Threats to the Bull Market Jude Wanniski June 17, 1997

The forward surges in world financial markets seem to be looking past the current political rapids in North America, Europe and Asia and seeing a broad expanse of blue water in the world political economy. At home, there are two worries: one that the Fed will raise interest rates next month or soon thereafter, the other that the budget deal will break down without meaningful increase in the rewards to capital. In Europe, there are two worries: one that the “bubble” will burst on Wall Street, the other that the fresh political crisis over monetary union will somehow undermine equities. In Asia, there are two worries: one that China will stumble in the handoff of Hong Kong on July 1, the other that the United States will stumble over trade and political issues involving its relationship with Beijing. If all six of these worries are resolved in the weeks and months ahead, our January 2 guess that the Dow Jones Industrial Average could go as high as 7800 would be left in the dust. The fact that the DJIA’s nose is already nearing the 7800 wire represents the market’s judgement that blue water is more likely than not. Let’s briefly review the six worries.

1. THE FED: Chances of a Fed interest-rate increase in July or soon thereafter have dwindled to about one in five. I’m now fairly confident that Alan Greenspan led the March rate increase in order to assuage those Fed governors and regional presidents who pressed for a rate increase last fall. The White House stood still for the increase because it knew Greenspan did the President a favor by not tightening in the midst of the elections. With gold at $342, nicely below the $350 Greenspan prefers and the $360 that would begin to make him nervous, he can sit back and enjoy life. Vice Chair Alice Rivlin is still making Phillips Curve grumbling noises about keeping the economy from growing faster, but we must surmise she is auditioning for Greenspan’s job. We can assume that if there is no crisis at the time Greenspan’s term expires in July 2000, the President and Hillary will relish naming the first distaff Fed Chairperson. 

2. THE BUDGET: The Republican fiasco with the disaster-relief bill reminds us that House Speaker Newt Gingrich can single-handedly jinx the budget deal. Senate Majority Leader Trent Lott and House Majority Leader Dick Armey cannot count on him for any coherent strategic thinking, as he is afraid of offending the Democrats who made a fool of him in the 104th Congress. By consciously tagging the President “a spoiled brat,” Lott has elbowed Gingrich aside and announced that he is not afraid of hand-to-hand combat with Bill Clinton. The weapon he has chosen is tax cuts at dawn -- the best weapon Republicans have had these past 20 years. The President is threatening to veto a GOP tax bill, but that is pro forma at this stage of the game. He will veto, though, if Lott cannot come up with a strategy to alter the public-relations momentum that now favors Democratic liberals, who want to water down the capital gains tax cuts until they are meaningless. Lott will probably get a good number from the Congressional Budget Office when it revises its projections of economic growth this summer, taking into account the tax bill that the President threatens to veto. This would give Congress enough new revenue to cover the “costs” of the tax cuts and thus checkmate the liberals. Lott’s problem is that neither the calendar nor his GOP Senate colleagues are working in his favor. They want the tax bill passed before July 4 and out of the way, before new revenues arrive from the CBO. House Ways&Means Chairman Bill Archer has been playing his cards well, now announcing that he expects there will be another tax bill in 1998 to use any new revenues that show up because of economic growth -- to cut tax rates again. This will not make the markets happy this year, though. Until we see a sound strategy from Lott, we see somewhat less than a 50/50 chance of decent tax cuts this year. 

3. THE EURO: I’m just back from a week in Switzerland and England, the two European countries that are for the moment standing aloof of the developing EMU crisis. The several dozen asset managers with whom I met seemed very receptive to my argument that the French electorate did the European economy a favor by throwing out the Gaullists and forcing a pause for reflection. The average 11% unemployment rate across Europe only could get worse if the Germans and the Eurocrats force the mechanics of the new currency down the throats of the people of Europe. There is even a broad chance that Tony Blair can play a positive role in getting the continent to rethink the process by which Europe can get to a common currency. There was surprising understanding and receptivity to my arguments that it will be impossible for Europe to make the euro work without using gold as a numeraire, more likely a gold dollar. In any event, there is now less likelihood austerity will be forced on Europeans in the near future.

4. EUROPE AND WALL STREET: If the budget deal falls apart here and tax cuts go down the drain, it will weaken the ability of the Fed to manage liquidity. We would expect a significant correction on Wall Street. Because we are at the top of the global financial pyramid, our weaknesses and strengths travel throughout the world. They hit hardest among our neighbors in North America and among our trading partners in Europe. If we hold up, Europeans will have more room to sort out their current political problems and cause fewer feedback problems here.

5. HONG KONG: With only two weeks to go before the July 1 handoff, it appears all is well. We think the chances are excellent that there will be a successful transition -- because the mainland Chinese and HK Chinese want it to be successful. There’s really nothing anyone else can do about the transition at this point, except to cause a disturbance on the ground to provoke the authorities. A surprise disturbance would cause a temporary run on financial assets in the region, but if the ruling elites of HK keep their heads, the disturbances would be very temporary.

6. MFN: It appears MFN is in the bag for China for another year, given its support by the White House and the Establishment. If provocateurs in HK cause political disturbances in the period ahead that are not handled well by the authorities, MFN would not be in the bag. If all goes smoothly, we should see a general advance of the financial markets throughout Asia as this primary political risk is lowered. China would have added to its $120 billion in monetary reserves the $80 billion of Hong Kong. This $200 billion war chest -- as big as Japan’s -- would then be sufficient to help China take the next step on the capitalist road, to full currency convertibility. Its cash earnings from exports could then be deployed to import capital goods, which would cause positive feedback effects here, in Japan, and throughout SE Asia. China’s surplus on the current account would be moving next year toward at least balance, if not deficit.
 
As noted, the weakest link, the biggest of these six worries, is the ability of the Republicans to bring home at least the kind of meaningful tax cuts we see in the House bill voted by Ways&Means on Friday. Chairman Archer’s promise of a tax bill next year, to incorporate revenues that may show up later this year, may give Lott and the GOP something to work with in this year’s legislation. The problem is complex and I don’t see any easy answer. It would produce so many benefits in reducing the other five worries, though, that it is worth Lott’s time to explore for an answer.