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ALM First Financial Advisors
Fisrt Quarter 2004 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
January 13 , 2004
TOPICS
COVERED
Fourth
Quarter Review
2003 may have come in like a lamb, but it went out like a lion. Well over 70 percent of the economic indicators in the final few weeks of 2003 managed to smash through expectations. And in contrast to the paltry 1.3 percent growth rate that was posted in fourth-quarter 2002, it looks like we will easily achieve 4 percent in the fourth quarter of 2003.
Several scandals erupted during 2003, but you wouldn't know it from the financial markets. The year began and ended with a scandal that threatened to derail the steam engine of economic growth in the United States – the housing market. In January, Freddie Mac, the country's second-largest mortgage finance company (after Fannie Mae) became embroiled in what would turn out to be a $5 billion accounting scandal, announcing that it would have to restate earnings for at least the past two years. With new management and increased regulatory and legislative scrutiny, Freddie Mac ended the year by paying $125 million in fines to settle civil charges.
Investors and homeowners largely shrugged off the scandal, however. Freddie Mac's stock fell this year, but it is up approximately 25 percent from its lows in early June.
The biggest scandals of the year involved the New York Stock Exchange and the mutual fund industry. The NYSE, the nation's oldest and one of the world's most prestigious stock exchanges, became ensnared in a massive controversy over the huge retirement package for its chairman and CEO, Richard Grasso.
Meanwhile, New York Attorney General Eliot Spitzer began an investigation into the $7 trillion mutual-fund industry. The probe revealed that top executives and mutual-fund managers from many of the biggest mutual-fund companies took advantage of market inefficiencies to rapidly trade in and out of their own funds for a quick profit, at the expense of long-term fund holders.
A total of 88 firms were surveyed by the Securities Exchange Commission in 2003 regarding improper fund trading. Approximately half the firms admitted they had deals with select investors allowing market timing. Some fund companies and executives have been charged with fraud.
Investors again seemed unmoved by the turmoil in the fund world, as net inflows to stock funds for the first 11 months reached $138 billion, compared to a net outflow of $19.4 billion a year earlier.
And with good reason – U.S. stocks just completed their first positive year since 1999. Indeed, stock markets across the globe sprang back to life in 2003, enjoying their first broad-based rally in four years and whetting expectations for more to come.
Despite a slump early in the year, touched off by worries over the war in Iraq , the Dow Jones Industrial Average finished 2003 with a gain of 2112 points, or 25.3 percent, at 10,454. That compares with a gain of 25.2 percent in 1999, the last winning year for any major index. The broad S&P 500 index rose 26.4 percent for the year. What a change that is from the mood 15 months ago, when the fear was that stocks were headed down for the foreseeable future. (Oddly enough, the capture of Saddam Hussein had virtually no long term impact on financial markets.)
It is interesting to note the biggest gainers have been the stocks that were the most discredited during the bear market – technology stocks, notably those related to the Internet. Amazon.com, which lost more than 90 percent of its value during the bear market, more than doubled in value last year.
The Dow now is up 43.5 percent since its low of 7,286 on October 9, 2002 , and the more volatile Nasdaq Composite Index has risen 80 percent since its low of 1,114 that same day. The recovery of the past 15 months brought the Dow industrials more than half-way back to the record high of 11,722 hit four years ago, in January 2000.
For the first time since 1999, investors pulled away from Treasuries in search of higher profits. Yields on the benchmark 10-year U.S. Treasury note (which move in the opposite direction of its price) rose to 4.25 percent at the end of the year from 3.82 percent at the beginning. It was the first time in four years that the yield on the 10-year bond rose for the year.
In July and August, disappointed bond investors sent Treasury yields soaring as economic data came in stronger than expected. The 10-year yield shot up to approximately 4.6 percent, from 3.1 percent in a little more than a month. In the fourth quarter, yields settled down and traded between 4 percent and 4.5 percent. The 10-year Treasury finished 2003 with a total return – including price changes and interest payments – of 1.38 percent.
Monetary
Policy
Despite the lowest policy rates in two generations and an improving global outlook, monetary policy is likely to remain accommodative in the major global economies this year. With low inflation in the United States , the Federal Reserve's Federal Open Market Committee (FOMC) need not act preemptively to preserve price stability, in sharp contrast to the policy rate cycles since the early 1980s.
