ECONOMIC AND MONETARY TRENDS Mitchell J. Held SMITH BARNEY FORECAST SUMMARY Growth: Momentum likely to moderate during 1995. GDP growth in 1994 about 4.0%, cooling to around 2.0% by second half of the year. Recession fears by mid-year? Consumer: Structural factors are still working against "normal" increases in consumer spending. Still very price conscious, with some tentative signs of a reduced willingness to borrow and spend. Housing: Starts were 1.45 million in 1994, up from 1.29 million in 1993. We are projecting about 1.40 million in 1995. Autos: Light vehicle sales were 15.1 million in 1994, up from 13.9 million in 1993. We are projecting about 15.5 million for 1995. Capital Spending: Outlays were up almost 14% in 1994. We are projecting another 10%+ gain this year in light of capacity constraints and the continued emphasis on enhancing productivity. Trade: Terms of trade favor U.S. manufacturers. U.S. export growth has been strong but will be crimped by the economic adjustments underway in Mexico. Our thirst to import should slow as inventories are built up and spot shortages are met. Inflation: Some upward creep is likely because of diminished slack, but cyclical upswing to be relatively muted. CPI: probably in the 3.0%-3.5% range in 1995, following 2.6% in 1994. "Value pricing"" strategies to help. Lower inflation becomes institutionalized. Budget Deficit: FY92: $290B: FY93: $255B (first drop since 1989): FY94:$203B (first "repeat" since 1973-74); FY95 estimate: $165B (first "three-in-a-row" since 1946-48). Another round of deficit- reduction measures would help the Fed moderate economic growth and be constructive for the rate outlook. Profits: After-tax profits were up roughly 11% in 1994. We anticipate a slowing to about 6% growth in 1995, S&P earnings (before write-offs) were $30.75 in 1994. We are estimating $32.25 for 1995 and $31.25 in 1996. Short-term rates: The degree of slowdown in the economy will determine how much higher real rates need to rise. A gradual slowing may require some encouragement from another rate hike by the Fed (more likely at its May meeting than at the March meeting). A gradual slowdown would limit the Fed's latitude to ease back from a restrictive stance later this year. Long-term rates: Recent signs of some slowing in economic activity prior to clear evidence of an acceleration of inflation have kept alive the "soft landing" scenario. This has allowed rates to move lower. In an up market, the 10-year/3O-year spread is likely to widen. Dollar: Look for some appreciation as belief in the soft landing results in stronger capital flows dollar-denominated securities. TREASURIES Douglas Schindewolf Data released this week lent to the view that economic growth is slowing and the market built on its recent gains. In the process, the yield curve flattened further, with the yield spread between the three-month bill and the newly auctioned 30-year bond narrowing to roughly 165 basis points. This is the narrowest this spread has been since the Fed began the campaign to tighten its policy stance one year ago. At midday Wednesday, the yield on the long bond stood at 7.55% down about 60 basis points from the high of early November and the lowest level since 1994. The first estimate of retail sales in January showed a 0.2% increase overall and a 0.4% gain for non-auto sales, along with small upward revisions to November and December figures. After accounting for the revisions, the level of retail sales in January was a bit higher than generally expected. Nevertheless, the modest gains during the past three months suggest that the pace of consumer spending has slowed. Similarly, the Fed reported a widespread slowing in manufacturing activity during January, with its index of manufacturing output increasing by 0.3% compared with monthly average increases of 0.8% during the fourth quarter. These indications that the economy may be beginning to roll over allowed the market to be more forgiving of the inflation indicators released during the week. In particular, the CPI core rate registered a 0.4% increase in January, resulting in a jump in its year-over-year change to 2.9% from 2.6% in December. In addition, the capacity utilization rate for manufacturing industries inched up another 0.1% to 85.1% in January - another reminder of the diminished slack in the system and the importance of a significant slowdown in economic activity. (We note that in our judgment, the economy is operating