In a New Year, Some Perennial Questions

A year ago, it was easier for many investors to imagine any number of disaster scenarios for the economy and financial markets than the possibility that things might work out OK.

Things worked out more than just OK in 2003, of course, as evidenced by the fastest economic growth in 20 years and a 25.3% rise in the Dow Jones industrial average.

Now, the outlook is decidedly more optimistic on Wall Street and elsewhere. Iraq remains a serious problem, but the doomsday forecasts associated with the impending war a year ago have largely dissipated.

What remains are the kinds of questions about the economy and markets that investors have faced many times before, with different degrees of urgency.

Here are some of those questions, how they might be answered this year and what investors should consider in preparing for various outcomes:

* Do interest rates jump, with or without a push from the Fed? The vast majority of professional money managers expect interest rates to go up in 2004. A recent Merrill Lynch survey of 300 fund managers worldwide showed more than 80% expect both short- and long-term interest rates to be higher in 12 months.

The near-universal belief is that the Federal Reserve and other major central banks, having held rates near generational lows in 2003 to make sure the global economy got itself on firmer footing, will acknowledge the pickup in growth by tightening credit in the new year.

The Merrill survey found that most money managers believe the Fed will raise its benchmark short-term rate, now 1%, within six to nine months.

But most market pros also figure the Fed won’t boost rates much this year -- perhaps no more than half a point by year’s end. Even if that forecast is correct, or even if the Fed doesn’t raise its benchmark rate at all, the marketplace might have its own nasty way with rates such as on bonds, analysts warn.

Treasury bond yields snapped back last summer after investors concluded the Fed was done easing credit. The yield on the two-year Treasury note bottomed at 1.09% in mid-June, rose as high as 2.1% by early December and ended Friday at 1.94%.

One risk for bond and stock markets is that some bond investors could overreact this year, driving yields sharply higher -- at least temporarily -- based on stronger economic data or any hint from Fed officials that a credit-tightening move is on the horizon. It wouldn’t be the first time the bond market overreacted.

“Interest rates have been low for so long, the economic and market impact of what might otherwise seem an unimportant shift [in the outlook] might actually be magnified in markets,” warns Tom McManus, chief investment strategist at Banc of America Securities in New York.

What’s more, he said, “even if the Fed does remain on the sidelines in 2004, rising rate expectations for 2005 might cause the equivalent reaction in 2004 that a real tightening would.”

Then again, the Fed might be happy to let the marketplace do its dirty work: If bond yields rise, that could tone down economic growth without the central bank moving its own key rate.

Because it’s a presidential election year, one widespread assumption is that the Fed would prefer not to raise rates, to avoid hurting President Bush’s reelection chances. But history shows that the Fed isn’t shy about making rate moves in election years.

In fact, McManus said, “interest rates are actually more likely to rise in a presidential election year than other years.”

For investors who own high-quality, longer-term bonds, the upshot is that they should be prepared for significant volatility this year, and most likely that the market value of their bonds will decline. But it’s all relative: Even in their worst years, bonds don’t lose anywhere near what stocks lose in a bear market. In a diversified portfolio, there’s always a need for bonds, most financial advisors still say.

*

* Does “reflation” mean inflation? Reflation refers to the massive amount of stimulus the U.S. economy has enjoyed in the last year in particular. That includes the Fed’s easy-money policy and the Bush administration’s tax cuts that have resulted in record federal budget deficits (and borrowing).

Despite that stimulus, inflation as measured by the U.S. consumer price index has remained tame. Through November, the annualized percentage change in the CPI was below 2%.

If there’s no inflation problem in 2004, the Fed may not feel compelled to tighten credit. That’s the expectation of David Rosenberg, economist at Merrill Lynch, who sees the CPI rising just 1.1% in 2004.

Of course, there is inflation in the economy -- in housing prices, stock prices and many commodities, for example. It just isn’t showing up in classic inflation gauges, in part because companies face intense competitive pressures on the pricing of many goods. (Thank China for that.)

Scott Grannis, economist at Western Asset Management in Pasadena, reminded his clients repeatedly during the late 1990s economic boom that faster growth alone doesn’t fuel inflation. Historically, inflation is a byproduct of too much money chasing too few goods, he noted.

Grannis wasn’t worried about inflation in the 1990s. But he is now. “There is a growing body of evidence that suggests the Fed is in the initial stages of committing an inflationary mistake,” he said.

As with low interest rates, it might not take much of a change in inflation to seriously disturb investors.

