Matters of Interest
Financial experts offer their perspective on the current economy and what may lie ahead

Given the state of the United States economy at present -- high asset prices in the stock market and low inflation across the board -- astute followers of Alan Greenspan and company at the Federal Reserve are waiting for interest rates to creep up again. The Lane Report posed a series of questions to Jim Stuckert, chairman and chief executive officer of Hilliard Lyons in Louisville and Sam Barnes, the president and chief executive officer of Fifth Third Bank in Lexington, to get their take on the short- and long-term outlook on the U.S. economy as it relates to interest rates, specifically their effects on the stock market and borrowing and lending practices. This is what they had to say.

Samuel G. Barnes,
President and CEO Fifth Third Bank -- Lexington

How will the Fed's recent interest rate hikes and anticipated further hikes affect borrowing and lending practices for the remainder of the year?

Fifth Third Bank believes, given the current market and economic conditions, that there is about a 50 percent probability we will see another interest rate hike this year. However, from the consumer's standpoint, perception will play a major role in borrowing behavior. If the consumer believes another rate hike will occur before year end, we anticipate near-term increasing demand, which should fall off after the hike is announced. From the lender's perspective, a rate hike will have little impact on lending practices. We will continue to lend credit to worthy customers and raise rates only if it becomes necessary.

What roles, if any, do the following areas of the economy play in the Fed's desire/need to raise interest rates: the weak U.S. dollar vs. the yen and pound, higher bond yields and a highly volatile technology sector in the stock market?

The weak U.S. dollar results in a wider trade balance, which makes it more difficult for the U.S. economy. An increase in rates throughout the United States could make foreign investment here more palatable and provide for continued growth in the U.S. The Fed analyzes the stock market, and in particular the volatility of the market, in an effort to anticipate major downward moves. While many investors bought into the technology sector on margin or have borrowed against their holdings, a hit to this industry could cause a significant drop in disposable income which, in turn, could cause a slow-down of overall economic growth forcing the Fed to cut rates. The Fed would much rather see an orderly revaluation of P/Es (price/index ratios). The bottom line here is inflation, not just current inflation but pipeline inflation in comparison with economic growth. All three of these react to inflation -- bond yields, equity markets and the trade deficit. The Fed's focus with respect to rises in rates has been, and will in all likelihood continue to remain, on inflation.

Is it an overreaction to assume that the U.S. economy, with its combination of higher asset prices and low inflation, may be following the disastrous path the Japanese economy took in the late 1980s?

There really is no good comparison here. The P/E levels in Japan during the late 1980s could not be justified by the country's economic fundamentals and the interest rate environment. In the U.S. today, we can make a case for current P/E levels based on these factors. Asset values here are not near as inflated as they were in Japan during that time. Would you agree or disagree with the following statement: The Fed is plagued with uncertainties -- it doesn't trust its own economic models and forecasts and therefore doesn't feel comfortable with a 'pre-emptive' interest rate policy beyond what's already been done. I would disagree with that statement. I think the Fed does understand its models even as they have become much more complex over the years. The Fed has proven to be very pre-emptive to keep the economy moving along with low inflation. They are not afraid of short-term volatility in the quest for long-term growth and stability. The Fed cannot dictate what happens worldwide. Events that have caused the Fed to move quickly have been global in nature, otherwise they have been very methodical throughout Greenspan's tenure, and quite frankly, very successful as well.

What advice would you give to a new home-buyer or a new car-buyer in regards to borrowing capital in the current state of the U.S. economy?

For any consumer who might be considering a major purchase, we suggest they review their current financial situation and make decisions based on the current economic environment. I wouldn't let anticipated rate moves by the Fed stop my personal or business growth strategy. If I make the purchase today and rates go up, I'm better off; if rates go down, there are many ways to refinance and restructure.

James W. Stuckert
Chairman & CEO Hilliard Lyons Inc. -- Louisville

How will the Fed's recent interest rate hikes and anticipated further hikes affect the stock market for the remainder of the year?

