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ALM First Financial Advisors
First Quarter 2003 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
January 13, 2003
TOPICS
COVERED
Fourth
Quarter Review
The fourth quarter brought more of the
same – uneven economic performance resulting in sub-par
growth for the U.S. The overriding theme continued to be the
threat of war with Iraq with additional tension added by North
Korea. Fourth quarter GDP growth is expected to be 1%, although
some see a risk that it could be as low as zero.
Business
managers continued to retrench and cut costs, waiting for
a better day, while consumers exhibited amazing resilience
and found creative ways to fund their spending. The housing
market remained robust while manufacturing and corporate America
experienced a bumpy ride. Accounting scandals and the threat
of war continued to devastate investor confidence and further
eroded business sentiment.
Stocks
recorded their worst December since 1931, and posted a third
year of losses. This marks the first three-year losing streak
since 1939 – 1941. The S&P 500 index has lost 40%
over the past three years, the Dow Jones Industrial Average
was down 27%, and the Nasdaq gave up a whopping 67%.
For 2002,
the Dow lost 17%, while the S&P 500 index declined by
23% and the Nasdaq lost 32%. According to the Wilshire 5000,
the broadest measure of U.S. stocks, the total market value
of stocks declined by nearly $3 trillion last year.
Treasury
bond yields continued to reflect economic weakness and the
downturn in sentiment. Yields swung wildly throughout the
past year with the two year note’s yield trading in
a 218 basis point range. The yield curve steepened as investors
braced for war and possible deflation. Treasuries rallied
to their largest annual gains since 1995 while yields fell
to the lowest levels seen in forty years.
Fiscal
Policy
President Bush proposed a fiscal spending package totaling
$680 billion over the next ten years. The objective is to
offer long term incentives for business investment and provide
the critical shot in the arm to business and investor confidence.
The crux of the proposal is tax cuts afforded to all individual
marginal tax brackets and the elimination of the dividend
tax. The bulk of the near-term stimulus would come from the
acceleration of tax cuts currently set to take effect in 2004
and 2006. The degree of stimulus this year will of course
depend on when the legislation takes effect.
The plan,
as proposed, would cut taxes by an estimated $65 to $75 billion
in calendar 2003 – a boost of 0.4% to GDP. Adding $55
billion of additional spending on homeland security and stepped-up
military outlays would provide a total stimulus of $120 to
$130 billion. The greatest potential would occur in 2004,
when $110 billion of additional tax cuts would take effect
(just in time for the election). That, plus the lingering
effects of the 2003 tax cuts, would add about 1.1% to economic
growth.
Since
both moderate Republicans and Democrats have expressed objections
to the President’s fiscal plan, there is a good chance
that the plan will be modified before it is finalized. For
example, many believe that dividend taxes will be cut to 20%,
putting them in line with capital gains taxes, rather than
eliminated altogether.
When will
the final plan be enacted? The typical timeline for the budget
process would call for Memorial Day at the earliest, or July
4th at the latest. A quicker route would be for all Republicans
to sign off on the plan and convince nine Democrats to vote
for the package. This is possible since the President is extremely
eager to have it signed into law and may be willing to deal
with the Democrats to ensure quick passage. Furthermore, moderate
Democrats up for re-election in 2004 will be hesitant to clash
with a highly popular President. In this case, passage could
occur as soon as early spring, but the more likely time frame
is the Memorial Day recess.
Given
the likelihood of a war with Iraq and the fiscal stimulus
package, the budget situation will almost certainly deteriorate
further in 2003. Estimates now call for a budget deficit of
$300 billion in fiscal year 2003 followed by a deficit of
$235 billion in fiscal year 2004.
Monetary
Policy
The Federal Reserve finally succumbed to market pressure and
eased the federal funds rate by 0.50% to 1.25% at their November
meeting. The Fed will continue to keep interest rates at unusually
low levels until the recovery shows definite signs of sustainable
growth. Although there is speculation that another rate cut
will be necessary, at this point no further movements are
expected until the second half of 2003, when the Fed should
begin to tighten, assuming an improvement in economic conditions.
Economic
Indicators
Consumer
spending remained remarkably resilient, with consumer consumption
still advancing 1.8% at its worst and 4% for the third quarter.
Pessimists continue to forecast the demise of the debt-laden
consumer with low savings balances and diminished net worth
as capitalization of home equity becomes a diminishing source
of funds.
Are consumers
tapped out? Debt service burdens are manageable. Delinquencies
on credit cards and consumer loans are down. Consumer debt
as a percentage of disposable income has receded from its
peak in 2001 although it remains at 14%. Consumers still have
easy access to credit. Should this situation change, the outlook
for the consumer would become much bleaker. While there are
problems within some sectors, consumer finances remain in
generally good shape. It is possible that the consumer will
continue to surprise the skeptics as healthy income growth,
increasing housing wealth, and potential reductions in tax
payments combine to boost disposable income.
While
banks have not tightened credit on consumers much in the last
few years, they have significantly restricted credit to businesses.
Many firms turned to the corporate bond market for credit,
but smaller firms have had a tougher time. With a lot of growth
coming from smaller companies in recent years, this has been
a major concern. The good news is that profits have been slowly
improving and cash flows are rising. As with the consumer,
business debt service burdens are not a problem overall, though
credit troubles will likely be apparent for a number of firms
over the course of 2003.
The recent
softness in the economy has largely been isolated in manufacturing.
Inventories have grown even leaner, which suggests the potential
for a pick-up in production in 2003. In the manufacturing
sector, orders have been choppy, but may have stabilized.
The November survey by the Institute for Supply Management
(ISM) edged up to 49.2%.
