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Business Week's Plan for Action
CUT INTEREST RATES
Central bankers of the Group of Seven industrialized nations should coordinate cuts in interest rates to increase global liquidity
CUT TAXES
To promote economic growth, the U.S., Japan, and Western Europe should cut tax rates
LIQUIDATE BAD DEBTS
Governments should broker a deal to wipe out bad debts--and force banks to take a hit for their ill-advised loans
KEEP MARKETS OPEN
Congress should extend NAFTA and give the International Monetary Fund an $18 billion infusion--but only if the IMF adopts pro-growth policies
GET JAPAN MOVING AGAIN
Balky Japan must finally cut taxes and boost liquidity to restore economic growth
TAME HOT MONEY
Developing countries need to avoid capital controls, and instead beef up financial disclosure and bank supervision
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THE FED: NO SIGN OF THE DOVE, YET
Greenspan isn't likely to rock the monetary policy boat
As soon as the Federal Reserve's annual policy gabfest in Jackson Hole, Wyo., broke up on Aug. 30, Alan Greenspan dashed off to one of his favorite summer vacation spots, a tennis camp in California. But you can bet the Fed chairman had his hands full between sets. With Russia in chaos, Asia's currency crisis threatening to take down Latin America, and Wall Street buffeted, Greenspan is the man on the spot. Increasingly, traders, business leaders, and politicians are looking to him to bring stability to a wobbly global economy.
Their advice to Greenspan: a bold interest-rate cut by the U.S. central bank. It would aid emerging markets parched for liquidity and provide a psychological lift to investors who fear the global economy is in a deflationary spiral, they hope. National Association of Manufacturers President Jerry J. Jasinowski, for one, is imploring Greenspan to slash the federal funds rate, charged on overnight interbank loans, from 5.5% to 5%, to ''help prevent the spread of worldwide recession.'' Ford Motor Co. Chief Economist Martin B. Zimmerman agrees on the need for a rate cut, taking note of the ''risk that the financial market instability could erode consumer and business confidence.''
But Greenspan is likely to spurn such appeals, at least for now. The Fed chief has long been praying for a slowdown of the U.S. economy and an orderly correction to an overheated stock market. Now that he has gotten both wishes, Greenspan is not about to rock the monetary-policy boat--as long as conditions on Main Street and Wall Street don't deteriorate much more.
EIGHTIES REDUX? Fed officials say that if more foreign currency crises erupt, sending U.S. markets down, say, an additional 10% or 20%--and creating a worldwide panic--Greenspan might be inclined to jump in with a rate cut to provide some psychological support to global markets. Indeed, some senior Fed officials say that if such a gloomy scenario came to pass, they might push for a coordinated rate reduction with central banks in Europe, where economic conditions also remain relatively strong. There is precedent: The U.S. has coordinated monetary policy with other governments in response to past global crises.
Still, as nervous as they are about global events, Fed officials appear in no rush to act--in part because they aren't sure a rate cut by itself is a magical salve for the world's ailments. True, lower U.S. rates would briefly help the few countries that peg their currencies to the dollar, such as Hong Kong and Brazil. A small rate cut not coordinated with any actions by other countries, however, would do little to pull Asia's struggling economies out of recession--and accomplish nothing in Russia, whose problems stem from a lack of political will to adopt market reforms. ''How would a rate cut solve Boris Yeltsin's real problem--that he can't collect taxes?'' asks one Fed official.
The economies of Korea, Thailand, and other Tigers will start to mend, Fed officials argue, only when they swallow the bitter medicine prescribed by the International Monetary Fund--namely closing insolvent banks, balancing their budgets, and ending the incestuous ties between business and government.
That belief is shared by some Wall Street economists who say that without structural reforms in countries such as Indonesia or Russia, foreign investors are unlikely to return. They say the risk from a rate cut is that any extra liquidity created by the Fed might only flow back into the U.S. and other safe-haven markets, which are already awash in liquidity. ''Monetary policy is not the panacea for the rest of the world's problems,'' says John Lipsky, chief economist at Chase Manhattan Bank, who nonetheless believes the U.S. economy will slow enough on its own to warrant a rate cut.
What's more, most of the Fed officials surveyed insist that a rate cut is out of the question if the U.S. economy remains strong. ''We'd be hard-pressed to do something that wasn't justified by domestic conditions,'' says one insider. ''Our mandate is not to be the central bank to the world.''
So far, the Fed sees few signs that the domestic economy is losing serious altitude. After a temporary lull in the second and third quarters in the wake of a massive eight-week strike at General Motors Corp., some Fed officials are bracing for a snap back in the fourth quarter. Some officials see the possibility of growth above 3%--double the estimated rate for second and third quarters--and maybe as high as 4%. One reason: GM is ramping up production as fast as it can to replenish inventories depleted by its strike. That alone could add as much as 1.5 percentage points of growth in the fourth quarter.
