(MONEY Magazine) – Greg A. Smith, 52, is willing to go way out there on the subject of inflation. The chief investment strategist for Prudential Securities says: "It isn't coming back." He figures that fierce global competition will keep prices in check for the foreseeable future. Couple that with disciplined corporate cost cutting, especially among the large blue-chip companies, and Smith thinks investors can look forward to healthy corporate earnings in the second half of 1997 and a Dow that will ring in 1998 at 8300. He recently told writer Susan Caminiti why he thinks inflation is as out as the power suit.

Q. The past three years have been pretty good for investing: low inflation, low interest rates, high corporate profits. How did we get so lucky?

A. A lot of things have fallen into place, but I believe the most important economic event was the fall of the Berlin Wall in 1989. Eastern Europe opened up to commerce; so did China, India and many parts of Latin America. Until then, the world for business purposes was defined as Western Europe, North America and Japan. After the Wall fell, lots of governments decided it was important to become attractive to private capital. Bureaucrats tried to balance their budgets and keep inflation under control, and they privatized businesses.

There were opportunities for a lot of companies, particularly U.S. companies, to expand their markets. When you create businesses in economically repressed countries, you create jobs that, in turn, create demand. But you also create supply, which leads to competition. So on a global basis we expanded the world market and we expanded competition. To reap the benefits, companies had to become more efficient. The result for those that did was profits.

Q. Was there anything happening closer to home?

A. Oh, sure. In the U.S. we had aging baby boomers who were getting interested in saving. Just look at mutual funds. By next year that industry will probably have more assets than the banking industry. At the same time, inflation, which the Federal Reserve has been committed to fighting since the late '70s, is under control. In fact, I would argue that the big opportunity for investors is in realizing that inflation isn't coming back.

Q. You're sure about that?

A. There's just too much competition in the world. The only way a company stays ahead of its competitors is by having a clear, strong franchise like, for example, Coca-Cola, where competition can't be created overnight. But for a business operating in a crowded field without a marked advantage--for example, a retailer--there are really no barriers. Just think about it: Most companies can now produce whatever they want wherever in the world it is cheapest to do so. There's certainly no lack of labor on a worldwide basis either. It is really hard to see how you can have any inflation in the prices of most manufactured goods. And if you look at statistics, you'll see that we're actually having very slight deflation in durable goods like cars, no inflation in nondurables like foods and very little inflation in services.

Q. Then why are there so many inflation worrywarts?

A. I think they're simply projecting the past. If you're seven years into a recovery, certain things are supposed to be happening. Unemployment is low, so workers are supposed to demand higher wages. That means business costs go up, so companies raise prices. Then the Fed has to fight that inflation, and you get higher interest rates. That's a classic business cycle. But it's not where we are, because of global competition. Managers are wary of creating any permanent increase in their cost structure because they know there will always be someone to undercut them. In the forecasting business, however, it's easier to forecast something that's consistent with history than to say those very dangerous words: "This time it's different."

Q. But doesn't the United Parcel Service settlement signal the possibility of higher wage costs?

A. No. The UPS settlement is out of step with the way the private sector works these days. It was not that UPS employees got more money, but that the deal was structured to give it to them regardless of how well the business does. Most managers today try to make all costs, including wages, as variable as possible. In good times, you will pay people more but you pay them with profit sharing or stock options. Now the business-cycle folks will say that you're still paying people more money, so it doesn't matter whether it's fixed or variable. But it does matter when you pay employees more only if you succeed.

Q. In fact, you've been saying profits will be stronger than expected in the second half of the year. Why?

A. I think of cost reduction as a freight train that is gaining momentum. There were so many examples of companies in the second quarter that managed to generate okay profits on little or no revenue growth. Whirlpool had a 7% decline in revenues, but earnings were up. Chrysler says it asked its suppliers for cost-cutting ideas, and they came up with something like $1 billion in cuts a year. Because Texas Instruments' operations keep getting more efficient, every two or three years there's a plant they don't have to build. Who knows how much more efficient we can get? I think [Fed chairman Alan] Greenspan was right: We're in the sweet spot of something. But it isn't the business cycle. It's the process of cost reduction.

Q. How should investors take advantage of this?

A. They should divide their portfolios into 70% stocks, 20% real estate investment trusts (REITs) and 10% cash.

Q. No bonds?

A. It's been my feeling that since early in the year if bonds are attractive, stocks are even more so. Now whether bonds are better than cash is another issue. Washington's balanced-budget agreement looks credible, and I'm less afraid that the Fed is going to raise rates. So if someone said why not have 10% in bonds instead of cash, I wouldn't fight that idea. But bonds would be the asset of choice only if you believed that inflation will go even lower or turn into deflation. And I don't.

Q. Why a separate allocation for REITs?

A. I wanted to diversify beyond cash, bonds and stocks, and real estate was the obvious choice. REITs are the easiest way to own it, but the S&P 500 does not include them. So I decided to make them an asset class.

Q. Which REITs do you like?

A. The ones on the West Coast--especially Pacific Gulf Properties [ticker symbol: PAG; traded on the New York Stock Exchange at $24; 6.8% yield]. It has a nice yield and owns mainly industrial real estate in Southern California and the Pacific Northwest. But in Southern California it is also developing what are called senior apartments, which are designed for people who are 55 and older who want an attractive place to live with great amenities and not a lot of screaming babies around. I think it's a good demographic group to be going after.

Q. How are you telling investors to fill that 70% stock allocation?

A. I start by asking myself: What are the businesses that the U.S. is very good at in a world context? The ones I like are all on the New York Stock Exchange. We're very good at consumer products, so I like Avon [AVP; $63; 2%], Colgate [CL; $68.75; 1.6%] and Procter & Gamble [PG; $142.75; 1.4%]. Those are real franchise businesses with products that have broad appeal throughout the world. The odds are high we'll see 15% to 20% a year earnings growth from them. We are very good at technology. Here I like Compaq [CPQ; $69.25; no yield]. The company has totally changed its business model by producing products on demand rather than pushing a lot of goods through retailers and hoping it guessed right. Storage Technology [STK; $47.75; no yield] has teamed up with IBM. So when the IBM sales force is out selling mainframes, they're also pushing Storage Technology's devices for storing things like credit-card information. I like IBM [IBM; $99.50; 0.8%] too, because over the next two or three years there's likely to be a bigger market for mainframes. It's pretty expensive, between the hardware and the software, for companies to keep putting so much computing power on every desk. High-speed intranets plus cheaper, faster mainframes might mean that some companies will use dumb terminals again.

Q. How much higher do you see the market going this year?

A. My guess is that, if I'm right on profits and interest rates stay steady, we'll be up 35% for the year with a Dow around 8300 at the end of December.

"The Dow will be around 8300 by the end of December, up 35% for the year."