above its full potential and the risk of overheating remains significant.) Part of the slowdown in the months ahead should come from a slower pace of inventory accumulation, but data released this week indicated that business inventories increased by only 0.2% in December while sales surged 1.3% Consequently, there does not appear to be a large overhang of inventories that would tend to hinder the upward momentum in industrial production in the months ahead -- slower production will hinge on a sustained falloff in final demand, which still is an open question at the moment. In congressional testimony a few weeks ago, Alan Greedspan indicated that there are some tentative signs of moderation in economic activity, a concept that also appeared in the announcement that accompanied the last set of rate hikes on February 1. Next week, Greenspan will have an opportunity to amplify on this notion when he presents the Fed's semi-annual Humphrey-Hawkins report to Congress on Wednesday, February 22, and Thursday, February 23. CORPORATES Diane Garvey New issuance of corporate debt securities fired up on the 14th with over $800MM issued for the day. Rockwell International issued a two-part deal totaling 500MM with a 7 5/8% of 2/17/98 at +33BPs and 7 7/8% of 2/15/05 at +43BPs. Norwest Financial 7 7/8% of 2/15/02 at +42BPs and Southwestern Public Service 8 1/2% of 2/15/25 at +85BPs to comparable Treasuries. Secondary marker activity was fairly brisk for the week. As for industrials, investors continued to exhibit strong demand for Time Warner paper, causing spreads to tighten by an additional 5BPs. Lower rated industrials remained active with strong demand for RJR Nabisco paper causing spreads to tighten by at least 10BPs. Airline paper tightened by 5BPs due primarily to strong investor interest. Short paper under 5 years in maturity continued to be in demand with firmer spreads reported across a variety of industries. Bank spreads remained tight through mid-week after a short lived widening of JP Morgan paper as a result of the Moody's downgrade of its senior debt to Aa2 from AA1. I general, Yankee paper remained unchanged with relatively little market activity, although China 10-year Global paper tightened by 15BPs mid-week. On the utility front, investors remained focused on single-A intermediate paper, although spreads remained unchanged. * Smith Barney usually maintains a market in the securities of this company. # Within the last three years, Smith Banrey, or one of its affiliates, was the manager (co-manager) of a public offering of the securities of this company or an affiliate. MUNICIPALS The municipal bond market rally that began in mid-November was still very much in evidence on Wednesday morning as we went to press. Yields are down 90-110 basis points from their highs at the time. The municipal futures contract is up a whopping nine points since November 17. The demand side of the market appears to reflect both a rate shock and a sense of urgency driven by excruciatingly tight supply. Municipal yield as a percentage of Treasury yields are reaching "nosebleed" levels, particularly on shorter maturities. And yet these ratios seem destined to stay low, since supply will remain very light and the greatest historical source of shorter paper pre-refunded bonds is dwindling. We would guess that by the end of 1996, well over half of the volume of pre-re's outstanding at the peak in late 1993 will be gone, and they aren't being replaced. On the long end, we are hearing anecdotally that demand for municipal bond funds is beginning to turn the corner, although it isn't showing up in the numbers yet. If that pattern continue, we could see further flattening of the long end of the yield curve, since funds tend to focus on long-term paper, and there isn't much to go around. Accrued Market Discount: We're not out of the woods yet.. But we're heading in the right direction. On Wednesday, February 8, Rep. Ben Cardin (D-Md) and Rep. E. Clay Shaw (R-Fla) introduced legislation in the House to repeal the 1993 law requiring market discount on municipal bonds purchased after April 30, 1993 to be subject to taxation as ordinary income. The new legislation would restore capital gains treatment of market discount. While this is without question a positive development, the introduction of the bill is only the first step in what could be a long, slow journey through both houses of Congress, probably attached to other legislation, Executive