Still, Fed officials acknowledge that the risks have shifted from an overheated, inflation-prone U.S. economy to one at risk of being destabilized by a stock market crash or dragged down by the deflationary forces sweeping Asia. That's why St. Louis Fed President William Poole, who favored a rate hike in May, voted with other Fed policymakers to stand pat on rates in July.
CHAIN REACTION. And while just a few months ago some Fed officials would have welcomed a stock market correction, today they admit they're watching closely to make sure that the downturn doesn't crimp consumer spending --and set off a chain of events that triggers a recession. That would justify monetary easing that would keep the economy from dipping into recession.
For Greenspan, the trick is to make sure the domestic economy stays strong enough to keep the world from drifting into a synchronized slump--and pulling the U.S. with it. If his interest-rate calls prove accurate, he may even find more time to work on his backhand.
By Dean Foust in Washington
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WHY NO COMPANY IS IMMUNE
A few months ago, Gillette Executive Vice-President Jorgen Wedel said Russian sales of its razors, batteries, and toothbrushes would more than double, to $500 million in five years, from $200 million in '97. Today, with the ruble in shambles and Russia retreating from market capitalism, that forecast has been reduced to rubble.
It might be bearable if the problems were confined to Russia. But with markets from Asia to Latin America also in or near crisis, ''every multinational is going to have a much stronger headwind,'' says Jay H. Freedman, an analyst at Chicago investment firm Lincoln Capital Management Co.
The damage won't be confined to the most global companies, such as Coca-Cola Co. and Gillette Co. ''There is not a U.S. company that does not have global exposure, directly or indirectly,'' warns Maureen Allyn, chief economist at Scudder Kemper Investments Inc.
Take Chrysler Corp., which isn't in Russia at all and has just minor operations in Asia. ''It's not our direct exposure to these areas that has me concerned,'' says Chairman Robert Eaton. ''As it gets worse, that's starting to affect the multinational companies back here...[and] the people who work for them.'' Ultimately, he adds, ''that starts to affect the people who buy cars.''
While a flood of cheap imports from distressed countries is great for American consumers, it wreaks havoc on domestic manufacturers. ''The U.S. is bearing a disproportionate part of the burden as these countries try to export their way out of crisis,'' complains Andrew G. Sharkey, president of the American Iron & Steel Institute.
As recently as July 1, analysts surveyed by First Call Corp. thought companies in the Standard & Poor's 500 would post 10% profit growth in the third quarter. That number has now been slashed to just 3.7%, says First Call's research director, Charles L. Hill. He predicts that after Labor Day, ''the number will go significantly lower.''
Standard & Poor's DRI says S&P 500 profits will fall 3.2% for 1998 and then rise about 5% in 1999. ''Corporations are caught,'' says David A. Wyss, chief economist at DRI, a unit of BUSINESS WEEK publisher The McGraw-Hill Companies. ''Their employment costs are going up due to tight labor markets, but they can't pass it on due to the strong dollar and import competition.''
Still, far from retreating, many multinationals are boosting bets on emerging markets. Ford Motor Co. says it will keep bidding for insolvent Korean carmaker Kia Motors Corp. Campbell Soup Co. is also scouting for buys in Asia. ''Mexico taught us that when there's a crisis, that's when smart people can move in,'' says Campbell CFO Basil L. Anderson. Indeed, Gillette is going ahead with a $40 million plant in Russia's St. Petersburg. Ultimately, the crisis could leave prepared U.S. multinationals even stronger in emerging markets.
By William C. Symonds in Boston, with bureau reports
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THE MARKET: IT'S NOT SO BAD, HONEST...
But gurus say the highs for the year are behind us
Stock prices are showing all the stability of a kid on a pogo stick. They're gyrating between the fear that poorly understood forces abroad will infect the U.S. economy and the hope that the U.S. will continue to shake off the contagion, as it has to date. Fear won out on Aug. 31, when the Dow Jones industrial average tumbled 512 points. Hope claimed victory in the 288-point snapback on Sept. 1. It promises to be a long, hard slog to the end of the year, one that surely will leave few investors untouched.
Does the turbulence represent a pause in the bull market--or does it signal the onset of a bear market, even a recession? Many investment pros say the odds favor the relatively strong economic fundamentals of the U.S. market withstanding the global malaise. Most also believe, however, that stocks will not hit new highs in 1998 and that there's a good chance that the market has not yet hit bottom. The challenge is figuring out what fair value should be, given such a murky earnings outlook.
