U.S.: A Less Exuberant Wall Street Isn't All That Bad

That, and consumer moderation, should forestall the need to hike rates

The economy has grown just shy of 4% for two years in a row now. Will 1999 be a threepeat? Not without a hand from Wall Street.

A key driving force of this economy during the past two years has been unusually stimulative financial conditions. The 67% surge in stock prices and the drop in long-term interest rates from 7% to 5% propelled domestic demand like an afterburner last year, sending spending by U.S. consumers and businesses soaring at the fastest clip in 14 years. Some of that momentum is still evident in early 1999. But if you expect an encore of 1998's muscular economic growth, capped off by an upward-revised 6.1% pace in the fourth quarter, you must also be looking for even more thrust from further gains in stocks and bonds.

And there's the problem. Heading into March, long-term interest rates have moved up sharply, with the yield on 30-year Treasuries up to 5.68% on Mar. 3, from 4.94% on Dec. 10 (chart). The bond market fears that the Federal Reserve might lift short-term rates in the face of a relentlessly strong economy. After all, even manufacturing, hit hard by the Asian crisis, is looking stronger. Moreover, stock prices have gone nowhere so far this year, as interest-rate and profit worries weigh on investors.

The good news is that this moderation on Wall Street is a plus for the outlook--as long as it doesn't turn into a rout. A more temperate financial climate may well ease the economy back into a sustainable cruising speed and allay worries that the Fed might have to hike rates. Higher long-term rates and a diminished wealth effect from stock prices would slow growth in consumer spending and housing. Also, higher borrowing costs, along with already sluggish profit growth, will put a damper on capital spending.

HOUSEHOLDS ARE THE SECTOR to watch. Taken by themselves, consumer spending and homebuilding accounted for nearly all of last year's economic growth. Capital spending also contributed positively, though only about a third as much as those two, while foreign trade subtracted heavily from overall growth.

Last year, inflation-adjusted consumer spending rose 5.2%, far ahead of the very healthy 3.5% growth in aftertax income (chart). The difference was achieved through stock market gains, without which the overall economy would have grown much more slowly--by more than a percentage point.

More important, consumers carried over some of their 1998 momentum into 1999, though household buying in January eased a bit from recent months. Outlays for goods and services rose a slim 0.1% in the month, dragged down by a drop in car buying, vs. the incentive-driven surge in December car sales.

Vehicle demand shot up in February, but first-quarter sales may still only match the fourth quarter's pace, so overall growth in consumer spending this quarter is likely to be less than the fourth quarter's 4.5% growth rate. As of January, household spending grew at a 2.2% annual rate from the fourth quarter, but that pace is likely to pick up by the quarter's end, given the February strength in car sales and weekly surveys of retail activity.

INDEED, EVEN IF THE ADDED BOOST to spending from stock and bond gains continues to wane, the labor markets are strong enough to support growth in consumer spending in the 3% range. Although below last year's pumped-up pace, that still counts as solid growth by historical standards. Moreover, the job markets show no sign of loosening up. New claims for unemployment benefits remained at a 10-year low through late February.

However, the backup in long-term rates, and thus mortgage rates, will crimp housing, which already appears to have peaked. January sales of new single-family homes dipped to an annual rate of 918,000, the second drop in a row after hitting a record 1 million pace in November.

That ebb is consistent with recent declines through February in both mortgage applications to buy a home and the homebuilders' index of market conditions. And in the first week of March, fixed mortgage rates jumped a quarter-point from the previous week. Fewer sales will mean not only fewer housing starts in coming months but also less demand for home-related consumer goods that were a big contributor to household spending last year.

Less accommodative financial conditions would also act as a further restraint on capital spending already hobbled by waning profit growth. Business outlays for new equipment and buildings grew at an annual rate of only 7.3% in the second half of last year. That was down from 17.4% in the first half, and the slowest two-quarter pace in three years.

The capital-spending slowdown is evident in both equipment and in new construction. Production of business equipment, especially industrial machinery, has fallen off sharply in recent months, and in January, output was below its fourth-quarter level. Also, business construction outlays are running far ahead of new contracts. Although outlays on current projects are still rising, the value of new contracts has fallen 14% since last August. That suggests that as buildings are completed, there are few new projects on the drawing boards to keep builders working.

IF DOMESTIC DEMAND SLOWS in 1999, it will come at an inopportune time for U.S. manufacturers--just when they are showing signs of getting back on their feet after the Asian crisis hammered exports. Without soaring U.S. demand last year, manufacturers would have been in even worse shape than they were.

Now, the drag from the Asian crisis appears to be waning. Manufacturers' orders for durable goods jumped 3.9% in January, following a 3.4% advance in December. Although aircraft bookings boosted the January total, the recent trend in orders is up, and the backlog of unfilled orders is rising.

The February index of industrial activity, compiled by the National Association of Purchasing Management, rose nearly three points, to 52.4% (chart). That was the first reading above 50%, the dividing line between growth and contraction in manufacturing, in nine months. The NAPM's index of new orders led the gain, and the index of export orders rose above the 50% threshold for the first time in 15 months. Keep in mind, however, that global conditions do not appear to be much better than they were, especially with commodity prices, a good proxy for global demand, still sitting on a 12-year low.

The firmer look of manufacturing was the latest in a series of stronger-than-expected economic numbers that has tempered the mood on Wall Street. But if that also brings more sobriety to Main Street, this eight-year old expansion just might make it through a ninth year as well.

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