approval and incorporation in the Tax Code. Still, we're somewhat confident that Congress will eventually succeed in repealing the ordinary income tax treatment of Accrued Market Discount (AMD). We note that on Tuesday, February 14, Rep. Cardin suggested that enactment this year was a possibility, but also warn that it is only likely if there is more than one tax bill in 1995. The necessity for repeal is a topic we've covered at length in the past. The AMD tax has damaged liquidity in the secondary market for municipal and arguably worsened the municipal market's slide in 1994. But it is an ill wind that blows no good. Hopefully, the one lasting effect of the AMD tax after its repeal will be a heightened awareness of After-Tax Yields. When the ordinary tax treatment of AMD treatment took effect the market has in the final stages of a tremendous bull market, and there were no market discounts in the municipal market. (Which does make us wonder about the assumptions underlying the original revenue number associated with the tax in the budget. We would only note that revenue estimation usually smacks more of art -- and artifice- than it does of science.) When the market turned in February 1994, and created a plethora of market discounts, much confusion ensued, much of it revolving around After Tax Yield (ATY) -- how to calculate it, what it means, how to apply the de minimus rule, and how to handle ordinary income in "tax-exempt" bond funds or back common trusts. Finally, we have yet to find an accountant that can handle the complexities of calculating the tax effect of AMD on bonds bought and sold in the secondary market -- or who cares to. After Tax Yield Still Matters The irony of all this, as we have pointed out in the past, is that the marginal effect to after tax yield of treating accrued market discount as ordinary income instead of capital gain was quite small -- significant only for short and intermediate maturities. Effect of Ordinary Income Tax Treatment of Accrued Market Discount Current Discount After Tax Yield After Tax Yield Spread Years Coupon Coupon Maturity Yield 28% 36% 39.6% 28% 36% 39.6% 3 5.45% 4.45% 5.21% 5.14% 5.11% -24 -31 -34 5 5.60% 4.60% 5.38% 5.32% 5.30% -22 -28 -30 10 6.00% 5.00% 5.84% 5.79% 5.77% -16 -21 -23 15 6.25% 5.25% 6.13% 6.10% 6.08% -12 -15 -17 20 6.40% 5.40% 6.31% 6.29% 6.28% -9 -11 -12 30 6.45% 5.45% 6.40% 6.39% 6.38% -5 -6 -7 As the table shows, capital gains (28% tax rate) treatment of market discount has a significant effect on ATY greatest for shorter maturities, but still appreciable for the longest maturities. The incremental effect of treating discount as ordinary income, is significant principally for shorter maturities in high tax brackets -- 36% or higher. The lesson: Don't forget how to calculate after-tax yield in the event that the 1993 law is repealed. Bert Mosley George D. Friedlander Following the Fed tightening on January 22nd many additional buyers have begun to shift away from the extremely short term issues into longer term notes and bonds due to the perception that the Fed may be done tightening. In recent weeks this has meant a renewed interest in the 1 year to 18 month sector of the market. This additional demand has caused this "SUPPLY STARVED" sector of the market to trade richer as well as allowing any new issues to receive very strong bids. Currently. one year tax-exempts are trading at 4.70% which represents 70% of underlying Treasury Bills and 18 month bonds are trading at 4.80% which is also 70 of underlying Treasury notes. These sectors of the marker have been trading as cheap as 75% of Treasuries. One issuer who was able to benefit from the strong demand was the City of Milwaukee which sold $81 million of one year promissory notes at 4.81% and were re-offered as rich as 4.72%. One short-lived theory that died in Wednesday's rally was that pressure from First Boston's exit from the municipal business would cheapen yields. The strong demand is surprising because historically February is when the market experiences a pull back as customers sell notes and bonds coming into corporate and individual tax payment dates. The short term marker could still experience a sell-off as the market's current rich levels cause holders of short term tax exempts to take profits or if the market perceives that me Fed may tighten again. Mark Matthews For more of these reports, go to internet address of omnifest.uwm.edu, log on as a visitor, then type 'go finance'.