In the context of productivity-driven growth and historically low inflation, the Fed has established the theme that a solid recovery alone does not set a timetable for tightening. An environment of self-sustaining above-trend growth, mixed with an overly accommodative monetary stance, was sufficient to launch an aggressive turn by the Fed at the start of the last major upturn in 1994. However, inflation then was near 3 percent, not today's 1 to 1.5 percent range. The combination of strong productivity trends, visible slack in labor and product markets, and the high level of Fed credibility reinforces a cautious approach to changing policy's direction that is very different from cycles of the past two decades.
Given this setting, it is likely that any move toward restraint will proceed cautiously. Fed officials have not yet articulated the process for tightening in a setting where inflation is in a range broadly consistent with price stability. Such guidelines should be sorted out in the first half of this year.
The language of the FOMC's last post-meeting press release changed in subtle ways, suggesting that the seeds have been planted for an eventual tightening of policy. While the FOMC repeated that it could keep policy accommodative for a “considerable period,” it also said the risks between declines and increases in inflation were balanced. Moreover, the FOMC pointed to both low current inflation and significant slack in the economy – suggesting that it would be looking at the core inflation rate and the output gap (the difference between productivity growth and GDP) as key indicators about when it might change policy.
Fiscal
Policy
The fiscal stimulus unleashed over the past two years has come at a cost as the federal budget balance has turned from a surplus of $127 billion in 2001 to a projected deficit of $374 billion in 2003.
In this election year, the federal government will once again inject a generous amount of stimulus into the economy in the form of tax relief and spending increases. As a whole, federal stimulus should add as much as $180 billion, or 1.6 percent of GDP, which accounts for about 30 percent of next year's estimated headline growth. The budget deficit is poised to reach over $550 billion in 2004 (4.7 percent of GDP) in one of the fastest erosions in public finances on record.
With wide federal budget deficits, an accelerated pace of Medicare spending looming in 2006, new infrastructure needs rising, and baby-boomer retirement on the horizon, the need for a major shift in fiscal policy will become more urgent as time passes.
Currency
Despite newspaper headlines that proclaim worrying new lows for the dollar in foreign exchange markets, the dollar's slide has so far been positive for U.S. economic performance. Yet many worry that the dollar's fall threatens a loss of confidence in U.S. markets and higher interest rates.
Worries that the dollar's decline will cause higher interest rates center on our huge internal and external financing needs, on the recent decline in U.S. private capital flows, and on a tilt toward protectionism.
Economic
Indicators
Economic releases continued to show robust and broadening U.S. expansion, as the industrial sector clicked on all cylinders for the last few months of the year. Consumer demand is advancing moderately, and the labor market is finally showing signs of improvement. Factors promoting economic growth in 2003 included low interest rates, lower tax rates, defense spending, and low inventories in the face of rising demand.
Third-quarter GDP growth came in at a blistering 8.2 percent. This surge represented a significant turnaround in economic activity and sentiment. No one expects this pace to be sustained, but estimates for the fourth quarter are in the 4 percent range.
Productivity growth continues to accelerate and is now running greater than 5 percent on a year-to-year basis. This is roughly double the average of the past four decades and has been at the root of the profit revival.
While the pace of productivity gains may slow, they are still projected to contribute significantly to economic growth, which will help keep profit growth in double digits and core inflation low.
Labor conditions have lagged the recovery as surging productivity and tentative cost-cutting initiatives trimmed nonfarm payroll levels, leading to an advance in the unemployment rate to 6.4 percent in June 2003. Just two years after the economy supposedly bottomed in November 2001, nonfarm payrolls are still down nearly one million with the manufacturing sector shedding 8 percent of its jobs.
Payrolls were particularly disappointing in December, rising by only 1,000 jobs, with previous months revised downward. Some of this may be seasonal, given that business slows during the holidays. 
However, the job market is finally improving as the pace of layoffs subsides. But it is still tough to find a job, as seen by the elevated level of continuing claims. The number of people jobless for 27 weeks or longer is at its highest level since 1992, and the average period of unemployment is at its longest since 1983.
The bottom line is that there are structural changes taking place in the job market. Self-employment, part-time workers and temporary agency employees all represent an ever greater share of the labor force because companies do not want to take on the benefits cost that comes with adding full-time staff.
Nonetheless, stimulative financial conditions have boosted U.S. activity sharply since April, and labor demand recently has begun to turn up. Above-trend growth should boost employment substantially in 2004-2005.
