Is This 1991 All Over Again? By Brian Reynolds Special to TheStreet.com 5/1/01 4:51 PM ET

I wrote a column at the end of last September that concluded the economy was going to deteriorate given last year's rise in oil prices.

A poll at the end of the column asked readers for their opinions, and only one-third believed we were headed for a 1990-like recession. One-third felt we were in for a repeat of the 1994 experience, when the Fed engineered a soft landing after a tightening of 300 basis points, and one-third were just waiting for James Cramer's fictional investment duo Buzz and Batch to mark up their stocks at the quarter's end.

In response to that poll, I penned another piece that concluded that it would be difficult to repeat that soft landing. It turned out that September saw the peak in industrial production, and by now everyone knows how the economy and stock market subsequently fell off a cliff.

In the initial piece, I was hopeful that things wouldn't get as bad as in the 1990 recession. By technical definition, I was right, as the economy has yet to have a negative GDP quarter.

However, I was really surprised (and judging by the stock market's behavior since then, a lot of other investors were, too) at how quickly things deteriorated and how some parts of the economy behaved even worse than they did during the last recession.

Even though we have (for now, at least) avoided a recession, it still feels like one. Given that experience, I believe it makes sense to look at how the economy recovered in 1991, and compare it with the current situation for clues on what lies ahead.

That recovery was so sluggish that a president who was at the height of popularity at the end of the Gulf War in 1990 was defeated just a year and a half later. I believe that a big reason for the sluggishness was the failure of long-term bond yields to follow short rates down, and it looks like we are having a repeat performance of that now.

I believe the overall economy will continue to do better than it did coming out of the last recession. However, I believe there are similarities to 1991 that will limit how much the economy can accelerate. That is not necessarily bad for investors, but it may disappoint those who are hoping for a quick, V-shaped economic rebound.

In the charts that follow, the red line covers the period from September 1989 to September 1992. This encompasses the 12 months leading up to the peak in industrial production (a handy, though simple, way to date turns in the economy) in September 1990, and the two years following that. The blue line represents the current environment, starting in September 1999 and going through the peak of the economy in September 2000 up to March or April, depending on the data availability, of this year.

The first chart looks at real (after inflation) personal consumption:

Consumer Spending Slowdown Despite staying in positive territory, its growth rate has come down similarly to 1990

Source: Federal Reserve Bank -- St Louis.

Consumer spending is the main reason why we have been able to avoid negative GDP numbers. Despite staying in positive territory, though, its growth rate has come down in a similar fashion to 1990. The difference is that we were starting from a much higher level last year, so spending is still growing.

Mortgage rates fell at the end of last year, boosting refinancing activity, which helped to support spending this year. However, mortgage rates are climbing now, which could choke off the refinancing surge and limit how much spending can accelerate.

The Fed's lowering of short rates could help the sales of Ford (F:NYSE - news - boards), General Motors (GM:NYSE - news - boards) and DaimlerChrysler (DCX:NYSE - news - boards), which are somewhat sensitive to the short end of the yield curve, but I don't see a big surge in spending happening unless mortgage rates fall by a half-percent or so.

Industrial production also has seen a sharp decrease, more than consumption. The numbers are positive, but the drop in the growth rate is what makes it feel as bad as a recession. I've used the same scale for the industrial production chart as I did for the consumption chart to put them in perspective.

Headed South Industrial production growth has decreased, making this feel more and more like a recession

Source: Federal Reserve Bank -- St Louis.

The sharper slowing of production relative to sales indicates that inventories should be in better balance now relative to where they were a few months ago.

We need two months of 0.4% growth for this series to avoid falling into negative territory, and there is a chance that we will get that given auto-production schedules.

To me, a big risk is that companies increase production in anticipation of an acceleration in spending, to the point where output is stronger than consumption.

The sector of the economy that has been the weakest link is capital spending, especially in technology and telecommunications. The next chart looks at capital spending orders, stripped of defense and aircraft orders:

An Extraordinary Drop While capital spending numbers (minus nondefense and nonaircraft goods) are not as bad as 10 years ago, the fall has been steep

Source: Federal Reserve Bank -- St Louis.

While the capital spending numbers are not as negative as they were 10 years ago, the drop from peak to trough has been extraordinary.

As it was six months ago, I believe this will be a key swing factor for the economy. Unfortunately, many fixed-income investors fear that the Fed has been easing too aggressively, and bond yields are starting to rise again. This higher cost of capital is making a quick, strong rebound in capital spending less likely, and may mean that there may be more fruitful investments than tech stocks.

The good news is that inflation is better than it was a decade ago. It hasn't come down the way I had hoped, and electricity and gasoline prices will not help this summer, but I believe the economy is soft enough to keep the CPI under control, barring a surge in crude oil prices. If so, then I believe that the fears of fixed-income investors may be overdone, and bonds should provide a decent return over the CPI.

Bonds! Buy Bonds! Barring a surge in oil prices, the economy should keep the CPI under control. If so, bonds should provide a decent return

Source: Federal Reserve Bank -- St Louis.

The next chart takes a look at the fed funds rate during the two cycles:

No Sure Thing The Fed eased by 500 points from 1989-92, but the economy didn't gain momentum until the end

Source: Federal Reserve Bank -- St Louis.

I believe the Fed's surprise April rate cut demonstrates its willingness to do what it takes to get the economy moving. Yet, I am always amazed when I look back at that period from 1990-92.

The Fed brought short-term rates from 8% to 3% (500 basis points!) in two years, yet the economy never really gained momentum until the end of that period.

I'm hearing the same things from my former fixed-income counterparts that I did 10 years ago: The Fed has eased too much, inflation is coming back, etc. The difference is that bond yields fell somewhat coming out of the last recession (though not very much; I've used an 800-basis point scale on both the chart below, which shows Moody's Baa Corporate Bond Index, and fed funds charts to keep them in the same perspective), while bond yields have started to climb recently:

But Which Bonds to Buy? Buy less-risky, short-term bonds if you think the economy will pick up steam

Source: Federal Reserve Bank -- St Louis.

This is the opposite of 1998's experience, when bond yields fell faster than short rates, sending refinancings to all-time highs and setting off a two-year consumption boom. Fortunately, corporate and mortgage yields have not risen nearly as much as Treasury yields over the last few months, but the higher that yields go, the lesser the chances of the economy accelerating.

This provides an interesting choice for bond buyers. If you believe that the economy and inflation are about to pick up steam, you can buy less riskier, shorter-maturity bonds (or even money market funds) and wait for even lower bond prices.

However, if you believe that higher bond prices make a strong rebound and higher inflation less likely, you can now buy longer maturity bonds (as I have started to do recently) at cheaper prices than a few months ago.

So it seems that, while the economy will do better than it did a decade ago, the chances for an economic boom are not great unless bond yields come down. This is not necessarily bad for stock investors (and is why I've increased my stock exposure, using stops of course):

Increased Exposure Even though the economy was sluggish, coming out of the last recession, stocks did well on the S&P 500.

Source: Federal Reserve Bank -- St Louis

Where Do You Believe the Economy Is Headed?

Economic weakness will intensify. Moderate growth will continue, but there will be little acceleration. Growth will be moderately faster. There will be a sharp acceleration.

See Results

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Brian Reynolds is a Chartered Financial Analyst who spent more than 16 years as a fixed-income portfolio manager and economist at David L. Babson & Co. in Cambridge, Mass. He currently writes and lectures about investment issues and trades for his own account. At the time of publication, he was long Ford, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell. He welcomes feedback at Brian Reynolds .

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