Investors: Keep Your Seat Belts Fastened!
NINETEEN-NINETY-ONE has been a good year for Wall Street. Not only have security prices risen substantially, but the underwriting calendar is more robust than at any time since the 1987 stock market crash. Financial engineers collected fat fees for stripping more than $600 billion of equity out of United States corporations in the 1980s with leveraged buyouts and other techniques.
They are now beginning to put some of that money back. It will be expensive, and profitable, to undo the mischief of the past decade. Small wonder brokerage-house stocks are up.
By contrast, times are tough on Main Street. The $47 billion drop in domestic demand last winter made plain that business activity has some distance to drop before it hits bottom. Total employment is still falling. That means that consumer income and outlays will remain weak. Investment in plant and equipment is also now starting to tumble.
While the US trade balance has improved, the major part of those gains was due to lower imports, not higher exports. The International Monetary Fund predicts that the US current account deficit will soar close to $100 billion in 1992 from $38 billion this year. If Europe slides into full recession, the swing could be larger.
The Commerce Department's estimate of a 2.8 percent decline in first-quarter gross national product (output of goods and services) masked the full extent of the deterioration in the American economy. Two items stand out:
First was an unexplained, indeed inexplicable, surge in real consumption of miscellaneous "other" personal services - a grab bag of outlays for items as diverse as haircuts, health clubs, ball games, and private schools. According to the government bean counters, such expenditures jumped at an annual rate of 10.8 percent this winter. This jump was totally out of line with the pattern of consumer spending in all other categories (down).
Second is a purported increase of $12 billion in exports of merchandise from the fourth quarter of 1990 to the first quarter of 1991. The "improvement" in exports appears to be a pure statistical fiction. Measured in 1987 dollars (soon to be the benchmark for real GNP), exports were actually slightly lower during January and February than in the fourth quarter.
Taken together, these distortions add up to more than $20 billion. When the government revises its preliminary GNP estimates at end of May, the net result should be a reduction in the overall total of about $10 billion to $12 billion. That would bring the rate of decline in GNP in the first quarter to 3.9 percent.
Meanwhile, domestic corporate profits have crashed. According to the most recent estimate (which was well below the figures published just a month ago) pretax profits from current domestic operations were annualized at $220.8 billion in the fourth quarter of 1990, down at an annual rate of 32 percent from the summer.
In this setting, interest rates should hit bottom by Labor Day (federal funds, 5.5 percent; long treasuries, 7.5 percent). Rates may well inch up as the economy recovers. However, if inflation remains under control, which is probable, the drop in bond prices should be modest.
Low inflation and relatively stable interest rates will be the key benefits of the Federal Reserve's rigorous monetary policy. Since Alan Greenspan became chairman of the Fed in August 1987, the average monthly gain in total bank reserves has been at an annual rate of less than 2 percent. Under Paul Volcker, the Fed increased bank reserves, which are raw material for the money supply, at an average rate of 9.3 percent.
It should take another three to six months for the Fed to jump-start the economy. The central bank will not flood the markets with money. But even if the money managers were to pump up the money supply at a rapid rate, the recession would still have to run its course.
Despite a fairly confident outlook for the financial markets, investors should keep their seat belts fastened. The economic storm front has yet to pass.