I don't think the rate hikes will affect the market a lot between now and the end of the year. The marketplace basically already knows what's going to happen out there, and I don't know what will happen. The market has moved sideways since April, through these hikes and everything else.

What roles, if any, do the following areas of the economy play in the Fed's desire/need to raise interest rates: the weak U.S. Dollar vs. the yen and pound, higher bond yields and a highly volatile technology sector in the stock market?

Editor's Note: Mr. Stuckert responded to questions two, three and four in the following manner:

Japan has been in a downtrend as far as growth, a period of disinflation or a declining growth mode, and then they flipped into a negative mode. It was recently announced that the Japanese GDP (gross domestic product) grew more than what they thought. I think, frankly, that Japan is coming out from under. Our economy here has been driven by three things over the last five years.

One, the collapse of the Pacific Rim countries with their currencies where they felt they had to produce everything they could and ship it to America. That helped tremendously in keeping inflation down.

Number two, Japan is the world's largest creditor nation. Even though there is a lot more money owed to them than is owed by them the dollars kept coming into Japan. In America, T-bill rates were, let's say four and a quarter. If you're an enterprising American, you're going to take dollars and covert them to yen and get a hold of this money, then re-convert back out and get four percent net. So, I'm paying a quarter, and I'm getting four and a quarter. What happens though, is the marketplace knows that Japan is probably going to start going up as far as improving on our economy, so interest rates begin to tick up over there. At the same time people say 'Oh! My goodness! I better unwind my position.' Once a trend starts and you've been leveraged out, no matter what the arbitrage is on interest rates, the currency changes whip it around and everybody wants to unwind their positions. What then happens is people are in a panic to unwind these type of positions, because they are losing far more on the currency changes than they were making on the interest rate arbitrage. But what really happened, if you back things up, I think interest rates in this country got artificially low- home building kept going, the GDP kept going, everything kept going- but there was so much interest rate arbitrage going on with the Japanese interest rate market and the American interest rate market that Japan supplied a lot of credit for us over here and we're not going to get that credit anymore because people are losing their shirts on this currency swap. We don't have this cheap money anymore. That's creating pressure on the upside as far as interest rates are concerned.

The third thing is the technology improvements- the 'Just In Time' (JIT) inventories to a much greater degree. Less money is tied up in inventories; it's just tied up one time. That's due to computerization and the tremendous improvements in technology where everybody could keep track of where everything was. I think all of those things were one-time happenings, and I think interest rates are going back up. The American economy has always done well, now I think the world economies are going to begin to do better, so there is going to be growth in the pricing of the commodities and growth in the pricing of money, which means higher interest rates. Although people think there is an unlimited amount of money, when there isn't a lot of growth, the excess monies -- dollars, Euros, yen -- go into stock markets, usually. But when you get real growth in the economies, the excess money, instead of going into the stock market, will go into the development of businesses to carry more inventory, to build more facilities, to buy more equipment. This, in turn, will strengthen the economy but will raise interest rates because there is more of a demand for money.

What long-term and short-term advice would you give to a client who is looking to invest in the stock market? For example, should they be investing in stocks, bonds, CDs, T-bills, etc.?

I would be very judicious in buying stocks at the moment. When I say buying stocks, in the S&P 500 there's about 50 stocks that have taken that index on up the line- those are the ones I'd be careful with. For whatever reason, if you got a nice market scare of some type, I'd have to say candidly that I would be inclined to buy them. If you buy them today, however, you always stand the chance of some pullback. In the short run, I'd put my money in T-bills just awaiting opportunities. If in fact interest rates are going to go up, which I think they are, bonds wouldn't be a good investment right now. I'd rather keep money in T-bills, but there are a lot of small and mid-cap stocks that have had a lot of nice records and they've never been recognized.

John Gaver is editorial director of The Lane Report.

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