Wall Street's Ghostbusters

By GEORGE J. CHURCH

A specter is haunting Wall Street--the specter of runaway interest rates. Yields on bellwether U.S. 30-year Treasury bonds in early June jumped to just over 6%, the highest close in more than a year, as nervous traders bid prices lower. They are taking no chances that a flare-up of inflation will squeeze the real return to buyers.

But in the gloom-and-doom scenario, the Federal Reserve Board will not be satisfied with such modest rate hikes. In order to nip in the bud any renewal of inflation, the Fed will begin an aggressive tightening of credit and deliberately push interest rates much higher still. That will cause a chain reaction. It will knock stock and bond prices much lower, make consumer buying and business investment more difficult to finance, and maybe put a stop to what is about to become the longest economic expansion in U.S. history.

Relax. That won't happen. This specter is no more real than the many others that stock and bond traders torture themselves with every now and then, especially when times are good. In fact, inflation is likely to revive only slightly, if at all. The Fed may not tighten at all, and if it does, it will most likely be with a small, one-shot move that's already been discounted. Interest rates a year from now may well be lower than at present.

That is the conclusion of TIME's Board of Economists, which met recently in Manhattan to assess prospects for the U.S. economy and stock market. And that opinion comes from Wall Street itself; on this occasion the board was composed of influential investment advisers, chosen to offer a different perspective from academic and corporate economists. The panelists disagreed considerably on the likely course of the stock market and the broader economy next year and after. But on the subjects of inflation and interest rates they chorused in unison: not to worry.

A sharp further rise in interest rates would be "a dagger in the heart" of the U.S. stock market, says Vincent Farrell, chief investment officer of Spears, Benzak, Salomon & Farrell, an investment firm. But he believes the dagger is well sheathed: "Interest rates have probably about run their course." Abby Joseph Cohen, who chairs the investment policy committee at Goldman Sachs, is more emphatic. Says she: "I think yields on long-term bonds cannot move much higher and stay there on a sustained basis."

Joseph Battipaglia, chairman of investment policy at Gruntal & Co., a major brokerage company, predicts an actual decline in the rate of the 30-year Treasury bond to around 5.75% by year's end and possibly to 5.5% sometime in 2000. Barton Biggs, chairman of Morgan Stanley Dean Witter Investment Management, is generally the most pessimistic of the board members, but on this subject he goes Battipaglia one better. His prediction: "A year from now [the 30-year Treasury rate] will be in the area of 5%."

But hasn't the Fed officially warned that it has a "bias" toward making money and credit tighter? Yes, allows the board, but the Fed may already have accomplished as much tightening as necessary--or maybe more--by subtle measures. True, it may kick up the "Fed funds" (very short-term) interest rate it controls by a modest quarter percentage point at its rate-setting meeting at the end of June--"just to prove it can do it, for practice," in Farrell's words. But such a move has been so widely expected, and discounted, that board members think it won't ruffle the markets much.

The only reason interest rates are even as high as they are now, says Charles Clough, chief investment strategist of Merrill Lynch, is "the bond market's proclivity to identify growth with inflation." But that proclivity, in the board's opinion, is simply wrong: there is no inflation threat scary enough to push the Fed into drastic action. Prices did spike abruptly in April, but that, says Clough, was due largely to a speculative rise in industrial commodity prices that "has already lapsed." Though Asian countries are starting to recover from the crisis that knocked demand and commodity prices so far down in 1998, recovery has been too weak, in the view of board members, to sustain the early-spring increases.

Battipaglia adds that "wage increases will be more than offset by productivity gains, despite the remarkably low U.S. unemployment rate--4.2% in May, matching a 29-year low--that might be expected to force pay and prices up faster. Employers will have less trouble than the jobless rate might suggest in finding the workers they need, he says, for three reasons. First, "you have had a tremendous amount of downsizing that freed up a lot of individuals who are now coming back" into the work force. Also, "second wage earners"--primarily wives and husbands--who may not have been counted as unemployed because they were not actively seeking jobs are now being pulled into the job market. Finally, "you have a million legal immigrants [coming] into the U.S. each year." Though it would be too much to hope for a 1999 inflation rate as low as last year's 1.6%, Battipaglia thinks consumer prices will rise only around 2.5% this year and perhaps 2.3% in 2000.

