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Flashback to May 2005

IT'S NO WONDER INVESTORS ARE biting their nails. The stock market has been in a temperamental mood for months, oil prices have soared, GDP growth is slowing and capital spending is far from robust. If the dreaded R word isn't on people's minds just yet, it's only because they're pondering another unhappy scenario that has begun making the rounds: stagflation.

Is the economy falling apart? Not according to Lakshman Achuthan, managing director at the Economic Cycle Research Institute, an economic forecasting firm in New York that has accurately predicted the past three recessions. Achuthan says the economy hasn't hit a soft patch recently rising inflation and stagnating economic growth have been the reality for at least a year.

The good news? The disappointing data, says Achuthan, are actually indicative of the end of a slowdown, not the beginning of one. He says ECRI's leading indicators touched their lows months ago, prompting the institute to forecast a "firming" in the economy for the second half of 2005.

That's not to say that Achuthan thinks folks should sit back and expect nothing but flowers and sunshine. His language is qualified: The cyclical indicators have started to "edge up," but he isn't calling for a "strong reacceleration."

As for the recently choppy stock market, Achuthan says investors shouldn't feel so unsettled. Bear markets usually go hand in hand with recessions, and since he sees no recession on the way, bears needn't get excited. We've been hearing a lot about stagflation. Is it a realistic prospect or just hype?

Lakshman Achuthan: It really depends on how you define stagflation. If you define it broadly, as slowing growth and higher inflation, then that's already been happening. For much of 2004 we've had a downshift in growth and rising inflation. It seems to be between 3% and 4% growth. At the same time, we had inflation almost double from early 2004. So if you were defining stagflation as slower growth and higher inflation, it's already happened. I think the reason it strikes fear into people is because it's meant to remind people of the late '70s when you had very high inflation, multiples of what you have now, and growth falling below trend. And that's not the case now, and it's not likely to become the case. It doesn't look like growth is turning down that sharply.

There are some structural things going on now that would make it very difficult to get the very high inflation rates we got back in the '70s. There's a reflex to associate [the recent troubles] with oil...But nothing is ever that simple. Right now, one of the structural ceilings on inflation is coming from two very long-term trends that have met up finally. One of those trends is globalization. The result of that is you can get cheap products from other places, which holds inflation down. And the second long-term trend is the Fed's fight against inflation. It took it awhile, but the Fed basically won. It's not about to give up the credibility or the little bit of increase in control it has won.

SM: What do the latest manufacturing numbers portend for the economy? The ISI Index of Manufacturing Activity slipped in April, its fifth consecutive monthly decline.

LA: We view the weakness in manufacturing, or GDP or employment numbers we view that as part of a slowdown that has been going on for a year. That's in contrast to those who view it as a new slowdown. We think it's the end of the slowdown. These things tell you about the current economy or the recent past. They, by definition, can't forecast. They don't tell you about the future. To [forecast], is it going to be softer, in the middle or stronger, we look at the leading indicators, which are composite indexes. We look at a bunch of them, which are designed to lead turning points in the economy. They seem to have made their lows months ago. Now they're rising, which we translate into a forecast of a firmer economy in the second half of 2005 as opposed to an economy that's below trend or experiences a vicious cycle of downturn.

SM: What other indicators are signifying a positive outlook for the economy?

LA: The leading indicators are taking the pulse of key drivers of the economy. For instance, stimulus, low interest rates, a lot of money is running around, easier credit. That's all stimulative from the monetary side. That's a key driver of the economy. We'd put that in the positive camp, even though the Fed's raising interest rates. The cost of money is still very low. Then you have that "conundrum" that Greenspan talked about. [The relatively low longer-term interest rates] are super-stimulative. That allows people who want to borrow money to spend on business or buy a home to do it easily, at attractive rates.

The second driver of the economy is housing. We see that it's not in a straight line, but it's safe to say that housing remains pretty strong.

SM: So you don't think there's a bubble?

LA: Well, there may be a bubble, but it doesn't mean that it's going to pop. We're forecasting only the next few quarters...I am convinced that housing prices will turn down; they have to because it's cyclical. However, looking at leading indicators of prices, we don't see it happening anytime soon, in the next few quarters. Those nightmare scenarios, we don't count a sharp downturn in housing prices as a likely event. Strong housing activity has powerful knock-on effects through the economy. It's a kind of pervasive activity, rising demand associated with housing, and something that reinforces the expansion. It's the virtuous part of the expansion, and allows things that are tangential to housing to benefit from that activity.

