1994-95: REVIEW AND OUTLOOK : Thrills, Chills : The ‘Real Economy’ Enters the Center Ring
In 1994, the best U.S. economic growth in perhaps 10 years begot the worst stock market since 1990 and the worst bond market in more than 60 years.
Little wonder Wall Street so fears what the economy might do for an encore in ’95.
The seeming paradox--bullish times for business and workers equating with bearish times for financial markets--remains the focus of investor debate and concern worldwide as the new year dawns.
It’s easy to simply blame the Federal Reserve Board for 1994’s lousy markets, of course. The central bank tightened credit for the first time since 1989, seeking to rein in the economy and crush inflationary pressures before they developed.
The Fed-engineered surge in short-term interest rates--to four-year highs--drove long-term bond yields sharply higher, devaluing older bonds and causing devastating losses for bond investors and speculators, Orange County’s investment fund among them.
And in the usual chain reaction, rising interest rates clipped stock markets around the globe. The Standard & Poor’s index of 500 blue-chip stocks fell 1.5% in 1994, not including dividends. Many world markets fell much more.
If the Fed were the markets’ sole problem, the worries might be over soon enough. Although the Fed is expected to raise short-term interest rates further this year to cool the still-strong economy, it’s a reasonable bet that the most substantial rate increases are behind us. Short-term rates, after all, have already doubled from a year ago.
But some experts now see a larger issue confronting Wall Street. The Fed notwithstanding, they say, the sun is finally shining on the “real” economy of goods, services and the workers who provide them. Hard assets and people have value again. And for a number of reasons, that may relegate the “financial” economy--meaning stock and bond markets--to the shadows for a while.
“Wall Street had a big party for three years,” from 1991 through 1993, says David Shulman, investment strategist at Salomon Bros. in New York. “Now it’s Main Street’s turn.”
In effect, wealth now is being transferred from the financial economy to the real economy--a reversal of what happened in the early 1990s, and in fact for much of the last 13 years.
From 1991 through 1993, an anemic real economy allowed for plunging interest rates that dramatically bolstered the value of stocks and bonds. That enriched investors, even as many non-investors feared for their jobs.
With demand for real goods and services waning, money wasn’t needed to build new plants or buy equipment. So, much of the wealth generated in the economy went into paper investments.
Individuals, for example, invested a record amount in stock and bond mutual funds in 1992 and 1993: Gross fund purchases totaled $876 billion in those two years--nearly as much as was purchased in the entire 1970-89 period.
Commercial banks, finding little demand for loans in the early ‘90s, invested their idle cash in a mountain of U.S. Treasury bonds.
But when the U.S. economy finally began to break out of its cocoon late in 1993, the stage was set for a reversal of the money flow back into the real economy. And as Europe and Japan followed America into economic expansion in 1994--while the Third World continued its rapid growth--the focus shifted worldwide from investing in paper to investing in real things.
Think of it this way: Whatever the monthly payments, the $30,000 that the Gonzalez or Smith or Lee family spent on a new Jeep Grand Cherokee in 1994 reduced by some significant amount what the same family might otherwise have added to its financial investments. And Chrysler sold a lot of Grand Cherokees last year--an estimated 237,000, up from 217,000 in 1993.
The need for real things is reflected in much more than strong car sales. Imports of foreign steel are surging, not because U.S. steel makers aren’t competitive, but because they can’t make enough to meet demand. Thus, new plants capable of producing between 11 million and 15 million tons of steel annually will be built in North America over the next three years, estimates J. Clarence Morrison, analyst at Prudential Securities.
For steel companies, investing millions of dollars in new plants uses up capital that otherwise might have gone to buy back stock or retire debt--uses that might have benefited the financial economy by boosting stock prices and making bonds more scarce.
Steel companies aren’t alone in expanding, of course. Overall, U.S. factories are running at near-maximum capacity, spurring new plant construction and equipment purchases across a broad spectrum of industry. That is in sharp contrast to the story of much of the last 13 years, as factories were closed in massive numbers in the great corporate restructuring wave.