Housing starts jumped 4.5 percent in November after posting a 2.5 percent gain in October. Total starts are now 17.6 percent higher than a year ago – and reached their highest level since February 1984. It doesn't hurt that mortgage rates have remained below 6.5 percent for 17 consecutive months, a record since the series began in 1971. Total home sales remain on pace to set new records in 2003, although they have begun to slip a bit.
The MBA's weekly survey of applications continued to edge down in the fourth quarter. The four-week average is now at the lowest level since June 1992. It still remains just above the threshold level that the industry uses to define a boom, however, so refinancings remain strong in an historical context.
Consumer spending rose sharply in November. Income growth has been the key driver of consumer spending, providing for a sustained expansion. Consumers should continue to play their part in keeping the economy going, but spending will be dependent upon improvements in the labor market.
Softness in business investment in the first half of 2003 was disappointing to say the least and largely self-imposed, as managers were reluctant to undertake new initiatives in an uncertain economic environment.
Corporate America went overboard in slashing capital spending and payrolls, so that the headwinds of excess have turned into tailwinds of pent-up demand. Narrow credit spreads, the first signs of looser bank lending standards, the ongoing decline in the dollar, and further increases in stock prices are all financial fuel for the revival.
Capital investment expenditures rose sharply in the second half of 2003, as businesses put resources toward raising output as well as productivity.
Indeed, pent-up demand for capital goods and hiring is beginning to appear in incoming data. Nominal outlays for equipment and software rose by 5.6 percent from the third quarter a year ago, and there are strong hints that the upswing is sustainable. The passing of the baton from the consumer to corporations should facilitate a more sustainable recovery and faster rate of growth.
Commodity prices surged, reflecting worries about possible future inflation and a weaker dollar. Gold prices soared past $400 in 2003, from less than $300 at the start of 2002 and less than $350 at the start of last year.
Oil prices, which rose above $30 a barrel last year as the war with Iraq loomed, finished the year above $30 despite the war's quick completion, held up by a recovering economy and continued tensions in the Middle East .
In spite of the rise in commodity prices, there is no mistaking the fact that inflation is at an historical low by any measure. With the core consumer price index (CPI) running at 1.1 percent, the economy has a great deal of capacity to absorb expanded activity without straining resources and inflating prices.
Higher energy, industrial, and raw materials prices, combined with a falling dollar, have heightened inflation concerns; but remarkably strong productivity growth has kept inflation in check. 
The low rate of CPI gives Federal Reserve officials considerable leeway in determining monetary policy. Given that inflationary pressures are not an issue these days, the Fed can maintain an accommodative policy without fear that inflation will rear it ugly head any time soon.
Looking ahead, cyclical reflationary forces should begin to gain the upper hand and gradually lift inflation. Corporate America has reduced capacity, monetary policy is inflationary and above-trend growth is closing the output gap.
First-Quarter
Outlook
It seems safe to say the U.S. economy has finally turned the corner. Economic growth has accelerated to an above-average rate, and the unemployment rate has begun to decline. This shows that the economy is finally reaping the benefits of recent tax cuts, interest rate cuts and the dollar's decline.
Staying Power
Investors increasingly seem to accept the view that the economic revival now under way has staying power in 2004 and should mature into a sustainable expansion in 2005, with real growth running at a 3.5 percent trend rate and inflation edging higher.
It's no surprise the economy is heating up as a presidential election year begins. Over the past four decades, election-year GDP growth has averaged nearly 1.5 percentage points more than in non-election years, according to Merrill Lynch's economics team .
The expansion appears to have reached a self-sustaining stage, with labor demand likely to rise substantially in coming quarters. Pessimists still find sources of worry in the “usual suspects,” including the modest household savings ratio, high debt levels and the record external deficit. It is unlikely, however, that these factors will diminish the U.S. cyclical expansion.
Economic indicators suggest that growth will remain strong, although not at the third quarter's frantic pace. The recent data suggest that, in the absence of a significantly negative shock (such as a terrorist attack, a freefall in the dollar, or an oil price spike), growth should remain at an above-trend pace throughout 2004.
Growth Factors
A number of factors will contribute to above-trend GDP growth in 2004: expansionary monetary and fiscal policy, the lower dollar, continued low interest rates (albeit rising), the late replacement cycle for high-tech equipment, stronger world-wide growth, and inventory accumulation from record low inventory-sales ratios. However, there are also several reasons why growth will be moderate: little pent up demand after several years of strong consumer spending, rising interest rates (which will slow housing activity), and structural shifts in the economy that suggest job growth will continue to be slower than normal.
