The Federal Reserve Board's short-term interest rate cut last week is expected to help the markets advance further in the new year, and might be a prelude to further cuts.
However, institutional investors probably won't see a repeat of the stellar stock and bond market returns in 1996.
Some industry observers believe the Dec. 19 interest rate cut was only a prelude to even deeper interest rate cuts by the Fed in January.
"I think if I were a pension fund on the verge of making a major asset allocation decision, I would want to stay fully invested right now. This has got to be very encouraging for both stock and bond investors," said Tom Pipich, investment consultant with Buck Consultants, Pittsburgh.
In the days preceding the 25 basis-point cut in the federal funds rate, some market watchers had begun to doubt whether the Fed would act, although earlier a cut had been widely anticipated.
Stock and bond managers view the Fed's action as the first step in a long-term trend toward lower interest rates, with most bond sources predicting the 30-year Treasury bond will fall well below 6% in 1996.
"I think it is realistic to expect another, more aggressive rate cut of about 50 basis points in January," said Mr. Pipich. "Congress and the Clinton administration should have reached a budget accord by then and I don't think the Fed would have cut only a quarter of a point unless they had intended to move again in January. This cut sends a signal to the markets but doesn't take the pressure off Washington to reach a budget and deficit agreement," he said.
While stock market managers were encouraged by the rate cut, it was in the fixed-income area where the news was especially well received. The bond market soared in 1995 after a dismal 1994. The 30-year Treasury bond was yielding 7.88% on Jan. 2 of this year and had dropped to 6.09% after the Fed's Dec. 19 rate cut.
"This is very constructive for the (bond) market and is in line with all the economic information coming out, and will be even more positive in the future if inflation remains in check and a budget agreement is reached," said Rob Kapito, vice chairman and co-head of the portfolio management group at BlackRock Financial Management Inc., New York, with $35 billion in fixed-income assets under management.
"If there is a budget agreement and a realistic plan to lower the deficit, then I can see no reason the Fed can't do another 25 basis points," he said, adding the bull market in bonds is "definitely not" at an end and should continue into next year.
The Fed action came just one day after a 102-point drop in the Dow Jones industrial average, one of the largest single-day sell-offs in nearly three years. But it represented only about a 2% drop from record levels attained by the stock market in 1995.
Stock market observers aren't calling for a repeat of 1995's record performance following the Fed's rate action, but clearly they are encouraged and expect stocks to do very well.
"The stock market was looking for it (the Fed's rate cut) and the economy needs it and the market will respond," said Greta Marshall, president of The Marshall Plan, Boston. Ms. Marshall said she expects the market to experience gains of 5% to 10% in 1996.
"Companies have done a good job of improving their earnings and have been restructuring....I am optimistic about the economy and the stock market next year," she said.
The Fed decision came as something of a surprise to some financial analysts who had expected up to a half-point rate cut. But market psychology shifted toward pessimism after the Clinton administration and congressional Republicans stalled in their efforts over the federal budget.
"It was almost impossible for the Fed not to reduce rates," said Kenneth Safian, president of Safian Investment Research Inc., New York, who expects the long Treasury bond to reach 5.75% in coming months.
Mr. Safian said the rate cut may be neutral for stocks because it had been expected, although it certainly will not hurt prospects for the stock market in 1996.
In fact, Mr. Safian said there may well be a correction in the market due to "financial excesses" he believes exist. The correction "will come when economic activity declines. When will that be? No one knows. The only thing that stands to stall the markets is a weakening of economic activity. If we see economic growth weaken and we have a recession or a mini-recession, there will in all likelihood be a stock market decline," said Mr. Safian.
Patricia Klink, president of Advisers Capital Management Inc., New York, which has $2 billion in fixed-income assets under management, said she was "surprised" by the Fed move. She thought the Fed "would hold out" until later.
She said if economic indicators continue to weaken and "if the Fed believes that economic growth could fall on a consistent basis to below 2.5% toward the 2% level, I believe they will follow a carefully considered program of easing in 1996."
Ms. Klink said the Advisers Capital typical portfolio was not adjusted in anticipation of the move, and the firm for the past six months has been holding close to the nine- to 11-year range in its long-term portfolios and near three years in its short- to intermediate-term portfolios.
"This environment is very close to the type of thing (former Fed Chairman) Paul Volcker used to talk about, trying to achieve two-plus-two - 2% inflation and 2% growth. We are now approaching those goals.
"That means you can expect lesser magnitude of interest rate changes and less boom and bust in the equity market and maybe even higher multiples in equities because of the lower inflation," said Ms. Klink. "We are starting to see the first effects of running a tight ship."
"Short of some extremes, we think the hard work of budgetary discipline will pay off in stocks and bonds," she said.
Not all bond experts were enthusiastic about the rate cut.
Rebecca Garner, chief investment officer at Llama Asset Management, Fayetteville, Ark., said she moved the $220 million fixed-income portfolio to a market-neutral position "as a business decision, not an economic decision" to capture gains achieved during 1995.
She said she will hold that posture "until we see some direction in the markets." The move to market neutral was made "in reaction to the political games being played in Washington."
"Next year is an election year. (Fed Chairman Alan) Greenspan wants to be reappointed and Republicans want to strengthen their majority. There shouldn't be any long-term implications (from the Fed rate cut) since it had already been built into the market. This was just to keep the peace," she said. "It is all politics and has nothing to do with economics. We believe there is more risk on the downside."
Glen Davis, principal at Boston Partners Asset Management L.P., Boston, agreed there may be further interest rate cuts by the Fed next year.
"If we get a decent budget resolution and benign inflation, they could cut another 25 basis points," he said. The firm has $5.4 billion under management, $400 million of that in fixed income.
The Fed "acted appropriately in recognizing the continued good news on inflation," said Steven Gordon, director-fixed income at Warren D. Nadel & Co., Greenvale, N.Y. Nadel has $50 million in fixed income.
But, he added, the Fed's efforts to accommodate are but one part of the longer-term influences on the bond market.
"It's one piece of the puzzle, the budget is another, a strong dollar is another. All these taken together should cause the bond market to rally further into 1996 before rates turn around at some point. .*.*. Barring any unforeseen events, interest rates could head lower for a long period of time."