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Jewish World Review Oct. 14, 1999 /5 Mar-Cheshvan, 5760

Lawrence Kudlow

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Y2K will likely bring more prosperity -- SURELY THERE'S ANOTHER recession out there at some point in my lifetime, but as yet I still don't see one -- certainly not in the next year. Y2K, Fed rate-snugging, higher gold, oil, trade deficits, Japanese recovery, presidential elections; all these factors are in the mix. But more prosperity, not recession, is my best guess.

Let's start with the wisdom of the markets, especially the futures markets. Markets are smarter than high-priced econometric models. Ordinary people can derive reasonably accurate economic forecasts merely by following futures market trends each day in the daily newspaper. For one dollar or less.

Take oil, an unexpected problem in 1999. The slope of crude oil futures is backward-bending, and thus suggests lower oil prices in 2000 after a big run-up this year. From today's quote of $21.40 for Dec99, the oil curve slopes down to $18.90 by the end of next year, an 11.7-percent drop.

What's more, newspapers reported earlier this week that a surprise meeting is scheduled for next month in Riyadh and will include Mexico, Venezuela and Saudi Arabia. Will this be the first breakthrough for higher output and lower prices? I always figured that if it only costs $7 a barrel to produce, then a $25-a-barrel selling price cannot last long.

Over time, market forces always prevail over monopolistic cartels. Milton Friedman strenuously argued this in the late 1970s, and after oil was decontrolled in the 1980s he was proven dead right. He'll be proven right again over the next few years.

The Federal Reserve Bank of Dallas recently published a study that suggests the tax-hike effect of oil supply shocks lasts about one year, causing a temporary 0.5 percentage point loss of real GDP, while inflation rises by a similar magnitude. We are getting the temporary inflation hike this year. Next year we'll experience the growth slowdown. But the oil futures curve suggests normalcy after that, with no permanent damage to the trend of prosperity.

Other inflation indicators look equally calm. Gold futures move from $325 today to $332.50 by December 2000, a minor 2.5-percent rise, which is less than the 4.7-percent Treasury bill rate that represents the opportunity cost of the foregone benefit from an interest-earning asset.

So, with the oil threat out of the way and gold prices essentially flat over the next year, broad measures of year 2000 inflation are likely to hover around 1 to 1.5 percent, about the same as this year's core inflation rate. Elsewhere in the precious metals complex, silver and platinum futures prices over the next 15 months are backward-bending. A good sign.

Here's another low inflation indicator. The yield on 10-year inflation-indexed

<<...>> Treasury notes (TIPS) keeps rising, recently hitting 4.12 percent from about 3.6 percent earlier in the year. TIPS' falling price (and rising yield) implies weak demand for inflation protection. Meanwhile, the spread between conventional 10-year Treasury notes and their inflation-indexed brethren remains about 2 percent or slightly less, also signaling a benign consumer price outlook. If future inflation were truly a threat, TIPS yields would be falling, not rising.

Continued low inflation suggests continued economic expansion. Remember, rising inflation is always the number-one prosperity killer, as illustrated during the dark days of the 1970s. But near-zero inflation is a stimulant to growth. Think of it as a tax cut.

Actually, a 1-percent inflation rate implies a rock-bottom 27-percent effective marginal tax rate on real capital gains. For venture capitalists and other high-risk

<<...>> investors who provide the financial oxygen of our Internet economy, the incentive of low inflation-based capital return rewards will keep us churning toward even higher prosperity levels. More stock market rises will capture this wealth-creating process.

Now, there are some negatives in the outlook. Nothing is perfect. For one, the Eurodollar futures market shows a roughly 45-basis-point short-term interest rate increase between now and year-end 2000. Federal funds futures indicate a similar rate increase pattern. So do Treasury bills.

So expect the Fed to tighten policy a bit, probably next winter, though it could happen anytime. This is no big deal. Particularly if the Fed drains reserves to strengthen the international and domestic purchasing power of the dollar, which has lately slipped a bit.

Because the dollar has weakened in relation to foreign currencies and domestic gold and commodities, consumer and business buying power will be less strong, and foreign imports will be less cheap. In other words, deflation has ended. This will translate into a slower pace of consumer spending and corporate investment. Not a downturn, but a slowdown.

Corroborating this, growth of the M2 money supply measure has throttled back from 10 percent to 5 percent this year (measured on a six-month basis). No one looks at the money supply anymore. But I believe the M2 measure is a useful signal of transactions demand in the economy. Though consumer spending is now very strong, and likely to remain so till yearend, look for a softening in year 2000.

On the profit side, credit quality spreads in the bond market have been widening. The differential between Baa corporate bond yields and Treasury rates now stands at 180 basis points, about 60 basis points higher than 1997, and not far from the 210-basis-point spread registered during the credit crunch of 1990. This market price indicator suggests a slower profits rise next year -- perhaps 5- to 10-percent growth for S&P 500 earnings, down from this year's 15- to 20-percent rise.

Also, raw material input prices have been rising much faster than finished goods prices. In the producer price index, for example, intermediate materials have increased at a 6.1-percent annual rate over the past six months, much higher than the 3.4-percent final goods price pace. So for heavy commodity and energy users, expect a mild profit squeeze.


Pulling all this together, year 2000 economic growth looks to be around 3 percent or slightly less. This represents a slowdown from the 4-percent growth trend of recent years, but it would still be a terrific performance for the 10th year of the recovery cycle that began in 1991. Actually, in long-wave terms, next year will be the eighteenth consecutive year of prosperity. Pretty impressive, don't you think?

In stock market terms, my single favorite group for the next year is multinational companies that will benefit from more rapid economic growth around the world, especially in Asia and Europe. Latin growth will be mixed, but Mexico should be outstanding. Argentina may also surprise on the upside.

But let's not forget the technology sector, including the Internets, as well as telecommunications, chipmakers and international banks. And, as always, companies with good long-term growth records are the place to be. In fact, the stock market is the place to be. I believe the year 2000 low-inflation scenario will bring long-term Treasury bond yields back down to 5.5 percent or so. But the real beneficiary of next year's growth outlook will be the stock market. In the long run, stocks always outperform bonds.

Traditional prosperity killers such as high inflation, confiscatory tax rates, re-regulation and protectionist tariffs are nowhere in sight. Indeed, next year's political climate -- driven by New Investor Class desires for streamlined government and wealth-creating tax reform -- is likely to be quite favorable.

And don't forget the gales of creative destruction emanating from even more rapid technological innovation, investment and productivity. The Internet economy is more important than the Fed, a more accurate forecaster than Phillips curve econometrics, and a more reliable investment strategy than short-term timing techniques. Stay the course. Stay invested. Keep the faith; faith is the spirit.

JWR contributor Lawrence Kudlow is chief economist for Schroder & Co. Inc and CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


10/07/99: Clinton's tax-cut veto
10/01/99: What's really bugging the stock market?
09/23/99: Growth Trade
09/09/99: Bad Dollar Logic
09/09/99: Buttered bread
08/31/99: Bull Market Alive and Well
08/26/99: Let Prices Rule
08/19/99: Blame OPEC, Not Growth

©1999, Lawrence Kudlow