The Amazing Boom Machine

By Stephen Koepp

It was a week that started a million telephones jangling. Eager investors rang their brokers to buy stocks, driving the Dow Jones industrial average up a record 92.91 points to an all-time high of 1792.74. Happy homeowners phoned bankers to refinance their mortgages at interest rates not seen since 1978. Economists called up clients to report that U.S. growth will be more robust than almost anyone had expected. Corporate treasurers got on the speakerphones with their investment bankers in New York City to talk about financing bold projects with multimillion-dollar bond issues.

Bullishness was busting out all over. Nearly everyone from consumers to financiers was celebrating the belief that the 40-month-old economic recovery, which had slowed late last year to a 1.2% annual growth rate, is accelerating to a faster pace of 3% or more. Even better, many experts think the industrial world's economies are entering a new era, in which low oil prices are triggering a whole series of positive trends, thus creating a boom machine that could hum smoothly for several years.

The machine first started to crank up in 1982, when oil prices began to fall. Cheaper energy helped pop the inflation bubble, which in turn enabled Federal Reserve Chairman Paul Volcker and his counterparts in other countries to let interest rates decline. That development sparked a long-running bull market on stock exchanges from Wall Street to Tokyo. And when oil prices went into a steep decline over the past three months, the boom machine shifted into high gear. Says James Sweeney, director of the Center for Economic Policy Research at Stanford University: "We see a significant number of happy events."

Taken together, the positive forces have created what Economist Dimitri Balatsos of the Kidder Peabody investment firm has called a "virtuous cycle." This cycle is a mirror image of the vicious spiral of the 1970s, when soaring oil prices and roaring inflation created rising unemployment, slumping stock prices and economic stagnation. Now things are going the other way. Exults Barton Biggs, chief portfolio strategist for the Morgan Stanley investment firm: "It's like watching the movie of the 1970s run backwards."

While falling petroleum prices have grabbed most of the attention, an army of other friendly forces are at work. The decline of the U.S. dollar by about 30% since its peak in February 1985 will help beleaguered U.S. exporters boost business by making their products more competitive with foreign rivals. Meanwhile, the decline in global interest rates will ease the burden on staggering debtors, ranging from U.S. farmers to developing countries like Brazil and Argentina. And even one of the thorniest problems of them all, the U.S. budget deficit, is becoming slightly less severe.

Cautious forecasters point out, however, that the boom machine still has a few weak spots. The oil bust, for example, has threatened the stability of energy firms and banks in the Southwest. "There are always things that can go wrong," concedes Beryl Sprinkel, chairman of President Reagan's Council of Economic Advisers. "But I'd say they are minimal at the present time, and the things that can go right are pretty evident."

They are certainly evident to the bulls on Wall Street. The Dow Jones industrial average has posted all-time high closing levels on 36 different afternoons since last October, when it began the current spurt at 1350. On Tuesday of last week the Dow ran up its second-largest one-day gain in history, jumping 43.10 points. It leaped an additional 39.03 points on Friday. The New York Stock Exchange recorded its busiest week in history, trading an average 176 million shares a day.

Investors are exuberant, partly because they anticipate that lower borrowing costs will give a huge push to corporate profits. "The blizzard of earnings disappointments in recent years is essentially past," says Donald Straszheim, Merrill Lynch's head economist. The Data Resources forecasting firm expects a 10.7% rise in after-tax profits next year and an impressive 18% boost in 1988.

Many market watchers think the Dow will smash the 2000 milestone before the end of the year. Says Robert Farrell, Merrill Lynch's chief market analyst: "Stocks are having a once-in-a-generation move." The falling yields on savings instruments like money-market accounts will help the stock market keep its momentum because many investors, notably those with Individual Retirement Accounts, are seeking better-paying places to put their money. Even so, some experts contend, Wall Street investors have grown a bit too giddy about the economy's prospects. The naysayers predict that the Dow could stumble if the bulls suddenly start having doubts. Says Lawrence Chimerine, chairman of Chase Econometrics: "The market is already way ahead of what is likely to happen in the economy."

The other side of Wall Street's boom is bonds. During the past four weeks, Wall Street investment firms sold bonds worth a whopping $28.9 billion. Reason: companies are rushing to raise capital by issuing bonds at new, low interest rates. The rate on a top-quality, long-term corporate bond, for example, has dropped from about 14% in 1981 to 9% now. The lower cost of borrowing will propel the economy by encouraging investment. Last week the Conference Board, a business-supported study group, reported that the 1,000 largest U.S. manufacturing companies plan to spend $108 billion this year for new plant and equipment, a gain of 8% over 1985.