Meanwhile, the sudden boom times for business have produced the lowest U.S. unemployment rate in more than four years--5.6% as of November. An estimated 3.3 million new U.S. jobs were created in 1994, the most since 1984.
That job growth is a good-news story that hasn’t yet been duplicated in Europe, where unemployment rates remain in double digits. But the momentum created by the U.S. revival is spurring new growth there and in Japan.
Indeed, although most economists believe that the Fed’s 1994 rate increases will succeed in slowing U.S. growth this year from last year’s near-4% pace, the real-economy juggernaut is already a global phenomenon--which makes much iffier the prospect of a significant U.S. slowdown.
Allen Sinai, chief economist at Lehman Bros. in New York, is among the majority in his field projecting a lower rate of growth for the U.S. economy this year. But he also concedes that, of 45 countries tracked by Lehman, “43 now are in some kind of economic expansion.” The two exceptions: Russia and Venezuela.
For financial markets, the overwhelming desire to see growth moderated stems from a deeply ingrained fear of inflation. Fast growth often leads to rising prices for goods and services; that inflation eats away at the value of investments, eroding investor confidence.
Economists’ widespread belief that growth and inflation will be controlled in 1995 rests almost entirely on the expectation that the jump in interest rates worldwide last year will be enough to dampen activity in the real economy.
But some on Wall Street suspect that assumption is naive. Greg Smith, chief investment strategist at Prudential Securities, says the cost of money, in the form of higher interest rates, is more a Wall Street obsession than a true impediment to growth in a robust economy.
“In the real economy, I suspect that availability (of money) is more important than we perceive and that the price of money is less important than we perceive,” he says. And with banks bidding actively for new deposits and eager to lend money, credit is readily available today--a far cry from the credit crunch of 1990-93.
The banks’ new aggressiveness, too, has become a threat of sorts to financial markets. As banks chase deposits, yields on CDs are rising, providing greater competition for investors’ dollars at the expense of stocks and bonds.
But is it a fact of life that what’s good for the real economy must be bad for the financial economy, as 1994’s experience suggests?
One school of thought today on Wall Street is that last year’s dislocation in markets represents the shock of adjustment to a new era. Interest rates went up, perhaps more than they would have had they not dropped so far between 1991 and ’93. And that sent stocks down, even though corporate earnings continued to rise.
If the shock has now been absorbed, however, it’s conceivable that a moderately growing U.S. economy in 1995, without a surge in inflation, could allow interest rates to finally level off and stock prices to begin rising again, supported by corporate earnings.
“Any time you get a doubling of short-term interest rates, you will have great fallout,” says Sinai. “But I don’t think we can have the same degree of financial disarray in 1995.”
Moreover, at least for certain sectors of the stock market, the ascent of the real economy has a near-term and long-term payoff that should at some point be reflected in share prices.
Denis Laplaige, manager of the MainStay Value stock mutual fund, finds such chemical stocks as Dow Chemical, PPG Industries and Georgia Gulf to be “great bargains” after their 1994 declines--precisely because the real economy is doing so well.
“We think we’re only in the initial stages of increases in commodity (chemical) prices” as the world economy advances, Laplaige says. Even factoring in slower economic growth in the United States, he sees chemical company earnings booming.
But other Wall Street pros note that rising corporate earnings are no guarantee of higher share prices in the short run, as 1994 amply demonstrated. The prices investors are willing to pay for stocks depend not just on underlying earnings, but also on the level of interest rates, inflation, competition from other investments and simple market psychology--the perception that someone else will eventually pay more for a stock than you did.
Salomon’s Shulman worries that many of those variables will continue to work against U.S. stock and bond markets in 1995. The real economy’s continuing gains, he says, will “produce an environment where (interest rates) go up and stocks go down” again.
The better alternative for anyone expecting to make money in the short term, he says, is a bank CD or a money-market account--the same winners as in ’94.