But does all this mean that the economy and the stock market will roll merrily along to ever greater heights? On that, board opinion divides sharply.

Nobody foresees a continuation of the phenomenal 1998 rise in gross domestic product--a sizzling 6% annual rate in the fourth quarter, 3.9% for the year. But Cohen, true to her reputation as Wall Street's leading optimist, thinks the U.S. is in a "virtuous cycle" that will keep spinning, if a bit more slowly. The U.S., she notes, has created a stunning 15.5 million jobs since the end of 1993, even after subtracting job losses due to corporate downsizing. And two-thirds of these jobs pay more than the median wage for all U.S. jobs. By no coincidence, average U.S. real income has also risen in the past two years, after a long period during which wages rose less than prices. Result: consumers are willing to spend heavily, which creates still more jobs and higher incomes.

Corporate profits were the weak spot in last year's economy; they were slightly down, while just about everything else was up. But they rebounded strongly in early 1999, and Cohen expects that trend to continue. She explains that U.S.-based multinationals in 1998 "thought the global economy would perform better than it did" and got caught with the wrong plans. Having restructured over the past decade--not just to get rid of less profitable operations but also to concentrate resources on what they do best--they can now reap the benefits.

Putting it all together, Cohen expects operating profits of the 500 companies in the Standard & Poor's stock average to rise "a minimum of 7% to 8%" this year and next, while GDP goes up about 3%. Though less than last year, that would be well above anything that used to be considered "trend" (long-term average) growth. Battipaglia, even more bullish, forecasts twice as large a profit increase and GDP rises of 3.5% this year and "3% plus" in 2000.

Clough of Merrill Lynch is more dubious. He thinks "the consumer gets all the headlines, but business investment has been the economic engine." Though profits are rising, they are not going up fast enough to finance so rapid an expansion in capital spending, particularly in information technologies. So "corporations have to borrow in excess of $370 billion a year" to keep adding capacity, and that capacity is, in his opinion, more than consumer demand can absorb.

The investment cycle might have begun to slow last summer, but the Fed, fearing a global financial crisis, pumped money into the capital markets at an astonishing rate (its current tightening is a kind of confession that it went too far). But that, says Clough, created an inflation in financial assets and real estate that may prove unsustainable. "I worry that earnings may slow down next year. No recession; things aren't that out of kilter. The way capital cycles usually behave, though, if they lose momentum, things tend to slow for a long time. In that environment, interest rates would fall, and bond prices and interest-rate-sensitive stocks would rise."

Biggs of Morgan Stanley will not actually forecast a recession either, but he does say "there's a possibility" of one. If it comes, he says, it will be "because of something happening in the stock market." He believes stock prices are 30% to 40% overvalued, mostly because investors have bid up prices in expectation of a greater rise in profits than will occur. "These are still tough times for profits," he says. "Corporate managements have used every trick in the book to make profits look as good as possible, and I think you can do that only for a certain amount of time." While Biggs believes there are good investment opportunities overseas, he implies a sharp correction in U.S. stock prices or, at minimum, a long period of treading water.

Even the optimists concede that the market will have a hard time matching its striking performance of the past few years. Cohen in particular built a towering reputation in her specialized field by downplaying such traditional tools of analysis as dividend yield and price-earnings ratios, emphasizing other factors such as the durability of future earnings growth and return on equity. For years she insisted stocks were undervalued when most other analysts thought the opposite.

Now, she says, "the market is roughly at fair value. Stocks are priced about where we think they should be. So I think we have moved from an abnormal period of wonderful returns into a normal period of good returns." Amplifying the thought, Farrell sees the beginning of "a rifle-shot stock- picking environment" in which stock performance varies widely not just by industry group but also among companies in the same industry, based on their individual performances and prospects.

Who is right? The wide differences of opinion on matters other than the outlook for interest rates and inflation probably reflect the extent to which the length and strength of the expansion--if it lasts through next February, it will be the longest in U.S. history--have rewritten the rule book for forecasting. For at least two years, economists following conventional models have predicted a slowing of growth and modest rises in unemployment and inflation; the exact opposite has happened. So forecasters must search for new models, and it's anyone's guess who will find the most accurate one. But unless something happens that is much worse than any board member foresees, the outlook for the economy recalls the old gag about sex: when it's good, it's marvelous--and when it's only so-so, it's still pretty good.