Because of the perceived risk, many market pros are advising clients to think about whether their portfolios include investments that might serve as inflation hedges -- things that might benefit from, rather than be hurt by, a shift toward the view that consumer prices will increase at a faster rate.

Bill Gross, the bond market guru at the Pimco mutual funds in Newport Beach, suggests that investors look at tangible assets, which would include gold and real estate; inflation-protected Treasury bonds, which automatically rise in value in tandem with inflation; and foreign stocks and bonds, on the assumption that higher U.S. inflation could further hurt the value of the dollar, making foreign securities more valuable to American investors.

Fed Chairman Alan Greenspan has effectively said, “Damn inflation, full speed ahead,” Gross wrote in a recent commentary to clients. “I think an investor should believe him and invest accordingly.”

If you own a home, that probably would be your best hedge against inflation. But other hedges are more liquid.

Gold, and gold-mining stocks, have been in a bull market for the last two years. Experts differ on whether that’s because gold, historically an inflation hedge, is predicting higher inflation, or whether the metal simply became under-owned after falling out of favor over the previous two decades. Whatever the case, it isn’t difficult to imagine gold having another good year in 2004 as more investors take notice.

“We’re thinking about gold for a small portion of clients’ assets,” said Neta Gagen, a certified financial planner in Garden Grove.

Inflation-protected Treasury bonds, and savings bonds, can be bought individually. Some mutual fund companies also offer funds that own those bonds.

*

* Could stocks fare well even if interest rates or inflation rise? A popular assumption is that the stock market would sink in the face of higher rates or inflation. But that wouldn’t necessarily be true.

The course of individual stocks will depend on a number of factors. Interest rates and inflation matter, but so do companies’ earnings growth outlooks and the relative appeal of alternatives to equities.

The late 1970s, a period of soaring inflation, was a great time to own energy and other stocks in commodity businesses, for example. It also was a wonderful time to own many smaller growth companies whose businesses prospered despite, or because of, the inflation environment.

The Nasdaq composite index rose 107% from the end of 1976 through the end of 1980, even as many blue chip stocks struggled.

The point is that investors shouldn’t make blanket assumptions about stocks even if they believe inflation or interest rates will be going up.

One problem many investors face is that they have been keeping a big chunk of their savings in short-term accounts, such as bank savings accounts and money market mutual funds. There is more than $3.2 trillion in savings accounts and about $2 trillion in money funds.

Even if longer-term bond yields rise this year, the trend in shorter-term interest rates will depend on what the Fed does with its key rate. If the Fed barely raises that rate, investors won’t earn much more in bank accounts or money funds in 2004, and might face the same dismally low returns in 2005.

In the last year, money fund assets have fallen by more than $230 billion as some investors have sought greener pastures for their capital. In recent months, the total in bank savings accounts has stopped growing, after rising sharply since 2000. If even a small percentage of that bank cash mountain is funneled into the stock market, it could help fuel share prices in 2004.

*

* Could the falling dollar trigger a crisis? With the apparent blessings of the Bush administration, the dollar’s value has been tumbling for two years.

Why is the dollar falling? Many economists say the nation’s long-term appeal for foreign investors is declining because of our huge budget and trade deficits. In theory, a currency’s value reflects the underlying strength of the nation that issues it.

A weaker dollar means Americans’ purchasing power abroad is eroding. But the Bush administration is believed to support the idea of a weaker dollar because it should help fix the trade-deficit problem over time by making U.S. exports less expensive for foreign buyers.

However, because the U.S., with its deficits, is dependent on foreign capital, a falling dollar could become a crisis if it makes foreigners balk at buying our bonds because of the risk of further devaluation of those assets.

But most Wall Street pros say the buck’s decline isn’t near a crisis point. “I think we’re far from that,” said C. Fred Bergsten, head of the Institute for International Economics in Washington.

Measured against key currencies, including the Swiss franc, the dollar hasn’t yet given back the gains it racked up in the late 1990s, Bergsten noted.

Whether a dollar crisis is approaching, or not, the currency’s decline ought to be a wake-up call to U.S. investors who have shunned foreign stocks. A weaker dollar means foreign shares get an automatic boost in the currency translation. That’s a big reason the average foreign stock mutual fund has risen 39.1% in the last 12 months, compared with a 28.2% gain for the average U.S. stock fund, according to Morningstar Inc.

If the dollar is headed lower, foreign funds could be poised for another strong year.

*

Tom Petruno can be reached at tom.petruno@latimes.com.