Last Updated July 1999

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UNE 1999 BROUGHT AN END TO the long wait for the much anticipated "prequel" to the 1970's Star Wars trilogy. It also brought an end to what seemed as long a wait and equally anticipated: the Federal Reserve rate increase. In both instances, the good guys were fighting a phantom menace.

In our little economic drama, the Fed, fearful of the return to prosperity of foreign empires, strongly implied they would need to use the force of higher interest rates to head off this growing menace. In one of his most lucid comments, Alan Greenspan (ambassador of the Fed) telegraphed the impending move this way:

"When we can be preemptive we should be, because preemptive actions can obviate the need of more dramatic actions at a later date that could destabilize the economy."

Only the densest droid could miss the meaning of that. Bond traders (always looking for the darkside) abandoned ship and sent the long bond's yield past 6% and through the critical "support level" of 6.15%. The stock market, with no real equity-related news to move it, followed suit, tumbling on weak summer-like volume.

When the fateful day arrived, the Fed struck raising rates by .25% and announcing a "neutral bias" going forward. The neutral bias essentially means they aren't leaning one way or the other but will keep an ever-vigilant eye on the economy in deciding their next move.

The bond market had actually built a .50% increase into prices so immediately rallied, bringing the long bond briefly below 6%. Subsequent fretting has carried it back up above that level, but well below the support levels breached in mid-June.

The stock market also showed a return to sanity as investors returned to quality growth issues. All major markets hit new highs as July began.

So was this preemptive strike enough to calm the empire or should the markets brace for further battles with inflation (The Return of the Fedi?). Well let's do something radical and look at the facts.

Inflation? What inflation?

But there's a little more to it than that. Unlike some of its predecessors, the Greenspan Fed has been proactive, attempting to stop inflation before it starts. His quote above bears that out. Monetary police has a delay of anywhere from nine to eighteen months, so moves must be taken now to have an impact on inflation arising in that time period.

So far, so good, you probably won't find anyone disagreeing with the timing issue. Where there is room for debate is the belief that inflation really is looming in the future. Those who believe it is (evidently the Fed is among them) usually trot out the usual suspects.

The economy continues to grow at a pace averaging around 4%. Labor markets are tight with unemployment hovering around 4.2-4.3%. Consumers continue to spend and the savings rate (at least as measured by the government) is actually negative. To anyone who's had a freshman economics course, any one of these things can lead to inflation, much less a conglomeration of all of them.

Phillips Curve or Shotgun Blast?

But you know what? None of this necessarily follows. And no, this isn't saying, "It's different this time." Quite the contrary, it's more likely that it never really was that way.

You see, the reason economic growth, low unemployment, and consumer confidence raises the specter of inflation is the belief that they all ultimately lead to higher price levels. After all, consumers are willing to buy, companies are willing to produce, and they have to pay up for good employees in a tight labor market.

This relationship between unemployment and the inflation rate can be neatly summed up in a relationship called the "Phillips Curve". Essentially this is a graph showing a trade-off between unemployment and inflation. It's supposed to be an inverse relationship -- when one's high, the other's low. That's what leads to the belief that when unemployment is low, inflation must be high or at least on the way up.

A similar graph has also been postulated showing the direct relation between economic growth and inflation. In other words, when growth goes up, so does inflation. In the 1970's and 1980's when these constructed, they were taken as facts.

But now that the real facts are in, a different picture emerges. Ed Keon, Director of Quantitative Analysis at Prudential Securities, recently published a study based on data from 1949 through 1998. Instead of finding nice straight lines showing the relationships between unemployment and inflation and growth and inflation, he found their charts more closely resembled shotgun blasts.

More precisely, he found that the correlation coefficient is only slightly negative for unemployment and inflation, while it was actually -0.23 implying there was a slightly negative relationship between real growth and inflation. So much for freshman econ.

That's why things aren't different this time, they've always been different than the nice simple explanations of the Phillips Curve. In Keon's words:

"U.S. Companies grow earnings fastest under conditions of overall price stability, i.e., neither inflation nor deflation. Economic growth does not cause inflation; rather, low or no inflation fosters economic and earnings growth."