Companies
are not only carrying slim inventories, but have pared back
labor, and suspended capital spending for the past two years.
Extreme caution continues to constrain hiring, inventory replenishment,
and overall spending. In fact, some over-correction may have
occurred as inventories are near record low levels and equipment
is becoming obsolete and in need of replacement. With profits
on the mend, a gradual recovery in business spending should
occur once the uncertainty regarding Iraq subsides.
Labor
market conditions are still weak. Layoffs are trending lower,
but are still relatively high. Unemployment is starting to
track previous episodes of economic weakness. It jumped to
6% in November, matching the highest rate posted since August.
As it is a lagging indicator, a further increase in the unemployment
rate above 6% is anticipated before the labor situation improves.
U.S. worker
productivity, a measure of how much an employee produces per
hour worked, rose at a 5.1% annual rate in the third quarter.
It was 5.6% higher than in the third quarter last year, marking
the largest year-over-year increase since the first quarter
of 1973.
Productivity remains key to steady progress in GDP growth.
Heightened productivity affords companies flexibility in deploying
resources to boost income and profits. The offsetting impact
of productivity is a lag in payroll gains. The pace of payroll
growth will most likely lag the rate of recovery due to the
strength in worker productivity.
Overall prices for goods were little changed in 2002, not
totally inconsistent with the historical pattern of disinflation
during the first year of an economic recovery. Prices are
likely to rise in 2003. Preliminary signs have appeared in
the leading indicators of inflation such as gold and the dollar.
Gold prices rose 24% to $350 per ounce in 2002 after reaching
a low of $260 per ounce in April 2001. The U.S. dollar fell
15% against the euro and 10% against the yen last year, after
peaking in March. Commodity prices have also advanced as illustrated
by a 23% jump in the Commodity Research Bureau’s (CRB)
index last year.
The current
conflict with Iraq and the strike in Venezuela caused crude
oil prices to rise to their highest level in two years. Venezuela
is the fourth largest exporter of oil to the U.S., accounting
for approximately 14% of crude oil imports. Prices for Brent
crude are 51% higher from a year ago, with February delivery
trading at roughly $30 per barrel. The Energy Information
Administration estimates that oil prices will have a limited
effect on the economy unless prices remain at $30 per barrel
or more for several months. Prices should deflate however,
as OPEC has stated it’s intention to increase production
to make up for the shortfall due to the Venezuelan strike.
First
Quarter Outlook
The New Year
has already begun with many twists and turns manifested in
the form of an aggressive fiscal stimulus package, low interest
rates, uncertain prospects for global economic growth and
tenuous geopolitical conditions. The residual impact of the
events from 2002 will carry forward, at least initially, and
continue to depress activity early in the year. Added to the
real possibility of war with Iraq, these factors could prevent
economic growth from reaching its full potential in 2003.
Obviously, the
situation with Iraq will continue to be the dominant factor
in the early part of the year. Although the fiscal stimulus
proposal should boost economic activity over the next two
years, as well as the long-run economic growth prospects,
the first quarter outlook still remains dicey. The threat
of war with Iraq is having a powerful impact on the economy
and capital markets. The uncertain outcome of any U.S.–led
military conflict is underpinning a heightened level of risk
aversion, which has impacted financial conditions and business
decision making.
News reports say
that the U.S. will increase troop numbers in the Persian Gulf
to 100,000 by the end of January, and that by the end of February,
it may have as many as six aircraft carriers within striking
distance of Iraq.
The resolution
of the situation with Iraq, and also North Korea, should prove
to be positive with regard to the economy and could lead to
a path of stronger growth for the year. As the uncertainty
is lifted, confidence will rise and the outlook for the economy
will be more visible, providing a better environment for risk
taking. However, the risks of a prolonged conflict could change
this picture.
A brief, successful
war with minor disruptions to oil production is not likely
to hinder economic growth in a significant manner. However
the complications involved with prolonged peace-keeping efforts
in the Middle East could constrain what would otherwise be
a robust recovery.
The three key areas
likely to be impacted by military conflict are the budget
deficit, energy costs and defense spending. With a deficit
already headed toward $300 billion, the need to fund the war
effort will continue to cause the deficit to expand further
and require more issuance of Treasury debt. Energy costs may
initially climb above $30 per barrel; however the possibility
of supply from Iraq may actually lower oil prices. Finally,
the largest defense-spending bill in twenty years was passed
last year, and any escalation in the Middle East conflict
will result in greater appropriations. The net effect on the
economy is likely to be stimulative.
The global economy
was a major wildcard for the economy in 2002, and is likely
to remain so in 2003. A quicker, more robust global rebound
would be a big plus for the U.S. economy. Unfortunately, that
doesn’t seem very likely; the more likely outcome is
a moderate global recovery.
The economy is
expected to grow at a 2.5% annual pace in the first quarter,
up from a projected 1.0% for the fourth quarter of 2002. According
to the Blue Chip Economic Indicators survey, GDP is likely
to expand 2.8% for the entire year. Business spending to enlarge
factories, add computers, and other machinery should offset
weakening consumer spending.
All these cross-currents
have kept the bond market largely range-bound. The outlook
through the first quarter includes an on-hold policy for the
Federal Reserve and modestly rising long term yields. If geopolitical
tensions abate, however, the investment environment could
reverse rather quickly. Clarity on the situation with Iraq
will go a long way toward settling the markets, and the easing
of such tensions will cause both fundamental and technical
factors to turn against bonds. A reduction in risk aversion,
combined with accommodative monetary and fiscal policies,
would end the flight to quality trade, causing investors to
leave the Treasury market for other opportunities and sending
yields higher as demand decreases.
Summary
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