As we contemplate 1990, we recall the common prediction a year ago of an "overheated" economy in 1989. On March 21 it was a heresy for us to write: "we doubt that inflation has moved to a higher path, or that the Fed can safely stay as tight as it is, much less push fed funds [then 9.85%] higher....We expect that the Fed will let the fed funds rate drift down by a percentage point or two." Our May 31 call for a 2800 top on the Dow this year, without a cut in the capgains tax, is also close. Bonds have had more trouble than we expected staying "well below 8%." But the direction has been right and we believe a 7.5% yield is not far off.
Our optimism about stocks and bonds for 1989 was never based on a "rosy scenario" for the economy. In the June 30 outlook, we wrote of "a period of economic weakness such as the one we are already in," and noted that "any risk of recession would be much sooner than the consensus expects — most likely starting this fall. Yet the probability of two consecutive quarters of negative GNP is nonetheless fairly small." On July 21, we again stressed that "moderate stagnation this year will be followed by a moderate recovery next year, as inflation and interest rates decline and capacity and personal wealth increase."
This remains our view: Much of the trouble is probably behind us, largely caused by consumers rebuilding net worth by postponing major outlays and by the squeeze on profit margins inherent in any disinflationary monetary policy. Once some manageable inventory excesses are worked off, albeit with unprofitable discounts, we expect key leading indicators of a recovery (some of which, like housing and building permits are already turning up) to move less ambiguously upward within a few months.
As we anticipated November 27, impulsive predictions of a "severe downturn" on the basis of October industrial production and retail sales must now be reconsidered in the light of November increases in industrial production and retail sales. As we then noted, accumulated gains in real income and wealth throughout this year explain the high level of consumer confidence, and imply that it will not be difficult to unload inventories before Christmas. There will be more unprofitable discounts, to be sure, which is part of the disinflation process, but no enormous overstock dragging the whole economy down.
A more plausible case for a serious recession does not derive from the monthly figures, but is instead based on weak profits and the supposedly high risk of business failures due to heavy leverage. The charts below try to put these issues in perspective. Although aggregate operating profits (with the proper inflation adjustments) have indeed been a bit lower all year than in 1988, they have actually held up remarkably well considering big write-offs in financial industries and virtual stagnation of industrial production and construction since April. With actual and expected reductions in costs of raw materials, credit and labor, as well as increased domestic and foreign sales, profits should pick up next year without big price hikes. And with reduced inflation, the quality of profits should improve. Together with our expectation of continued progress in reducing bond yields, and reduced fears of recession, the overall outlook should support 3300 on the Dow later next year — with much better and earlier gains if we get a good capital gains tax bill.
The chart, "Liabilities of Business Failures," shows two things. First, except for April and August, failures have been smaller in 1989 than in 1988, and the cumulative losses have also been smaller. Second, failures amounting to two or three billion dollars a month may make headlines, but they aren't really particularly large relative to GNP, or to the many trillions of dollars of business assets. Bankruptcy results in new owners and managers of the affected companies, and to losses for a typically small number of financiers, but it very rarely means that bankrupt companies keep their doors closed forever, so it need not have much effect on output or income.
In the next few months, a crucial issue for investors will once again be the capital gains tax. Capital gains is very much alive as a legislative prospect next year, with Senate Finance Chairman Lloyd Bentsen indicating he's willing to try again with a package that includes a 50% exclusion for IRAs (e.g., $1000 of $2000 saved would be tax-free). He thinks chances are better than even that he'd get the package out of his committee if the administration plays its cards right. The White House has no strategy cooked up that we know of, but Richard Darman, who would be doing the cooking, is immersed in budget making and will not surface for another few weeks. The liberal Democrats still believe this is a winning issue for them and will fight tooth and nail, however. The strategy that can work, conservative Democrats will agree, is if Bush presents it as part of a competitive strategy for the 1990s in dealing with a robust Europe and thriving Asia.
