Money: Boom, Then Gloom


The remainder of 1984 should be, on balance, a big plus for the economy, for the American stock market, and for various other types of investments. But, looking ahead to 1985, get ready for the return of inflation and prepare to shift your investment strategy. First, let's look at the economic outlook for 1984.

Once again, the federal budget deficit will be very high, although probably not as high as the fiscal 1983 deficit of $195 billion. The trade deficit will probably greatly surpass last year's $70 billion. The budget deficit tends to keep the trade deficit high by pushing up interest rates and in turn the dollar, making US goods less competitive.

Notwithstanding the deficits, though, the economy should neither slip back into recession nor into inflation—not yet, anyway, for the economy has a number of buffers protecting it. One of these buffers is an unexpectedly large increase in business savings. Despite Federal Reserve chairman Paul Volcker's recent warning that Treasury and private credit demands are already straining the money markets, business as a whole actually has large amounts of surplus cash and thus does not need to borrow.

Thanks to rising profits, low inflation, wage restraint, and the 1981 business tax cuts, corporations are enjoying record cash flows, which enable them to invest heavily in Treasury securities even after making their own capital investments.

Economist Allen Sinai estimates that business savings due to President Reagan's reduction in corporate income taxes and accelerated depreciation schedules will have reached $181.7 billion by 1985—nearly $65 billion in 1985 alone, after savings of $37.6 billion in 1983 and $51.8 billion in 1984. So, despite the federal drag on the economy, business is planning a 9.4 percent increase in spending on plant and equipment in 1984.

In addition, recovery-generated increases in revenue and diminished demands for social services should reduce the deficit by at least $20 billion. At least through 1984, then, the government should be able, in effect, to get away with running large deficits. Therefore, federal financing pressures figure to be considerably less onerous than generally anticipated.

If, in addition, inflation remains moderate, interest rates should come down, relieving pressure on the dollar and making American goods more competitive. Lower interest rates would also mean lower servicing costs on the national debt.

Expect the Federal Reserve to do everything in its power this year to reduce interest rates. It will have relatively favorable conditions to do that this year, given the factors mentioned above plus the slowing of the recovery. But it will do so at the cost of long-range inflationary dangers.

Yet another potential buffer for the American economy is the emerging global economic recovery. Worldwide economic growth will not be dramatic in 1984, but any increase will redound to the benefit of the United States in the form of increased demand for American goods.

Looking beyond 1984 and the probable landslide reelection of Reagan, the outlook is not so rosy. As Lawrence Kudlow, former chief economist for the Office of Management and Budget, writes in his Foxhall Review, a budget "strategy where outlays will absorb 24 percent of GNP, deficits absorb 5 percent of GNP and 81 percent of net private savings, is not compatible with strong growth, moderate inflation and falling interest rates."

At some point late this year or early next, we will suddenly realize that both the recovery and disinflation have been undermined by the pressures of the deficit. Without major fiscal policy changes, which are unlikely, a number of things will happen as the recovery matures. The conflicting demands of the public and private sectors will begin to put inexorable pressure on interest rates. Bank and corporate demand for Treasury securities will evaporate. The Fed will be forced into the breach to make sure there is enough money and credit available to finance the deficit while keeping the economy alive.

As interest rates are kept artificially low, while the balance of payments continues to look sickly, the overvalued dollar will finally begin to fall—and fall dramatically—with two effects. First, no longer will we be able to buy foreign goods at bargain prices: more costly imports will feed directly into higher producer and then consumer prices. Second, the influx of foreign capital will halt and then reverse, making the deficit even harder to finance without resort to expansionary monetary policies.

What does all this mean for the investor? For most of 1984 it means prospects for more good profits in the stock market. There's also a good chance for a substantial bond rally as the Fed gets interest rates down around mid-year, if not sooner.

The best bet will be growth stocks. And most of the growth will be in the technology area. "About halfway through 1984 investors' focus will shift to earnings prospects in 1985 and beyond," says the California Technology Stock Letter. "That's when the technology stocks, with their long-term growth rates of 15–50 percent, will stand out."

Another good bet for 1984, for perhaps 10 percent of a portfolio, is foreign securities. The generally good performance of foreign stock markets in 1983 should be repeated in 1984, as recovery abroad picks up speed. The best bet is Japan.

Later in 1984, the worm will begin to turn in favor of inflation hedges. Inflation will not return to double-digit levels this year, but the markets will begin to anticipate it. Gold, silver, and the platinum-group metals will finally start their long-awaited resurgence toward year-end.

The dollar will probably begin its slide even before then. Those with a speculative turn of mind will be able to make large profits going long in such currencies as the Japanese yen, German mark, and Swiss franc. The less speculative can hold foreign-currency-denominated CDs (certificates of deposit) abroad or invest in foreign securities.

The one thing that could nix this admittedly gloomy forecast is if the Fed simply refuses to permit another resurgence of inflation and takes the politically unpopular course of letting the economy lapse back into recession. But if it tried such a policy, the Fed would likely have its hand forced the other way.

Steve Beckner is a financial reporter and columnist for the Washington Times and the author of The Hard Money Book.