Soft landing talk prompts 1990s flashbacks

A soft landing for the US economy in 1995 was followed by a boom. Could it happen again?

Talk of a soft landing for the US economy has investors dreaming of a 1990s-style boom soon afterward. A lot would have to go right for that to happen, but it isn’t as outlandish as it sounds.

Examples of the economy escaping a tightening cycle from the Federal Reserve without entering a recession are few. Some cite the Fed’s rate cuts in 2019, though it is impossible to know how that would have ended without the pandemic. The most frequently mentioned example is a series of rate hikes in 1994. They wreaked havoc on markets that year, but were soon followed by the dawn of a golden period for both Wall Street and Main Street.

The effective federal-funds rate rose from around 3 per cent at the start of 1994 to around 6 per cent in March 1995, according to data from the St. Louis Federal Reserve – a three percentage-point move in a little over a year. That looks similar to, though certainly less severe than, the Fed’s tightening from March 2022 through August 2023, which brought the target range on the federal-funds rate from 0 per cent to 0.25 per cent to its current range of 5.25 per cent to 5.5 per cent.

The economy of the mid-1990s slowed in response but stayed well clear of contraction, with real gross domestic product growth bottoming out at a 2.2 per cent year-over-year pace in the fourth quarter of 1995, Fed data show. The Fed made some modest rate cuts in 1995, similar to what economists now expect for 2024. What followed is known to anyone on Wall Street: one of American history’s great booms.

The S&P 500 declined 1.5 per cent in 1994, then rallied 34.1 per cent in 1995 and didn’t suffer another down year until the dot-com bubble burst in 2000.

“We could still get a recession late next year, but in that case it would be a case of a policy error by the Federal Reserve for not loosening soon enough,” said Jason Draho, head of Asset Allocation Americas for UBS Global Wealth Management.

If the US does dodge a recession, investors would want to start looking more at “midcycle” stocks that do well when the economy has a runway of growth ahead of it, including things like industrials, regional banks and small-caps, Draho argued in an interview.

Indeed, since the Fed’s meeting on December 13, in which policymakers unveiled lower expectations for rates next year, the small-cap Russell 2000 has rallied 9.8 per cent, and the KBW Regional Bank index has risen 10.0 per cent, compared with a 3.0 per cent rise in the S&P 500.

The S&P 500 declined 1.5 per cent in 1994, then rallied 34.1 per cent in 1995 and didn’t suffer another down year until the dot-com bubble burst in 2000. Picture: Getty Images

In a recent investor presentation, a team of UBS analysts led by Draho identified several factors that could lead the US economy to a “Roaring ’20s” scenario this decade, with elevated real growth of 2.5 per cent or higher, and controlled inflation of between 2 per cent and 3 per cent. Key are “supply-side” factors like capital investment in factories and infrastructure, and technological advancement, such as in artificial intelligence, that can boost worker productivity. These could increase the economy’s potential to grow without inflation, echoing what happened in the 1990s thanks to computer and internet technology.

“The potential to look like the ’90s is high, but it can also be overstated,” says Steven Blitz, chief US economist at TS Lombard.

“I think there’s still a lot of negatives in trail that will keep growth relatively low in the near term … In the long term, it’s a productivity bet.”

Among the differences between then and now: inflation was also held down in the ’90s by globalisation, Blitz notes. The current trend toward industrial reshoring is a positive for capital investment in the US, but it is also likely inflationary, as it generally means replacing cheaper imports with domestically produced goods.

Similarly, investment in more climate-friendly energy and infrastructure could be inflationary over the near term. It could even drag on productivity if it means investing in redundant energy sources, says Draho.

But if those investments eventually yield a more efficient energy system, that would be a positive for productivity in the long term, he adds.

Another difference: A lot of potential good news is already priced in today.

In December 1993, the cyclically adjusted price-earnings ratio, a measure developed by economist Robert J. Shiller that compares stock prices to average earnings over the prior 10 years, stood at 21.2, according to data from Shiller. That is not remarkably low, but it compares to an elevated 30.8 in September 2023, the latest month that Shiller has data available.

Worker-productivity data are notoriously volatile and difficult to interpret, but the signs were there in the mid-to-late ’90s that something very good was afoot. The year-over-year change in labour productivity reached 2.6 per cent in the fourth quarter of 1997 from 0.5 per cent in the first quarter of 1994, Fed data show. It then accelerated to 3.7 per cent in the first quarter of 1998.

Today, there are already some indications that worker productivity may have been meaningfully enhanced by pandemic-era advancements in remote work, videoconferencing, at-home shopping and the like. But the data are hard to read: Worker productivity rose 2.4 per cent from a year earlier in the third quarter of 2023, compared with a negative reading two quarters earlier.

Arguably, it is in AI that the prospects for a ’90s-style technology and productivity boom most likely lie today. But AI’s ultimate impact on productivity is hard if not impossible to forecast. “The range of potential outcomes is huge,” says Draho.

Still, if worker productivity numbers keep creeping up, look for investors to get more excited about a potential ’90s redux.

The Wall Street Journal