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Get Four
|  | APRIL 29, 2004
By Amey Stone An Overheated Economy? Don't Sweat Investors are fearful of interest rate hikes. Chances are, though, that the economy can cool by itself, with minor help from the Fed March and April have been whipsaw months for the market. Investors seem to alternate every few days from worrying that economic growth is leading to an uptick in inflation (it is -- but just a small one so far) to celebrating that the strong economy is generating impressive earnings growth (and is it ever). The bears held sway on Apr. 28, pushing the Dow Jones industrial average down 135 points to close at 10,343. "What we have here is an attempt to look on the dark side by investors," says Milton Ezrati, senior economist and strategist at investment firm Lord Abbett & Co. The past week has been especially volatile as earnings season winds down and violence escalates in the Middle East. Adding to the market's nervousness, an onslaught of major economic news is set to land in the week to come. On Apr. 29, the first-quarter gross domestic product report is due. On May 4, the Federal Reserve Board's rate-setting Federal Open Market Committee (FOMC) meets. And May 7 will bring the April payroll report. BOND MARKET BETS. With all these expected to show robust growth, lots of investors are more worried than ever that the economy is overheating, which will spark the Fed to boost rates sooner and faster than previously expected. Although few economists see the Fed raising interest rates at this meeting, most think it will signal its intention to do so soon. By the end of next week, investors should have a pretty good idea of whether a rate hike will come in June, August, or later this year. Right now, bond market futures are forecasting a 25-basis-point rate hike at the FOMC's Aug. 10 meeting, followed by a couple more at subsequent rate-setting sessions, to bring the Fed Funds rate (now at 1%) to 1.75% by yearend, says Donald Luskin, chief investment officer at research boutique TrendMacrolytics. Several market strategists from firms such as Smith Barney and SunGard Institutional Brokerage are forecasting a 10% to 15% decline in stocks in the coming months as investors adjust to the new reality of a surging economy, higher inflation, and rising rates. However, a compelling argument can be made that any setback in the market based on those fears could be a buying opportunity. Luskin, for one, thinks the recent weeks of consolidation have already provided such a buying opportunity. "I wish there would be a dip here," he says. "I'd love to buy 10% lower." COUNTERVAILING FORCES. Indeed, it's premature to worry too much about inflation now, says David Kelly, economic adviser with Putnam Investments. While first-quarter GDP growth is expected to register 5% or better, it will slow down to "a very comfortable" 3.5% or 4% for the rest of the year, he believes. Even if next week's economic news shows an accelerating economy, the Fed doesn't have to hike rates very far to slow things down a bit. Despite the fact that business spending is finally picking up, several countervailing forces are working to dampen economic growth, completely apart from any Fed action. Consumer spending, which has been growing at about a 4% pace, is bound to slow, says Kelly. Already, long-term interest rates have risen (the benchmark 10-year bond bottomed at 3.68% in mid-March and closed Apr. 28 at 4.5%), and mortgage refinancings have plunged -- down 76% from the peak in May of last year, says Kelly. Stimulation provided by last year's tax act is also drying up now that the refund season is ending. Refunds are up about $20 billion over last year, Kelly says, so as consumers deplete their windfalls, they're likely to shop less. Lastly, wage growth remains slow -- up just 1.8% in March over the prior year. UP TO THE JOB? Along with potentially less robust consumer spending, government outlays will also flatten out, Kelly believes. And Ezrati says the surge in growth in corporate earnings and capital spending will "run its course, too" as the recovery, which took off in the third quarter of 2003, lasts more than a year in high gear. The trick for the Fed will be to convince investors that it can shut off some of the monetary stimulus without either putting brakes on the broader economy or letting inflation run rampant (see BW Online, 4/19/04, "Greenspan's High-Wire Act"). Ezrati believes the central bank is up to the job. Most market participants would pray that he's right. Still, it might help to remember that, with or without a rate hike, the economy is bound to slow down from its current pace. That remains true no matter what next week's news brings.  Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist
BW MALL
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