Investor jitters were very much on the minds of Merrill Lynch & Co. Chairman and CEO David H. Komansky and Merrill President Herbert M. Allison Jr. on Sept. 1. That morning, the pair warned Merrill employees in a memo that ''selling in the equities markets has reached an emotional stage...with further declines possible before a bottom is reached.'' That day, Merrill's quantitative strategist lowered his recommended allocation to equities from 55% to 50%.
For some market-watchers, the fear runs deeper. If policymakers abroad don't take strong action, some say, the malaise will only worsen and spread, and the likelihood of it spilling over into the U.S. will increase. ''The biggest risk is if policymakers get stuck thinking inside the box,'' says Credit Suisse First Boston chief investment strategist Christine A. Callies. ''If they're too concerned with the relatively short-term issues of currency valuations and so forth, that could lead to their not doing enough to help stabilize the global situation.''
The fear that the Asian contagion will spread to Latin America and to America's trading partners in the North American Free Trade Agreement, Mexico and Canada, is a big factor in the recent market jitters. On the margin, export trade can be a swing factor for the economy, says Mitchell Held, co-manager of U.S. economic research at Salomon Smith Barney.
Abby Joseph Cohen, Goldman Sachs' bullish strategist, believes the strong fundamentals of the U.S. market can offset the global weakness. She doesn't foresee a worldwide recession in 1998 or 1999 and thinks the upheaval in foreign markets will ultimately have little impact on U.S. economic growth, corporate profitability, and cash flow. On Sept. 1, she upped her recommended stock weighting to 72% from 65%. With the Dow closing at 7539 on Aug. 31, Cohen pegged the market as 12% to 15% undervalued, using a Goldman Sachs inflation-based valuation model.
SKIMMING THE FROTH. With the average price of shares listed on the New York Stock Exchange sinking to $38.97 on Sept. 1, down from the high of $47.65 on July 17, a lot of froth has been skimmed from the market. Indeed, many of the models show the stock market to be a good value. Using a forecast of operating earnings of $51 for the Standard & Poor's 500 stock index, and an interest rate of 5.5% on the long bond, Morgan Stanley Dean Witter's dividend discount model shows fair value for the S&P 500 at 1055--or about 6% above its Sept. 2 level. And with the long bond yield now at 5.3%, the market may be undervalued by about 11%.
The trouble with such models: They don't fully capture all the things that affect stock and bond prices, such as bonds' safe haven status today. ''Our valuation model can't judge a flight to quality,'' says Brian F. Rauscher, U.S. investment strategist at Morgan Stanley Dean Witter.
Less bullish strategists than Cohen lay out a convincing scenario for weaker corporate earnings. In fact, earnings-growth estimates for the third quarter have slid from 8.6% on July 17, when the market peaked, to 3.2% on Sept. 1, according to First Call Corp. Their gloomy scenario: A spreading global meltdown that keeps stocks volatile, shakes consumer confidence, and curbs consumer spending. Prudential Securities Inc. strategist Greg A. Smith forecasts low-single-digit profit growth in 1999, since he doesn't see much reason to think revenue growth will expand with pricing power so weak worldwide. But a drag on earnings may be offset by a boost from lower interest rates.
If the stock market doesn't regain more ground soon, it could start cutting into expectations for economic growth. Down markets tend to slow consumer spending. Held says that if the U.S. stock market drops 10% and stays at the lower level for a prolonged period, the gross domestic product will be 0.7% lower than it would have been otherwise. The Dow has suffered a 17% drop from its mid-July peak. If a 20% correction dug its heels in, all else being equal, ''you'd probably end up with below-trend GDP growth for 1999,'' he says. The trend for growth is 2% to 2.5%.
Some technical analysts see signs of a bottom. Ronald E. Elijah, portfolio manager of the Robertson Stephens Value + Growth Fund, points to an indicator tracked by Merrill Lynch's Richard McCabe. It shows the number of stocks on the New York Stock Exchange trading above their 200-day moving average. After peaking at 80% in late 1997, the reading fell below 19% the week of Aug. 24. According to McCabe, history shows readings near or below 20% to be ''a deep oversold condition for the market, which can be one ingredient for a major bottom.'' Elijah is reassured by that--but isn't ready to buy yet. ''I want to let things settle down,'' he says. ''In such a frantic period, you can make so many mistakes.''
Neither the bull nor the bear camp is likely to declare victory soon. In coming weeks, the market will react to third-quarter pre-announcements, which tend to be negative. In such an unsettled environment, investors can count on only one thing: They won't be bored.
By Suzanne Woolley in New York
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