Stock and bond rallies can also lift the rest of the economy by creating a so-called wealth effect among consumers. Investors who hold bonds that were issued during the interest-rate bulge of the early 1980s have seen them skyrocket in resale value because the certificates earn much more than the new ones sold today. Similarly, the total value of publicly traded stocks has risen more than $500 billion during the past year. About one-third of U.S. households own some stock, and the profits that they have earned are likely to encourage them to increase their spending on everything from compact disks to compact cars.

Meanwhile, the interest-rate plunge has roused a sleeping giant: the housing industry. Last week mortgage lenders were charging about 10% on 30-year conventional, fixed-rate home loans, compared to 13% a year ago. Says John Duffy, president of the Philadelphia Board of Realtors: "We are just seeing an absolute avalanche of buyers coming in." The surge in the home-building industry will spread to many related businesses as well, from furniture makers to shingle producers. The number of housing starts reached an annual rate of 2.1 million in January, up from 1.8 million the previous month and a low of 1.1 million in 1982.

Volcker's Federal Reserve Board has been able to allow low interest rates to work their magic because inflation remains only a distant threat. In fact, the Labor Department announced last week that wholesale prices actually deflated in February, falling by 1.6% from January, the biggest one-month drop since record keeping began in 1947. The Consumer Price Index, which peaked at a raging 13.3% in 1979, increased only 3.8% last year. Moreover, the expected increase in U.S. economic activity, which ordinarily might send wages and prices sharply higher, is unlikely to do so this time, because factories have plenty of spare capacity and the labor force still contains 7.3 million jobless workers.

Inflation seems so weak that many businessmen and economists think the Federal Reserve could allow interest rates to fall even further without risking a jump in prices. Says Edward Yardeni, chief economist for Prudential-Bache Securities: "Lower rates could deliver us into the golden land of zero inflation and 6% economic growth. So why not ease?"

But Volcker, who had to push up interest rates in 1980 to conquer inflation, has reason to remain vigilant. One threat that could fuel new inflation is the falling value of the dollar, which pushes up the prices of America's imports. German automakers, for example, are increasing their prices by as much as 6% to offset the dollar's decline.

On the other hand, the higher cost of imports will help domestic companies sell more goods and generate new jobs in the U.S. Walter Heller, a University of Minnesota professor who was chairman of the Council of Economic Advisers under Presidents Kennedy and Johnson, predicts that unemployment will fall from its current level of 7.3% to 6.4% by the end of the year. Even more optimistic is Economist David Levine of the Sanford C. Bernstein investment-research firm, who forecasts that joblessness could dip as low as 5.2% in the fourth quarter.

The drop in interest rates has helped ease the U.S. budget crunch because it now costs the Government less to borrow money. New 30-year Treasury bonds are currently paying 7.95%, compared with 11.86% for those issued a year ago. Data Resources calculates that the decline in borrowing rates will help reduce the cost of interest payments on the nearly $2 trillion national debt by about $5 billion, to $143 billion this fiscal year. In a report issued earlier this month, the Congressional Budget Office projected a drop in the federal deficit from a record $212 billion in fiscal 1985 to $104 billion in fiscal 1991.

Many economists, however, consider the CBO forecast to be overly optimistic. Says Alan Greenspan, who was chief economic adviser to President Ford: "The probabilities for a significant deficit reduction have improved only modestly." Greenspan thinks that Congress and the White House cannot afford to lose their sense of urgency about cutting spending.

The improved economic outlook results in part from a new pattern of cooperation among the members of the so-called Group of Five--the U.S., Japan, West Germany, France and Britain. In its early years, the Reagan Administration was often reluctant to coordinate economic policies with its trading partners. Instead, the White House preached the gospel of free markets. But last year the Administration decided that persistent economic problems called for global remedies.

Treasury Secretary James Baker and the finance ministers from the other four G-5 nations gathered in September for a now famous meeting at the Plaza Hotel in Manhattan, where they drafted a successful strategy for pushing down the overvalued U.S. dollar. Then in January, the group met again in London, where Baker pressed the other ministers to lower their interest rates as a stimulant for the lagging world economy. After a few weeks' hesitation, the central banks obliged earlier this month in a flurry of interest-rate cutting. Says Robert Hormats, a partner at the Goldman Sachs investment firm: "Baker realizes that you can no longer make economic policy only in Washington, because what happens in Japan and West Germany tremendously affects what we can do."

