| "Most economists don't tend to be right about the economy." |
| -- Cedd Moses |
FTER AN INCREDIBLE OCTOBER and November, both the stock and bond markets seem to have hit some resistance. The Dow set a new high in late November, only to slide back 7%. It's been range-bound ever since. After trading as low as 4.7%, the long government bond seems stuck back up at 5%. Where do we go from here?
The Fed did its part by cutting rates at its regular September and October meetings. They even threw in a special bonus cut in early October. This was quite a turnabout since our central bankers spent the earlier part of the year fretting over potential inflation and possible rate increases. They remained on the sidelines at the December meeting leading some to speculate the cuts may be over. Are they?
As we enter 1999, there's more unknowns than usual. Your president's been impeached, foreign economies are still far from healthy, and Y2K looms. There's a lot more going on here than a simple interest rate forecast and stock market prediction. Where do you start?
The Usual Suspects
As random walk adherents, it's only logical to start with last year's biggest influences. That brings us back to the Fed. These conservative bankers finished 1998 in a very accommodative mode -- well at least for them. Their autumn rate cuts reversed a swooning stock market and breathed additional life into the bond market. What possessed them?The short answer is the lack of available credit. When the stock market dropped this past summer, liquidity had almost totally dried up in the credit 
markets. Skittish investors sought the safety of Treasury securities, sending them to their lowest levels in 30 years. At the same time, spreads between them and corporate obligations of equal maturities balooned to historic levels.
The Fed interpreted this as meaning investors were willing to pay excessive premiums for the relative safety of Treasuries while funds available for corporate borrowing were rapidly dwindling. Banks contributed to this concern by tightening lending requirements fearing defaults in a slowing economy. The Fed remembered the last time they failed to head off a credit crunch and the recession it engendered. Learning from their past mistakes, they lowered rates in rapid succession.
It worked. Yield spreads between treasuries and corporates retreated to normal levels. The stock market staged a remarkable recovery. The domestic economy continues to move ahead, albeit slowly. Some additional time has been bought for foreign economies to hopefully regain their footing.
Fed Up?
With all this accomplished, is the Fed done? You might think so with the stock market now 3000 points above the level that initially led to fear of "irrational exuberance". The failure to act at the December meeting further bears this out. Odds are, the Fed's in a wait-and-see mode. They'd probably be happy if no additional action was necessary, since further easing may ignite inflation in the coming months.But as we move into 1999, additional help will likely be needed. Domestic GDP growth will probably slow from 4% to under 2%. The Fed seems just as determined to fend off recession as they are to fight inflation, so if this GDP projection is correct, they'll need to act again as early as the first quarter of 1999.
Depending on the economy's strength, the Federal Funds Rate (currently 4.75%) could fall as low as 4.0%. In this process, the long government bond could trade as low as 4.5% sometime in 1999 before moving back into the 4.8 - 5.1% range by year-end.
Room to Spare
If the Fed does need to ease to head off recession, concerns about inflation shouldn't stand in the way. 
The CPI continues to be tame while the PPI is flat to down. Commodities continue to set 30-year lows.
Gold can't crack $300 and ounce and in December, gasoline was at its lowest inflation adjusted price since
1912. Contrary to what you might hear from your local NBA owners, wage and price inflation continue to remain quiet.
These trends provide additional room for lower interest rates. Fact is, during the 18 months when the Fed took no action, they were effectively tightening rates. Why? Because the PPI was falling during this time. Without concurrent rate decreases, credit was actually tightening. The Fed governers aren't stupid, they knew this. That's why they felt free to take decisive action last autumn and why they know they still have a .75 - 1.00% leeway if they need it.
That margin won't go away anytime soon, either. With a slowing economy and relatively strong dollar, neither consumer nor producer prices seem ready to spike up. At this point the best guess is for 1999 PPI to be in the 1.4 - 1.5% range, while the CPI should be 2 - 2.5%. Both are well below their historical averages.
Anyone Else Step to the Plate?
But as we've said before (November 1998 True Facts), low interest rates alone cannot sustain an economic expansion. If that were the case Japan -- with a long-term government bond at about 1% -- would be in the midst of one of the biggest booms ever. Instead, just the opposite's true. Why? Because Japanese companies are struggling, no one's spending, no one's buying their products, and no one has any profits. Why borrow to expand capacity when you can't sell what you have on hand now?Low rates have certainly helped U.S. equity markets by holding down borrowing costs providing higher corporate profit potential. They also make stocks attractive relative to low-yielding bonds. Low inflation allows P/Es to rise since investors can confidently pay more for future earnings if they don't have to worry about price erosion. But if we keep relying on rates alone, ultimately we'll end up in Japan's predicament. One way or another, earnings -- quality earnings -- must improve.
Pricing is still tight so for the near future, this isn't the solution. Corporate restructurings and layoffs are again being used as a means of cost cutting but ironically, this could ultimately undermine the main driving force that has kept the U.S. economy afloat -- consumer confidence.
That's right, consumer confidence. Despite all the foreign turmoil, despite domestic political soap opera, and despite declining earnings, consumer confidence continues at remarkably high levels. Consumer spending remains strong while the savings rate approaches zero. It's been speculated that consumers don't see any need to save when the stock market does it for them. After all, if your equity investments in your 401(k) are growing 20 - 30% a year (and that's before the employer match), why do you need to save anything else? The equity market owes its 1998 (and possibly 1997) success to liquidity and retail investor participation. This past year was truly a triumph of liquidity over fundamentals.
Earnings? Who's Got the Earnings?
But consumer confidence won't stay high if the economy slows and jobs are lost. To avoid recession, corporate earnings must improve. In a tough pricing environment, it comes down to a quality balance sheets and managment. Companies that have both will do OK. Those that don't (Boeing, anyone?) won't.The first and second quarters of 1999 will probably be the leanest. Earnings disappointment confessions are already on the rise for the fourth quarter of 1998 and analysts' (they're so reliable) earnings expectations for the full year are already being revised downward.
Yet things should look better as we move further into 1999. Global economies should improve, aiding U.S. exports. Domestic political "issues" should find some sort of resolution. The full effect of the Fed's 1998 (and possible 1999) easings should begin to be fully felt. If the market and the economy can get through the first part of the year, the second half should be easier sledding.
Based on all this, here's some predictions for you: Overall, bonds should be flat, possibly higher at the beginning of the year but falling back to present levels by the end of the period. As a result, bond investors should look to get their coupon and nothing more.
In the equity markets, stock performance should return to the average, if not slightly below, say 9 - 11%. 
Large-caps will continue to outpace small and mid-caps until investors are assured the bull market remains intact. Later in the year, small stocks should enjoy greater benefits from lower interest rates and the trend may begin to reverse. Growth will again outperform value -- the 5th consecutive year. Technology, healthcare, and financial issues will do the best, basic materials and capital goods the worst. If oil prices continue to remain low, transports may show some life.
So there you have it, the answers to all your economic questions. Just remember next year at this time when all these predictions have come true, you heard it here first. Also remember, if you can't be right, at least sound confident.
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