That doesn’t necessarily change anything for long-term investors, Shulman concedes. If you own stocks for a payoff years away, what happens in 1995 may be of little interest. And to turn your back on the stock market entirely runs the risk that the naysayers will be totally wrong--always a possibility--and that the bull market will resume in earnest this year without you.
But in the broad investment overview today, the money demands of the real economy provide extraordinary competition for the capital that could otherwise be casing stocks and long-term bonds, Shulman says. With one-year U.S. Treasury bills now paying 7.2% risk-free, many Americans are logically putting their monwy there. Sometimes, what is obvious in investing is right, Shulman says.
Sinai puts it this way: If you think of high short-term interest rates as a proxy for strength on Main Street, current yields are telling you that “the money to be made is in the real economy.”
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1994 Investment Score Card
Which investment categories performed best overall in 1994? Here’s a look at average performance of indexes measuring popular stock, bond and “cash” investments. Also shown are 1993 and 1992 returns for each category, to put 1994 numbers in perspective. All returns are “total returns,” which include the investment’s price change plus any dividends or interest earned. (Total investment return)STOCKS
1994 1993 1992 Science/technology mutual funds +10.8% +23.8% +13.5% Blue chips (S&P; 500 index) +1.7 +10.1 +7.6 International mutual funds -1.2 +39.2 -5.1 Small company mutual funds -1.4 +16.0 +12.6 Growth mutual funds -2.2 +10.4 +7.8
1994 1993 1992 High yield “junk” corporates -1.2% +17.2% +18.2% Intermediate-term U.S. Treasuries -1.7 +8.2 +6.9 Intermediate-term high-qual. corps. -2.4 +11.0 +7.6 Long-term high-quality corporates -5.5 +13.9 +9.3 Long-term tax-free munis (G.O.s) -6.7 +12.4 +10.3 Long-term U.S. Treasuries -7.5 +17.2 +7.9
1994 1993 1992 Five-year CD, annual average yield +5.4% +5.0% +5.8% One-year CD, annual average yield +4.0 +3.2 +3.8 Money market mutual funds +3.7 +2.7 +3.4
1994 1993 1992 (Consumer Price Index) +2.6% +2.7% +3.0%
Sources: Lipper Analytical Services (mutual fund returns); Merrill Lynch (bond index returns); Bank Rate Monitor and IBC/Donoghue’s (CD and money fund returns); Economic Development Corp.
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A Market Frustrated by Rising Rates
The year began with promise as the Dow Jones industrials hit a record high. But then the Federal Reserve Board, alarmed by the economy’s brisk growth and the threat of inflation, lifted short-term interest rates--six times during 1994. Bond prices plunged in response and stocks struggled to stay ahead. Dow Jones industrial average, weekly closes:
START OF YEAR: Dow at 3,754.09; Nasdaq index at 776.80; 30-year T-bond yield at 6.35%
Jan. 31: Dow reaches record high of 3,978.36.
Feb. 4: Stocks plummet after Fed raises interest rates.
March 22: Fed raises rates a second time, sparking a two-week selloff in stocks.
April 19: Fed raises rates a third time.
May 17: Fed boosts rates again, but this time stocks and bonds advance.
June 24: Weak dollar, higher oil prices keep stocks in a nose dive.
Aug. 16: Fed raises rates a fifth time.
Sept. 15: Dow again climbs to within 50 points of unprecedented 4,000 level.
Oct. 23: Thirty-year T-bond yield hits 8% for first time in 2 years.
Nov. 15: Fed raises rates a sixth time, sparking weeklong slide in stocks.
Dec. 1: Congress approves the worldwide General Agreement on Tariffs and Trade.
Dec. 16: New York Stock Exchange volume hits 479 million shares, highest since ’87 crash.
END OF YEAR: Dow at 3,834.44; Nasdaq at 751.96; 30-year T-bond yield at 7.88%
Source: Los Angeles Times