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5 Scenarios for 1995--and Tips for Investment

October 10, 1994|TOM PETRUNO

Wanted: A winning investment formula for 1995.

The near-term is looking like a stalemate to many Wall Streeters, who figure the markets may remain in a mode of backing and filling while waiting for the next Federal Reserve Board interest-rate hike, probably in November.

The more important issue is what happens after that. As some investors look ahead to 1995, they are increasingly intrigued both with the possibilities and potential pitfalls for stocks, bonds and short-term cash accounts.

With long-term bond yields already at 28-month highs, what if the Fed actually succeeds in engineering a "soft landing" for the economy? Could bond yields tumble?

What if economic growth remains strong in '95 and inflation zooms? Would the markets find that a deadly combo?

And what if, despite all of the current evidence to the contrary, the surprise in '95 is that the economy sinks into recession?

Financial markets would probably play out very differently under each of these scenarios. Here's a look at five scripts for the economy in '95, and how investors might structure portfolios accordingly:

* A soft landing. This is the most optimistic bet on Wall Street today. It assumes that the Fed raises short-term interest rates two more times at most, that real economic growth moderates from the current 4% range to about 2.5% in '95, and that bond yields level off or fall back.

Executives of some of the nation's biggest companies, meeting last week under the auspices of the Business Council, indicated their faith in a soft landing by projecting 2.6% economic growth in 1995.

They also expect the federal funds rate, a key short-term interest rate, to rise from 4.75% now to 5.5% in 1995. But long-term rates should hold steady, the council says.

If they're right, bonds are a great buy today, Wall Streeters say. With 30-year Treasury bonds yielding just under 8% currently, and many corporate bonds yielding nearly 9%, the after-inflation return on long-term bonds is 5% to 6% if inflation stays around 3%.

"There haven't been a lot of times in U.S. history when you've been able to earn 5% real returns," says Jack Kallis, manager of the Met Life/State Street Government Securities bond fund in Boston.

John Williams, economist at Bankers Trust in New York, is even more optimistic: He thinks slower growth and modest inflation will allow 30-year T-bond yields to fall to 7.25% in '95, giving bond owners a capital gain on top of interest earnings.

For stocks, meanwhile, a soft landing would probably be the best possible scenario. Corporate earnings would continue to advance, while investors would no longer face the threat of ever-rising interest rates. The bull market could conceivably resume.

* Strong growth/low inflation. This is what we've enjoyed so far this year, and the only real winners have been investors who have dis- invested--that is, people who have stashed cash in money market funds or other short-term accounts, reaping the rewards of rising short-term interest rates.

If economic growth stays strong in 1995, it's a sure bet that the Fed will continue to push short-term interest rates up sharply. Money market fund yields, now around 4.3% on average, could approach 6% by late-1995 if the Fed raises rates another 1.5 to 2 points.

So keeping hefty assets in short-term accounts would be a winning plan in '95, if you think the economy isn't going to slow soon.

But if inflation remains moderate even though growth is strong, must long-term interest rates continue rising as well? Some pros don't think so. They see a "flat yield curve" on the horizon: That is, short rates go higher, but long rates stay level or decline.

The result would be that short rates could nearly match long rates by late '95, or even exceed them. That has been a fairly common toward the end of economic booms.

"I think there will be an unmistakable tendency for the yield curve to flatten and eventually invert" next year, says Anthony Karydakis, economist at First Chicago Capital Markets.

The trick then would be to ride short rates up, then lock in long yields when it appears that rates overall have peaked. But such timing is no easy feat, naturally.

Art Steinmetz, manager of the Oppenheimer Strategic Income bond fund in New York, argues that investors who expect the Fed to keep pushing up short rates in 1995 should be in no hurry to grab long-term bonds. He is dubious that long rates can decline while short rates are rising, even if inflation remains tame.

Historically, "long-term bonds cannot rally until the Fed is done tightening," Steinmetz says.

As for U.S. stocks, strong growth and much higher short rates in 1995 might mean a repeat of '94. Some stocks would be driven by rising corporate earnings, but overall the market would be fighting a vicious head wind. Note, however, that many foreign markets might not face the same rate pressures, and could thrive.

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