In 'Paradise Economy,' Door Open to Surprises

What economic news will knock the stock market off its up escalator?

The return of inflation? Disappointing corporate earnings? A sudden shift in the dollar's fortunes? Or a crisis in the oil markets?

At the moment, the prevailing view is that none of these events are likely. A recession next year is considered improbable. In fact, some economists see no recession for years ahead, creating the longest expansion in US history. Interest rates, they say, may dip further, but not a lot more. Business promises to be good, but not great. Merrill Lynch economist Bruce Steinberg sums it up in two words: "Near Nirvana."

For much of Wall Street, economic paradise is low inflation, modest growth, and a shrinking federal deficit. "I believe such blissed-out economic conditions can continue well into 1997," Mr. Steinberg says.

The economic molasses has prompted some conjecture that the Federal Reserve has figured out a way to eliminate the business cycle - the recessions that often follow the spurts of growth.

Steinberg disagrees. "We are doing incredibly well, but we have not repealed the business cycle. Somewhere at some point, something won't work out and we'll go into a recession."

Still, recessions aren't in most economists' vocabulary for next year. The November survey of 53 economists by Blue Chip Economic Indicators found the forecasters expect only 2.2 percent real growth in 1997. Two economists predict zero or negative growth - and a minor recession - while another pair expect a flashier 3 percent annual growth.

The economic outlook has helped propel the Dow Jones industrial average to numerous records this year, including its first close above 6500 - Nov. 25.

Yet, even without a recession in 1997, risks lurk for stock investors.

Some economists are grinding their teeth over the outlook for corporate earnings. Company downsizing and restructuring has helped make earnings sizzle this year. Securities analysts who follow individual stocks are generally optimistic about 1997 earnings. But looking at the big picture, other observers are not so certain.

Richard Rippe, chief economist at Prudential Securities Inc. in New York, expects profits will be "less robust, as slower [economic] growth translates into slower revenue growth." He predicts corporate profits will climb only 2.8 percent next year compared with 7.1 percent in 1996.

One potential drag on profits: inflation. The low unemployment rate could give workers the leverage to ask for big wage increases. That, in turn, is one of the basic ingredients of inflation.

Christopher Low, a senior economist at HSBC Markets in New York, sees "scattered reports" of sizable wage increases in the Midwest, where the labor markets are the tightest.

The higher wages may not be cause for too much concern. Wage growth has been so subdued, the Federal Reserve recently suggested the country can absorb some wage hikes before there is any impact on prices. It is one area that Wall Street will be watching as 1997 unfolds.

"Unless the higher pay is accompanied by higher productivity, it puts pressure on profit margins," frets Dan Seto, a New York economist at Nikko Securities Company International.

For now, inflation seems dormant. "The consensus predicts that inflation will remain relatively low on a historical basis for the seventh year in a row," says Randell Moore, executive editor of the newsletter Blue Chip Economic Indicators in Sedona, Ariz.

Concerned about the possibility of any inflationary flame erupting, the Federal reserve will keep a rein on economic growth. But for now the Fed is expected to keep interest rates steady.

"Rates are on hold well into next year," predicts Steinberg of Merrill Lynch.

Though critics attack the Fed for being too restrictive, many economists view Alan Greenspan as one of the most successful Fed chairmen ever. And if the next few years prove recession-free, the current 5-1/2-year expansion could beat the current record-holder, the 1961-69 period.

But some economists wonder if the stock market has become overly enthusiastic - perhaps expecting the economy to be much stronger than it will turn out.

"One thing we will learn in 1997 is whether the market is a good predictor of the economy," says Gary Shoesmith, director of the Center for Economic Studies at Wake Forest University in WInston-Salem, N.C. "We can certainly say that the market is not expecting a recession."

One wild card: the consumer. The Conference Board's index of consumer confidence remained buoyant in November. But Americans have increased their debt loads to record levels.

"Early signs suggest consumers have finally noticed that their balance sheets are in lousy shape and have become stingy at the mall," Mr. Shoesmith says.

If it doesn't lead to a recession, consumer restraint could at least affect corporate earnings. And Shoesmith says that past consumer pullbacks have signaled periods of very slow economic growth. "In other cycles, a recession has not been very far behind this kind of plateau," he says. But if incomes rise, consumers may find a way to "muddle through."

One growth area for the economy is expected to be in durable equipment such as computers. This is reflected by the surge in the stock of such companies as IBM Corp., which has led the Dow's November charge.

"The automation of the American factory and office building is going to carry the economy for a very long time," Shoesmith says.

It looks like most elements of the economy will remain in low gear - which apparently is what the stock market is looking for. At least until investors change their minds again.