Treasury officials have been trying to get nebulous concepts about "savings incentives" into the State of the Union address, along with the familiar insults about businessmen (unlike politicians?) taking a "longer view." Yet others involved realize that a more specific emphasis on capgains, perhaps mentioning a potential bipartisan compromise on IRAs, holds far more promise than such rhetoric. Treasury was of minimal help on capital gains this year, and the issue is again likely to depend instead on Executive staff and key Congressmen. Something like a simple cap on the capital gains tax, such as 25% the first year, 20% in the second and 15% in the third could easily be sold to Congress in a package with Senator Bentsen's 50% exclusion for IRAs, perhaps with indexing as an option or for gains after three years. A very small tax on very short-term gains from pension funds is shaping up as the "revenue enhancer" that serves as a catalyst, though it could damage market liquidity and new issues if carried too far, and also yield no revenue (pension funds would just sit on blue chips).
The Fed's FOMC meets next week against the background of apparent weakness in some key sectors, notably autos. But it is hard to make the case that auto sales are mainly held back by interest rates, since producers can and do offer low-rate financing. Besides, the Fed is constrained by the strength of the German mark (due to high real interest rates in Germany, as well as premature euphoria about an integrated and enlarged Europe). Within the G-7 pact, the Fed can't ease right now unless Germany does. Yet with the recent 6-month CPI near 2% in Germany, there is little excuse for German money market rates to be as high as in the U.S.
Progress toward European monetary union should be hastening activity in the Bush Treasury toward some strategy to coordinate monetary policies, which would help put downward pressure on U.S. and German interest rates, but we don't see any such action from Mulford and Dallara, who openly applaud a softer dollar and thus keep U.S. interest rates up a bit longer. Secretary Nick Brady goes into the hospital for hip surgery and will be inactive for quite a while, Treasury becoming even more of a shell than it has been.
Recent speculation in gold, which may already have run its course, has also restricted the Fed's room to maneuver. Easy capital gains from hoarding tangible assets are rarely good news for financial assets. We would be surprised if the Fed eased at all before gold gets below $400 again, as we believe it will. Ending the speculation in tangible assets would be best achieved by luring the world into U.S. equities, with the promise of renewed economic progress, rather than by simply luring hot money into short-term securities with high interest rates. If we see progress on capgains early in the year, as we expect, and an inspiring State of the Union message, investment demand for dollars will pick up again, gold will fall back toward the $360-370 range, and the Fed would then be able to ease early and often, the financial markets booming. Without capgains, the interest rate decline would be glacial at best, gold hovering near $400 in early 1990. A tough Fed is not bad for bonds in the longer-run, though, even though it may keep more money parked in bills for a while, since interest rates ultimately have to come down as inflation does.
We doubt the gold price run-up has anything to do with speculation the Soviets may be doing a gold ruble reform in three to six months, as the WSJ suggested this week. We see no political signs of movement in that realm. The issue was not discussed at all at Malta, we hear. The report this week that Moscow has again deferred price reforms to 1991, and that Gorbachev has come up with a timid new incremental reform plan, indicates things will have to get even worse in the USSR before they'll be ready for ruble convertibility, or even gold bonds.
Rep. Richard Gephardt's shot at CEA Chairman Michael Boskin for having once served on an economic advisory panel to Japan reminds us rabid nationalism is alive in the land. There's concern throughout Washington, in both parties, that President Bush misplayed his hand in China, with the Scowcroft mission. But we're rather more sanguine there, suspecting it is somehow an extension of the recent Nixon visit. With the holiday season upon us, it seems the whole world has gone into a sudden lull after the dramatic political avalanche of the last several weeks. We're treading water along with everyone else, waiting to see where the waves will break. The water's a bit chilly, and choppier than we've seen for awhile. If we were managing money, we'd be keeping some powder dry, prepared to move more cash into equities with progress on capgains, continuing to put somewhat more faith in bonds in the meantime, and looking for marginal opportunities in both fixed-income and equities of emerging foreign markets.