The Darkside

So was the Fed's move appropriate? Perhaps, but it doesn't sound like it was made for the right reason. In testimony before Congress, Chairman Greenspan indicated that he was concerned about the current economic growth rate, implying he would be more comfortable with 3% rather than 4%. If Keon's analysis is correct (and we think it is), the Fed shouldn't be concerned about growth rates or even minute changes in inflation. Instead they should be making their decisions based on what is needed to maintain price stability. Hopefully, that's what they debated and why they acted.

The Fed's vigilance against inflation should be good news to the bond market, but oddly enough, it really wasn't. Despite coming back from their June lows, bonds really haven't responded nearly as positively as you would have expected. The long bond that started the year near 5%, still hovered around 6% following the Fed's action.

This, of course, is due to the naturally pessimistic tone of the bond market. Bond investors always fear further attacks from the darkside. In this case, the concern is that .25% wasn't sufficient to stop the inflation menace and that futher hikes are on the way. Some have gone so far as to speculate that the Fed will end up raising rates .75-1.00% before they're done.

As is often the case for the bond market, this prediction is probably overly pessimistic. While it's entirely possible (perhaps even likely) that further rate increases will be necessary in the future, there's little to indicate they should be imminent.

As usual, the bond market has overreacted. A range of 5.5-5.75% is probably more appropriate so current levels may provide short-term buying opportunities.

May the Force be with Stocks

In April and May, the threat of higher inflation led to a rotation out of large cap growth stocks into smaller, value-oriented equities. Instead of paying a premium for future earnings, investors sought safety in dividends and the recovery potential of neglected value stocks. Suddenly the Dow outperformed the tech-heavy NASDAQ and the Russell 2000 outperformed the S&P 500.

This of course actually reversed in June when it became apparent the Fed's move would be modest. At that point, large cap growth stocks had fallen well off their highs and investors again saw them as "fairly" valued. By early July, most major market measures had resumed their climb to new highs.

In general, this is both good and justified. The latter part of June and early part of July, traditionally "earnings confession season" for those companies that will miss their earnings estimates, concluded with far fewer companies stepping forward with hat in hand. Sure there were big announcements from the usual suspects (Compaq, Gillette, and Advanced Micro Devices), but those are now regular quarterly events.

When released, second quarter earnings should be the strongest in quite some time -- after all, isn't that why the Fed and the bond market are concerned? If stock investors aren't encouraged by this, what will it take?

Large Caps, Small Caps & Inflation
Total Return
Period	S&P 500	Small Caps	CPI
1926-1998	13.2%	17.4%	3.2%
1973-1983	9.9%	24.8%	8.3%
1994-1998	24.8%	14.1%	2.4%
1952-1955	25.4%	19.4%	0.4%
Source: Donaldson, Lufkin & Jenrette

Maybe this will: Thomas Galvin, Chief Investment Strategist for Donaldson, Lufkin, Jenrette, points out, a little inflation is actually good for smaller stocks. That's right, although small caps have outperformed larger stocks over the long-term, most of this outperformance was achieved in periods of high inflation. The accompanying chart illustrates this.

If Galvin's right (and he appears to be) a broader number of stocks will lead the market higher, breathing further life to the decade-long bull market. So much for the phantom menace.

The Empire Strikes Back

In the short-term, economically sensitive stocks and those with the highest P/Es will be most susceptible to further interest rate fears. In this time frame, consumer staples and communication services stocks will probably be the best bets.

Longer term, technology, healthcare, communication services will regain leadership. Before this can happen though, the techs will have to emerge from their seasonal summer doldrums, the threat of your president's silly Medicare prescription drug proposals will have to fade, and your government will have to stop delaying consolidation in the communication industry.

Although the Fed may have some sequels to the June rate hike, the rest of the year should be favorable for the financial markets. We can all take comfort in the fact that we are being protected by Mr. Greenspan and his Fedi Knights.

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