The real gusto behind growth in 2004 is expected to be business spending. With profits surging, inventories depleted and demand on the rise, companies have the wherewithal and the need to boost both investment and hiring.
Competition for capital should begin to heat up in late 2004, as accelerating capital spending and inventory accumulation collide with slowing growth in corporate profits and the government's still sizable call on the capital markets.
Right now, with ample slack in the economy and trend growth in productivity estimated at 2.5 percent or higher, there's plenty of room for the economy to grow strongly without much pick up in inflation. Rising corporate profits and steady economic growth are expected to prompt companies to hire workers more aggressively in the months ahead.
Financial Markets
A year ago, investors needed to allow for a possible war when they contemplated how to position their portfolios. This year, investors are faced with a more prosaic set of considerations.
Few analysts think stocks can rise 20 percent again this year, but a large number of them are forecasting some kind of gain. That marks a sharp contrast to the mood a year ago, when a fourth consecutive year of stock declines seemed a real possibility.
Rising interest rates need not promote a bond market bloodbath as it did in 1994. Both the domestic and international sources of inflation appear much tamer than in 1993, and inflation is below the Fed's presumed 1% – 2% comfort zone, so aggressive monetary tightening seems unlikely anytime soon.
Long-term interest rates should move up modestly over the next year as borrowing demands increase, but Fed policy is likely to remain on hold until mid-to-late 2004. The pace at which foreign investors are purchasing dollar denominated assets may be slowing, which will push rates up, but a slow-moving Fed and contained inflation should offset much of the impetus for rates to move upward. Rates should rise more quickly in 2005.
Still, many analysts fear that 2004 will be a struggle for the bond market. Exactly when and how forcefully the Fed acts are two of the questions likely to dominate the bond markets this year.
Another clue to how the bond market takes the possible news of a Fed interest-rate increase will be the steepness of the yield curve, which depicts the relationship between bonds of different maturities. Recently, the curve has been steep, another way of saying short-term rates are low and long-term rates are relatively high. This feature of the market proved profitable for many traders borrowing at short-term rates and investing in long-term rates, the so-called carry trade. But if the Fed increases rates, that trade could lose investors money.
Improving Economy
The combination of low interest rates, tax cuts, a weaker dollar and lean inventories has restarted the U.S. economic engine. Momentum is now building, which should carry into 2004.
“While the outlook might appear too good to be true, expect solid economic growth to be accompanied by gradually rising employment, low inflation and higher corporate profits,” Lynn Reaser, chief economist for Banc of America Capital Management, wrote in a preview of the new year.
We foresee a much healthier mix of economic growth, whereby some of the growth comes from job gains and not just productivity. In the past three years productivity growth has outpaced overall GDP growth, resulting in a contraction in employment. On the other hand, the fast pace of productivity growth should keep the core rate of inflation from rising significantly, even if commodity prices continue to rise.
Housing
A significant potential negative for the economy is a sharp pullback in the housing market. The blistering hot housing sector has been fueled by historically low interest rates. However, as the economy rebounds, interest rates will rise and this will dampen housing demand. The key for housing activity will be how much interest rates rise and the relative strength of the labor market. If the increase in interest rates is moderate and the labor market continues to improve, thus increasing personal income, the negative impact on housing should be moderate.
Transition
Many forecasters believe the economy will go through a transition in 2004. Last year, households did much of the heavy lifting for the economy. Businesses are expected to lead the way in 2004, by investing more in new equipment, hiring more and slowing down their rapid pace of inventory reductions.
Economists point to a variety of factors for their call for business-led growth. Corporate profits were up more than 25 percent in the third quarter from a year earlier, and are expected to continue to rise by 15 percent in 2004.
While the economy isn't expected to boom, economists are cheered by the expectation that the economic recovery, which picked up momentum in the second half of last year, remains on track and will run deep enough to trigger meaningful gains in employment and business spending. The consensus forecast calls for real gross domestic product – the broadest measure of economic output – to grow at an annual rate of 4.5 percent in the first quarter, 4.3 percent in the second quarter and roughly 4 percent in the second half of the year. That's somewhat slower than estimates of the just-ended second half, which was marked by an 8.2 percent growth surge in the third quarter, but represents a sharp acceleration from the 2.6 percent rate that prevailed between the official end of the recession in November 2001 and the beginning of third quarter 2003.
Summary
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