Another key driver of the economy is profits. If a business is profitable, it's less likely to retrench, and more likely to expand its business, because it's making money. There's a bit of a dichotomy here. Even though profits are good, capital spending was slipping a bit. My suspicion is that it may be linked to the longer-term structural trend of globalization. A business is profitable here, wants to expand; clearly some of that investment is going overseas, and not being invested here in the U.S. That's part of what explains lower readings of capital investment, we're losing some of that to China.

There you have three key drivers of the economy that are not pointing to a sharp downturn... Last year, early in the year, the leading indicators had eased up quite a bit, anticipating the slowdown. Now they seem to have bottomed in the fall and are edging back up. The rise is not terribly pronounced. It turned up generally since the fall. But since it's not very pronounced, we're not calling for a strong reacceleration. We don't see that. This is a strong divergence from the consensus. We see that the economy will firm.

SM: What's your read on inflation fears?

LA: We look at a future inflation gauge; we target the rate of inflation. Those indicators did turn up at end of '03; inflation rose in early '04. However, for almost two quarters they've remained elevated, but the pace of advance has slowed. The index ticked down for the last two months. And that suggests to us that while it's premature to forecast a future downturn in inflation, there is evidence that the Fed isn't behind the curve and that inflation isn't about to run away at an out-of-control pace. That is pretty much good news.

You don't want runaway inflation. And remember, it was only two years ago that people were wringing their hands about deflation...So to have this type of inflation may actually be a sign that the economy is not threatened by deflation, that it's relatively healthy...We still have to watch these indicators. The story could change; it's a relatively near-term forecast.

SM: What's your take on that "conundrum" of the yield curve? It's flattening despite a year's worth of interest rates hikes.

LA: I do think there are a number of plausible reasons as to why rates are a little lower than you'd expect, and you have a flattening yield curve. One of the key things must be the foreign purchases of Treasurys. I guess China is a major culprit there. This demand in the Treasury market pushed the price up and the yield down.

A few other ideas: The bulk of the tax cuts that we had, in terms of dollar amount, went to wealthier individuals. They have lower [marginal] propensity to spend. Where does that money go? It goes into the bond market. Then GDP hit 7% in 2003. Very high, huge big boost that was unexpected by corporate America, and a massive cash infusion. I think one of the things it may have done was it reduced business demand for credit, because they have this windfall in profits. Some of their demand for credit is a little lower.

What's also important is that inflation expectations have downshifted in the wake of the 2001 recession. Those two trends, the Fed fighting inflation and globalization, are meeting in the wake of the 2001 recession, which resulted in almost a deflation fear. When the assessment of inflation got all the way down to deflation, that represents a real downshift, it moves the framework of the debate. That's also contributing to lower yields. You also have the knock-on issue that firms, even though they might be producing something here in the U.S. and not directly competing with someone abroad, the general environment is one that's generally tough to raise your prices. And again that's feeding into that lower inflation expectation.

SM: What's your overview of the stock market [in light of the persistent strength of the bond market]?

LA: ECRI does not forecast prices. We don't have a typical forecast in that sense. What I can say is that most, if not all, major bear markets are associated or related to recessions in the economy. And we're not forecasting a recession. We don't see a recession in sight. The farthest we look is a year. And the stock market typically leads the economy by maybe half of that. So that would suggest that we don't have huge downward risk of a big drop in the market. There's been a little bit belated recognition of a slowdown in 2004. The economy, in the foreseeable future, is producing firm activity, which should allow for profit growth. And from that perspective, it doesn't seem like a huge downward risk on the market.

Another positive thing is that, so far, the future inflation gauge [doesn't indicate] that the Fed has to really stomp on the brakes. But it's still going to tap them.... We probably don't see as much risk going forward in equity markets as some would suggest, because of the growth outlook and inflation... Some sectors look a little healthier than others. The financial services sector looks pretty good, and construction improved a little bit. There might be some little pockets in there.

SM: Are you seeing anything else, positive or negative, on the economic horizon worth keeping an eye on?

It's not a forecast yet, just something we're watching closely, but we're starting to see some tentative signs of an upturn in the global industrial cycle. Our longer leading indicators of the global industrial cycle suggest there may be an end to that manufacturing decline somewhere in the second half of '05. If indicators continue to rise, we may get a swingback. We have to wait, get a month or two more of data.