That Fragile Recovery

Brazil's crisis was another blow. But this time, markets are relatively calm

It didn't take much. The news that the state of Minas Gerais in Brazil--a region few U.S. investors could find on a map--was balking at government austerity measures sent markets tumbling on Jan. 12. The next day, despite assurances by President Fernando Henrique Cardoso that Brazil wouldn't let a provincial default bust the national budget, the government bowed to the inevitable. The head of the central bank resigned, and Cardoso announced that Brazil would allow a controlled devaluation of the real, which promptly dropped 8%. Once again, the world was reminded that the recovery from the emerging-markets crisis remains fragile.

The good news is that after repeated scares, the markets weren't badly rattled by the Brazilian meltdown. The flight to quality that had suddenly shaved the yields on U.S. government securities just as quickly eased, relieving fears of a return to the liquidity crunch that threatened global recession last fall. And stocks in the U.S. bounced back from what could have been an ugly sell-off. The Dow Jones industrial average closed on Jan. 13 off 125.12 after plunging 261 points early on, while the NASDAQ recovered from a 100-point fall to end the session down a mere 3.94.

Wall Street's rapid recovery may say more about how markets have learned to absorb global shocks than about the shocks themselves--and the very real risks they pose. The world has long expected Brazil to be the next financial shoe to drop, which is why the International Monetary Fund had cobbled together a $41.5 billion package last fall to stabilize the country's economy. Still, the devaluation caught U.S. officials by surprise. Deputy Treasury Secretary Lawrence H. Summers, President Clinton's financial crisis point man, canceled a Jan. 13 trip to New York to manage the latest ordeal.

RISING RATES. The markets' relatively calm reaction to Brazil's devaluation shows how much investor confidence has solidified since last summer and fall, when Russia's default on its foreign debts and the rescue of the massively leveraged hedge fund, Long-Term Capital Management, created a near panic. "As far as financial earthquakes go, Brazil isn't as bad as the Russian crisis," notes David M. Jones, chief economist for Aubrey G. Lanston & Co., a New York securities trader.

Even so, Brazil's woes threaten the U.S. economy more directly than Russia's or Asia's. Brazil is the 11th-largest export market for U.S. companies. And U.S. bank exposure to Brazil through Sept. 30 was $18.6 billion. That's equal to half of the outstanding U.S. loans to all of Asia, excluding Japan--which is why many investors and policymakers viewed a Brazilian devaluation as the potential trigger for spreading economic misery throughout the hemisphere.

That would be a sharp change from October, when the deepening global crisis had a perversely positive effect in the U.S. While exporters and domestic industries such as steel took hits, the flight of capital from Asia found a safe haven in the U.S. The result: a strong dollar, low inflation, and falling rates that kept growth rocking along.

Now, the U.S. could be in for a different scenario: a falling dollar, increasing inflation, and higher interest rates. Why? Forces in place before the Brazil shock are still at work and, unless the real goes into total free fall and takes down the rest of Latin America, these forces are likely to prevail.

What's different now is that capital has begun to trickle back to Asia, and investors are flirting with the new euro, which debuted Jan. 4, as a would-be reserve currency. In fact, the dollar fell by more than 1% against the euro on the day of the real's devaluation because of worries about the effect on the U.S.

But the biggest issue for the U.S. may be pressure on long-term interest rates. The 30-year Treasury had risen steadily from its low of 4.7% last October 5, and was as high as 5.37% just before the Brazilian devaluation. The crisis briefly pushed it down toward 5%, but it was climbing on Jan. 13 and ended at 5.13%. Some economists still see it rising more in 1999. "It can definitely break 6% if the recent trends we've seen continue," says John E. Silvia, chief economist for Chicago-based Kemper Funds.

A rate rise of that magnitude isn't about to stall the 93-month expansion, a peacetime record. But higher rates would mean a slowdown from the economy's current growth clip of nearly 4% and a further squeeze on corporate profits, which could slow the bull market's unrelenting runup.

WEAKER DOLLAR? Among those expecting a slower economy this year is Federal Reserve Chairman Alan Greenspan, who cut short-term interest rates three times in 1998 to keep the world financial crisis from spiraling out of control and dragging the U.S. economy down. In a Jan. 11 speech to a group of fellow central bankers in Hong Kong, Greenspan said that any slowdown would be only "relatively moderate," a hint that he sees no need for further cuts.

Though Greenspan spoke before the Brazilian crisis erupted, he's unlikely to change his views now, says Aubrey G. Lanston's Jones, a veteran Fed watcher. "I don't think Brazil will shake him the way Russia did," says Jones. "I wouldn't expect Greenspan to come running to the rescue with another rate cut." That's one more reason forecasters are raising their interest-rate projections.

After a year of handwringing over the Asian crisis and the prospect of a global slump, many economic forecasters are surprised by the jump in rates. But then, they didn't expect U.S. growth to be so strong in the fourth quarter. Nor did they anticipate glimmers of recovery in parts of Asia--particularly South Korea--and a falling dollar. These factors all put upward pressure on rates. "The days of the strong dollar are in the past," predicts Joel L. Naroff, chief bank economist at First Union Corp.

With the U.S. expected to log a record current-account deficit of $230 billion for 1998 and $285 billion this year, Naroff's forecast looks like a safe bet. Already, J.P. Morgan & Co. calculates that the dollar is down 9% on a trade-weighted basis from its August high. It has taken the biggest hit from the Japanese yen, which soared 32% in five months, to 108, until the Bank of Japan intervened on Jan. 12 by buying dollars. But the dollar is also off 10% against non-Japanese Asian currencies and 7% against European currencies that now make up the euro, which some forecasters are betting will appreciate another 5% to 10% against the dollar.

The euro's lure, along with the shift of funds to Japan has put the dollar in a "squeeze play" that's driving up U.S. bond rates, says William H. Gross, managing director of Pacific Investment Management Co. in Newport Beach, Calif. But he adds that the higher yields won't last unless inflation accelerates.

That is exactly what some economists now expect. More stable prices for commodities and imports, rising health-care costs, and wage pressures across the economy should push U.S. inflation from a three-decade low of 1.5% in 1998 to about 2.25% in 1999, predicts Wayne D. Angell, chief economist at Bear, Stearns & Co. Angell notes that two-year Treasury notes are already up nearly a full percentage point, to 4.75%, since mid-October. With the financial crisis spreading closer to the U.S., that wouldn't be such a bad scenario--even if long-term rates are 0.5% to 1% higher.

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