This morning’s Wall Street Journal runs its semi-annual survey of 57 economists who forecast the U.S. economy at mid-year and the end of 1997. They also forecast the dollar/yen rate at those two points. Years ago, when Alan Reynolds was chief economist here, Polyconomics participated in this roundup. Because there isn’t space devoted to the reasoning that underpins any of the numbers, though, it doesn’t strike us as being particularly useful to display an enormous matrix of numbers attached to 57 names. It may be more useful to use the Journal exercise as a springboard into our own thinking of where the economy and markets are headed in 1997.
What strikes us is how low the forecasts are in predicting Gross Domestic Product (GDP) for both the first and second halves of the year. The consensus sees a 2% increase in GNP (annual rate) both in the first half and in the second. The most pessimistic is John Mueller of LBMC, who a year ago predicted recession for ’96, and carries that forward with a (-1.3%) in the first half and (+0.3) in the second. The only economist of the 57 who predicts a GDP higher than 3% for the first half is William Dudley of Goldman Sachs, at 3.2%, slipping to 2.3% in the second. But he has the long bond climbing to 7.2% at midyear and 7.4% by year’s end! For this reasoning to make sense, Dudley has to be seeing a dramatic decline in the stock market. That is, he must see the robust economic growth he predicts in the first half being wrestled down by Fed Chairman Alan Greenspan through a series of interest-rate increases. Yet, at the same time, he sees the dollar/yen rate going to 105, which does not make any sense given the rest of the scenario unless the Bank of Japan tightens monetary policy in the teeth of its own economic decline. Dudley, by the way, six months ago forecast a 7.4% long bond at year’s end. It closed at 6.64%.
Our own bullishness a year ago, seeing a DJIA topping 6000 in 1996, was based on two assumptions we thought solid enough to support such a forecast. One was that the presidential campaign would shift toward a growth agenda, because of the role Steve Forbes played as catalyst. The other was that President Clinton would reappoint Greenspan, who had learned the lesson that real inflation could not be fought by higher interest rates and a weaker economy. The gold price did not respond to his series of interest-rate increases, but inched its way down as he left interest rates alone and economic optimism about the election outcome began to take hold. With gold at $368, there is every reason to expect that Greenspan might be able to get it to $350 before the end of 1997. This is likely to happen if President Clinton and Senate Majority Leader Trent Lott maintain a level of bipartisan harmony between the White House and Congress. That harmony must produce a cut in the capital gains tax, at a minimum, which would enable the economy to expand at its base through productivity gains.
We don’t bother predicting GDP because it has so little utility as an accounting tool. That is, there is no way of telling from the number itself whether it reflects growth through muscle or brainpower, through labor or capital. Two economies can grow to 1100 from 1000, which means GDP has increased 10%. But if one has grown with more man-hours worked, the other with fewer, we get completely different pictures. Indeed, for years we were told that the Soviet Union was keeping up with us on GDP, but only by having the entire population working like dogs. I’d rather have nominal GDP grow more slowly, but with enough productivity gains via capital growth to have real wages steadily rise. This is what we expect to see throughout the year. When this is translated into the stock market, it will mean slower growth of the Dow Jones Industrial Average and faster growth of asset values closer to the base of the economy. Say, the NASDAQ minus Microsoft and Intel, or the Russell 2000. In 1996, the DJIA was up 24.5% while the Russell 2000 was up only 14% -- slightly below the high point it reached last May. This is because the older enterprises benefit more from Greenspan’s Fed policy than do the little guys. In our model, the conditions for faster growth are seen in the extent to which the market increases its capacity to absorb risk, at the margin, by placing a higher value on lower-cap relative to higher-cap equities. At least part of the gains in the DJIA this year -- particularly after the mid-year correction -- reflected “defensive” strategies, in the sense of capital being drawn to those companies likely to be affected least by lower growth expectations.
With a 15% capital gains tax, we would expect these numbers to reverse, the Russell 2000 rising 25-30% and the DJIA up 15-20% -- between 7400 and 7800. Economic growth then could accelerate at the base, among the small enterprises which would find capital more readily available and earnings rising smartly. Instead of the 2 or 2.2% GDP growth rate in the consensus, it then could push above 3%, with the quality of the GDP composition improving. The long bond would weave its way below 6% as Greenspan then could get the gold price closer to $350 without deflationary strains. The long bond should end the year, in the modestly positive scenario, below the 5.87% it reached in September 1993.
With gold at $350, where might we expect the dollar/yen rate? Much of that depends upon what happens in Japan, in both tax policy and monetary policy. Tokyo’s determination to balance the national budget with fiscal austerity seems to point toward at least a modest easing of money. If the yen price of gold gets to ¥45,000, where it belongs anyway, and where this scenario would take it, the dollar/yen rate would be 130. This number is higher than any forecast by the 57 WSJ economists. Only Edward Yardeni of Deutsche Morgen Grenfell comes close, at 128 by year’s end, 120 six months from now. While we are not told of Yardeni’s reasoning, the set of numbers he presents have an internal consistency, unlike many of the others. He does see the economy accelerating in the second half of the year and the long bond ending at 5%. A. Gary Shilling has the yen at 125, but with the economy decelerating and the long bond at 7%, a combination of numbers that he seems to have arranged by throwing darts.
The kinds of things most likely to disrupt this modestly positive scenario all involve politics. Our biggest concern, though, is not that Newt Gingrich will not be elected Speaker, although we certainly hope he is. There will not be an outburst of partisanship over Newt that destroys any chance of harmony on economic policy. He’d be a more effective Speaker having been hobbled, with his rabid backbenchers no longer demanding he walk through walls. Our greater concern is that there will be a knockdown fight over the CPI adjustment, which is another in a string of backdoor brainstorms to balance the budget by spending cuts. It would not be the White House that gets in the middle of this fight, but Republicans arguing among themselves over “how to pay” for tax cuts with cuts in entitlements. Trent Lott will have to drive a stake through its heart, or at least throw it into an entitlement commission headed by someone who is not going to be fooled by the idea that this is simply a “technical adjustment.”
When the 105th Congress comes to order on Tuesday, we will be rooting for Newt, but even more so for Trent Lott, who is going to be the man in charge of getting things done. If he can get enough done with the Clinton team in the first six months, the economy can cruise through ’98 as well.