Jude Wanniski
January 4, 1999


In this week's (January 4) Barron's, Joanne Lublin asks eleven forecasters to predict 1999, including the Dow Jones Industrial Average and the S&P profit growth at year's end. There are the usual incongruities. Merrill Lynch's Charles Clough sees the DJIA at 10000 and S&P profits down 5% while Goldman Sachs' Abby Joseph Cohen has the DJIA lower, at 9850, but S&P profits up 5-7%. DLJ's Thomas Galvin is easily the boldest in picking the DJIA at 11000 and S&P profits up 12%, but he has the long bond at 5.75%, an impossible combination in our model that reminds us the Phillips Curve lives on in Wall Street. Most of the forecasts, in Barron's and in today's WSJournal, suggest the kinds of illogical combinations that can only come from a neo-Keynesian model that equates growth with inflation. What interested me most about the article is Ms. Lublin's comment that these "largely comfortable forecasts all came packed with warning labels" about Y2K. In other words, a year from now all eleven can say their forecasts were off the mark because of this unknown, which now is not predictable.

Because we don't think there is much value in a forecast that leaves aside major contingencies, we really can't be as precise as we would like, as precise as we have been in the last several years. A year ago, we saw a DJIA hitting 9000 during the year and then tailing off to 8800 at year's end. We thought the long bond would strengthen to 5.5% as Fed Chairman Alan Greenspan would at some point turn from fighting inflation to worrying about deflation. At midyear, our analysis became even more precise as we grew impatient with Greenspan on July 28 and said the market would head south until he was satisfied it was low enough to infer an end to inflation. On September 1, when the DJIA hit bottom, we said so, although continuing to argue that the broad low-cap market, the Russell 2000, would still need an end to the monetary deflation. The year-end rally did lift the Russell so that it ended the year with a loss of only 3.45%, but that still is in line with a broad weakening of the economy as we head into 1999.

As the biggest unknown, Y2K forces us to conclude that it will be a drag on equities as we get closer to 2000. That is, in a vector analysis of the forces impinging upon the DJIA and S&P500, the biggest negative push will come from Y2K and the push will increase the closer we get to the end of the year. How much? It still is too early to say, but with everything else being equal in our vectoring, Y2K alone could easily put the DJIA below 7000 in a worst-case scenario, primarily because of the impact it will have on international trade. Most economists pooh-pooh the problem (Stephen Roach of Morgan Stanley comes to mind) because they believe any weaknesses can be offset by other macro-economic policy tools. Hey, print more money. Or, they do not appreciate the linkages that could bear down on major companies, which themselves insist they are Y2K compliant. The best metaphor I've heard yet is from Paul Bond, who heads our Y2K special service unit, who compared the problem to lights strung together in series on a Xmas tree, where the whole tree goes dark because one bulb blows out. Eventually, the Y2K glitches will be fixed, but in the most troubling scenarios, it may take several months or most of 2000 to clean up the mess.

The problems associated with Y2K can be minimized by corrective economic measures, but as the Asian crisis showed, quite often policy fixes make matters worse. The Smoot-Hawley Tariff Act that caused the market crash of 1929 is almost exactly the kind of shock that Y2K could produce, impacting international trade. The whole world is working away to produce goods for trade, and when a new tariff wall goes up in the biggest market, surplus goods pile up everywhere on either side of tariff walls. Smoot-Hawley took a 40% bite out of the exhuberant DJIA between Labor Day 1929 and the end of October, taking it to 230 from 380. It was the second and third shocks -- foreign retaliation and the Hoover tax increases -- that did most of the damage, taking the DJIA to its bottom of 41 in 1932. If the IMF and World Bank are manning the fire hoses with their current personnel when Y2K hits, the Asian crisis we've come through will look like a picnic.

In our vectoring, the most positive force pulling the DJIA forward is the fact that the world remains at peace, which enables our political leaders and those in other countries to use their energies fixing the mess left by the 20th century and the Cold War. Our own federal budget will be in surplus for years even if nothing is done to push for more rapid economic growth to erase the projected deficits in Social Security and Medicare. There is zero talk of tax increases, which means there is no chance surplus liquidity will cause a new inflation. We expect the Fed to cut the funds rate twice more this year in response to the economic weakness caused by the deflation, and while this will not raise commodity prices, there will be new pressure on the Fed from the commodity sector to shift to commodity targeting. Indeed, Jack Kemp, who met with Greenspan last month to argue for such a shift and thinks he made some slight headway, has been in discussions with the American Farm Bureau Federation and independent oilmen, whose companies and communities and their banks are being hammered by the deflation. Kemp also believes the dollar/gold price should be fixed by executive order this year to cushion the Y2K effects. This kind of development could turn the sow's ear of Y2K into a silk purse.

The papers today are heavy with articles on how the Euro might hurt the dollar by replacing it as a reserve currency and driving up our borrowing costs and interest rates. This is silly cash-flow Keynesianism. As long as the Fed is targeting the funds rate to add or subtract liquidity, there will be no effect on exchange rates because of the Euro. If at the margin a Euro replaces a dollar this year as a reserve currency, the dollar will show up at the open-market desk in NYC and be absorbed by the sale of interest-bearing dollar debt. The only loss to the United States would be some seignorage, at most this year a billion dollars from what it otherwise might be. This is an inconsequential amount given the benefits to the world economy because of the common currency in Europe. The Euro will hold together this year, but if Y2K has variable impact on the 11 nations of Euroland, the system could be put under severe political strain in 2000. Let's hope not. And by the way, the Internet will do for the world by orders of magnitude what the Euro will do for the economy of Europe. The Internet is essentially a U.S. monopoly that can't be replicated abroad. The rest of the world will benefit enormously, but this is where the action will be and where it will remain.

In the political realm, I don't expect a major impact on the market if the President is convicted of the impeachment articles and is replaced by VP Al Gore. There now is no discernible policy change that would occur. If Kemp were to decide to enter the contest for 2000, there would be positive effects on the market. His positions are different enough to affect the debate and thus market dynamics. With him in, the market could make it above 10000 even with the Y2K drag. Otherwise we expect the DJIA to climb to midyear, then slide back at year's end to roughly where it is now. Y2K should help push the long bond to 4.5% by midyear and 4.25% yield by year's end. This, at least, is the framework of our market thinking as the year begins.