The dollar decline has been the salvation of many U.S. companies whose products had become overpriced in foreign markets. Control Data, the ailing Minnesota-based computer maker, has recorded a sizable boost in overseas orders for their large mainframe machines. Other companies should feel the same lift. Data Resources estimates that total U.S. exports, which declined 2.9% last year, will increase 5.5% in 1986 and 11.3% in 1987. The gain in exports will help control the U.S. trade deficit, which hit a record $148.5 billion last year.

The boom machine is starting to churn in other industrial countries as well as in the U.S. In France, where newspapers have referred to the cheap oil windfall as "manna," energy users will save about $9 billion on their $26 billion petroleum bill this year. In West Germany, the saving on gasoline is expected to be about $89 per driver in 1986. The country's growth rate is forecast to hit 4%, up from 2.4% in 1985. The break in oil prices helped push down Italy's annual inflation rate during February to 7.6%, its lowest in almost 14 years. Italian bankers think the country's 16% prime rate will drop by two or three percentage points this year.

The falling dollar, however, has forced some painful adjustments among U.S. trading partners who had grown accustomed to an easy American market. The transition could cause heavy losses for companies like Airbus, the European aircraft-building consortium that competes for business with America's Boeing and McDonnell Douglas. Some Japanese companies are already being hurt because of slowing exports to the U.S. "Right now we are in the midst of a storm," declares Kenjiro Hayashi, chief economist with Nomura Research Institute.

While the oil-price drop benefits most countries, it could have grave consequences for debt-ridden oil producers such as Mexico, Venezuela and Nigeria. Mexico, which owes $97.7 billion and depends on oil for 70% of its export income, estimates that it will need another $6 billion in loans this year just to meet payments on old debts.

The U.S. has its own depressed oil patch, whose troubles could conceivably dampen the overall economic boom. Texas, Oklahoma and Louisiana have been plagued by bankruptcies and layoffs. If oil prices average $15 per bbl. for the rest of the year, oil industry profits will plunge by as much as 65% and heavily indebted companies like Phillips and Texaco will start to suffer losses in the $300 million-a-year range, according to Charles Cahn Jr. of Sanford C. Bernstein.

Moreover, some economists believe that low energy prices could prove to be a long-term curse for the U.S. by reducing domestic exploration and boosting the need for oil supplied by the Organization of Petroleum Exporting Countries. "By about 1990, demand for OPEC oil will increase. It puts you right back in the soup again," predicts Henry Lee, executive director of the Energy and Environmental Policy Center at Harvard. Indeed, last week Exxon said it would reduce its capital and exploration budget by 26%, to $8 billion this year.

But whatever the long-term perils of cheap oil, they seem remote when compared with the benefits being showered on the world economy. Most economists are convinced that, at the very least, another year or two of solid growth lie ahead. "When it comes to economic forecasting, there can be no guarantees," says Irwin Kellner, chief economist for Manufacturers Hanover bank. However, "the outlook is about as definite as it could be, so relax and enjoy it." The boom machine shows no current signs of slowing down, and until it does, the bulls of Wall Street may keep right on running. --By Stephen Koepp. Reported by Christopher Redman/Washington and Frederick Ungeheuer/New York OIL PRICE

Refiners' acquisition cost of crude oil in dollars per bbl. (year's average) 1981 $35.24 1982 $31.87 1983 $28.99 1984 $28.63 1985 $26.76 March '86 $18.60[*] INFLATION

% increase in CPI (annually) 1981 8.9% 1982 3.9% 1983 3.8% 1984 4.0% 1985 3.8% Jan '86 4.1% INTEREST RATES

Yield on 30-year Treasury bonds (year's average) 1981 13.44% 1982 12.76% 1983 11.18% 1984 12.39% 1985 10.79% Week ending March 14 7.95% DOW JONES INDUSTRIALS

Year's closing 1981 875.00 1982 1046.54 1983 1258.64 1984 1211.57 1985 1546.67 March 14 '86 1792.74

[*]Estimate by Data Resources

With reporting by Christopher Redman/Washington, Frederick Ungeheuer/New York