global investment banker.

Those investment flows, Rohatyn wrote last year, are what will keep the global economy expanding. They will help the developing countries grow at 4.5% a year on average and so provide markets for equipment and know-how from the developed countries, which now grow at only 2% a year.

China, India, Russia and other large developing nations need total investment of about $300 billion a year, Rohatyn estimates. That’s a daunting figure, leading some to worry that the poorer nations’ need for capital will starve the rest of the world for funds.

But that is not how the world works.

The developing countries will generate much of the needed capital within their own economies, as the buildup of their own debt markets and stock exchanges channels their savings and the rising productivity of their industry. “Thanks to recent developments in computer software and manufacturing methods, it is now more possible than ever to transfer technology to countries that have labor forces to make use of it,” Rohatyn says.

Yes, but where does that leave our own labor force? Working to supply an expanded market--a growing pie--rather than struggling over a diminishing crust of bread.

What is really going on is that China and the other nations that have yet to develop need industrial capacity. And the United States and other countries sell them that capacity, whether in the form of Caterpillar construction equipment, General Electric power plants, Fluor engineering sophistication or Citicorp and J.P. Morgan financing.

Those are the growth markets that make possible a growing home market--and not only for big companies.

Economist John Rutledge--he runs a Greenwich, Conn., investment firm that invests for pension funds and large individual investors such as Bill Gates of Microsoft--is negotiating to invest $20 million in two Indiana companies. Each has about $30 million in sales. One forms powdered metal into locking nuts and other air compressor parts; the other makes axles for farm combines and other hydraulic vehicles.

Gates and other Rutledge backers look for a 30% return on investments in such companies. That kind of return can be had in ordinary businesses here in the United States because supplying industrial capacity to China, Russia and the rest will occupy the developed world for years to come.

And that’s why industry will continue to expand in spite of rising interest rates. If your perspective is the world, you’ll see that there’s a market and a need.