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Healthy Economy Could Bring Stocks, Bonds a Surprise

August 08, 1994|TOM PETRUNO

There are some things Wall Street would rather not talk about these days, and this one's at the top of the list: What if the U.S. economy just keeps rolling along?

After Friday's shockingly strong report on July job creation, which triggered a new surge in bond yields, the specter of another credit-tightening move by the Federal Reserve Board reared its Gorgonic head.

And as with each of the Fed's four interest rate increases this year, many investors are already labeling the next boost as the one that will "do the job": In other words, one more hike of half a percentage point and the economy will slow, inflation worries will evaporate and stocks will be off to the races again.

It's curious that anyone could have such faith in the Fed's gradualist approach to raising rates, given what happened between 1990 and 1993.

The Fed took a gradualist approach in that period, too, trimming interest rates in quarter- and half-point increments. And the continual surprise was that the economy failed to react significantly to the Fed's steady stimuli. By late 1992, many economists were urging the Fed to abandon gradualism and jump-start the economy with a rate cut of a full percentage point.

Today, it seems few investors believe that the economy has momentum going for it. Many think it can be easily restrained. What most aren't expecting is that the Fed will probably have to raise short-term interest rates continually well into 1995.

To be sure, some sectors of the economy do appear to be responding to higher rates. New home sales, for example, fell in June to the lowest level in two years, undoubtedly influenced by the rise in mortgage rates since winter.

But three powerful forces at work in the economy could ensure that growth stays stronger than the inflation-paranoid Fed would like, and thus that short-term rates will keep rising:

* Job creation is robust. Even with weakness in housing, the economy still managed to add 259,000 jobs in July, the Commerce Department said Friday. Year to date, the economy has created a net 2 million new jobs.

While some analysts fret about a buildup in product inventories at the wholesale and retail levels during the second quarter, they may be missing something important: Business owners sense that the economic outlook is terrific and thus they are unafraid to hire workers and restock shelves.

Every job added, in turn, means income for--and consumption by--that worker, adding fuel to the economy's expansion. People who already have jobs, meanwhile, feel more secure in them as new hires come on, which also boosts prospects for consumer spending.


David Hale, chief economist at Kemper Corp. in Chicago, calculates that the household sector will lose $3 billion to $5 billion in income this year from rising mortgage rates. "But such income losses will be modest compared to the income gains that would occur if employment growth held at the 2% to 2.5% range," Hale says.

Every 1% increase in employee compensation, he estimates, is worth about $24 billion a year to the economy.

* Corporate profits are booming. Eric Miller, strategist at Donaldson Lufkin & Jenrette Securities in New York, notes that corporate profits have topped expectations for six straight quarters.

That surge in earnings, in large part because of the painful restructurings of the late 1980s and early '90s that slashed corporate break-even points, has given managers a windfall of dollars with which to expand their businesses.

And expansion, in the form of investment in new plants and equipment, is definitely happening, further bolstering the economy. For example, Cimtek Inc., which tracks new-plant announcements nationwide, counted 802 from January through May, up from 591 in the same period of 1993.

In the government's report last week on June manufacturers' activity, factory shipments of electrical machinery rose 1.1% in that month, the eighth straight gain.

* Europe and Japan are on the upswing. After deep recessions in 1993, the economies of Europe and Japan are showing unmistakable signs of improvement. That will almost certainly raise demand for U.S. exports and in general contribute to a stronger global economy all around heading into 1995.

Britain's economy grew 3.3% in the second quarter, the fastest pace in five years, notes Joseph Quinlan, international economist at Dean Witter Reynolds in New York. Elsewhere, housing starts in France jumped 23% in May, he says, and German exports rose 11% that month.

And in Japan, an extreme heat wave this summer is driving a mini-boom in consumer spending (air conditioners, electricity, beer, bathing suits, etc.) while also guaranteeing a bumper crop in rice, Quinlan says.


Given the ongoing boost to the U.S. economy from all of the above, can the Fed make a meaningful dent in growth with just one more half-point boost in short-term interest rates?

Many Wall Streeters doubt it.

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