ALM First Financial Advisors
First Quarter 2005 Economic Outlook


Prepared by: Lisa K. McDaniel, CFA

January 11, 2005

• Fourth Quarter Review
• Monetary Policy
• Fiscal Policy
• Currency
• Economic Indicators
• First Quarter Outlook
• Summary Chart

Fourth Quarter Review
Global economic growth achieved the strongest gains seen in several years, led by a continued U.S. expansion. Profits saw strong expansion in the industrial world, but major equity markets experienced only moderate growth.

Throughout 2004, the U.S. economic recovery had to overcome seemingly endless hurdles of war and geopolitical uncertainty, surging costs for energy and raw materials, as well as the lingering taint of corporate scandal and its effects on business confidence.

U.S. financial conditions have eased as stock prices have risen, the dollar has fallen, and credit spreads have remained tight. In addition, lower oil prices have eased pressures on disposable income, and businesses have trimmed the pace of inventory accumulation faster than we had expected.

The bottom line is that the economy has performed very well despite some unforeseen contingencies, including the spike in oil prices. Had we known a year ago that the price of oil would go up to $55 a barrel and stay at $40 a barrel, many people might have predicted another recession.

The stock market has posted back-to-back yearly gains for the first time since 1999. After rising 25% in 2003, the Dow Jones Industrial Average added another 3.15% last year.

All of last year's gains and more were achieved since mid-October, as stocks shook off worries about terrorism, Iraq, the presidential election, and interest rates to stage a sharp year-end rally. The Standard & Poor's 500-stock index, which like the Dow industrials was showing a decline for the year in mid-October, finished with an increase of 9% after rise 26% in 2003. The Nasdaq rose 8.59% for the year.

Interest rates have remained remarkably low, despite five increases in short-term rates by the Federal Reserve since late June. In fact, the yield of the benchmark 10-year Treasury note has remained surprisingly tame, ending the year at 4.22%, a slight decrease from where it started.

This is surprising because bond yields typically rise in sync with inflation to make them more attractive to investors who may otherwise be lured into equities.

Analysts offer several explanations for the behavior of longer term yields. First, the Fed's moves were well telegraphed, thanks in part to the regular statements it publishes about the state of the economy even when it leaves interest rates unchanged.

Also foreign central banks, notably in Asia, have been buying U.S. Treasury bonds in an effort to prop up the dollar. Their strong demand has meant that yields haven't had to rise in order for bonds to find buyers.

Another important factor was the American consumer's growing appetite for taking on debt. Throughout the year, as mortgage rates remained relatively low and the housing market stayed buoyant, Americans continued to save little and borrow a lot to buy homes, cars and other big-ticket items.

Monetary Policy
The Federal Reserve raised its target on the federal-funds rate five times in 2004 to 2.25% in order to keep a lid on inflation.

At the last meeting the Fed left its language virtually unchanged from the previous statements. In particular, the Fed reiterated that “underlying inflation” was expected to be “relatively low” and that risks to price stability were “roughly equal.”

So far, nothing has been added to the language of the statement to suggest that rate moves from this point are going to become more dependent on the economic data. Nor is there anything here to suggest a pause in rate hikes anytime soon.

Against a backdrop of smoother functioning labor markets, the Fed will continue to unwind unnecessary monetary accommodation in 2005 with the pace of tightening hinging on officials’ assessment of inflation risks.

There is little doubt that the FOMC will bump the funds rate up another quarter-point on February 2 (fed funds futures have fully priced in the move) and again in March.

The first 2005 meeting outcome that shows significant disagreement between traders is in May, where the odds at this time are split roughly 60-40 for rates between 2.75% or 3.00%.

We expect rate hikes to continue throughout 2005. Why are we so convinced that the Fed will continue to raise interest rates? First, the economy has been growing for three years at an average annualized pace of 3.3%, which is a little ahead of the recovery pace of 3.1% over the first three years of the 1991-2000 expansion. Furthermore, over the last four quarters, the pace of growth has picked up to 4.0%. The current stance of policy is still accommodative and therefore ultimately inconsistent with the Fed’s objective of price stability. Monetary accommodation is no longer needed to support growth. Second, the bond and equity markets have rewarded the Fed for its transparent policy of gradual rate hikes and the markets continue to adjust to accept the next rate hike as a foregone conclusion.

The Fed has additional reasons to raise its target rate at each meeting next year: to fight real inflation over the short run, and to fight perceptions of inflation in the long run. A steady march higher in target rates may be key to keeping the long end of the yield curve as stable as it has been this year. If the Fed does tighten steadily in 2005, that would deliver 3.25% at the end of June and 3.50% in early August.

The combination of eroding slack, Fed tightening and increased business risk-taking suggests moderate upward pressures on long-term interest rates and a continued flattening in the yield curve.

Fiscal Policy
The federal budget deficit reached a record $412 billion in fiscal 2004. Under current law, the deficit is projected to decline to $360 billion in FY2005 and to $229 billion in FY2009 (1.5% of GDP). The dramatic shift from cash flow surplus in 2000 to large deficits reflects the sharp rise in spending for defense, the built-in spending momentum of entitlement programs, and the unprecedented decline in tax receipts, resulting from the 2001 recession, associated stock market declines, and sluggish economic rebound, along with legislated tax cuts.

As President Bush’s first term comes to an end, the administration is showing more signs of concern about fiscal discipline. With the election campaign behind them, the President and his economic team have begun speaking more forcefully of the deficit as a “problem” and pushing agencies to cut budget requests. The effort to rein in spending includes the Department of Defense, which has seen resources soar since the September 2001 terrorist attacks. To fund the huge outlays for operations in Iraq and Afghanistan, and potentially to pay for a larger active duty force, the Pentagon may defer or pare down some weapons programs.

Since his re-election in November, George W. Bush has formulated an ambitious reform agenda. Economic strategists say at least four major issues are likely to define the early years of Mr. Bush's second term: overhauling Social Security; overhauling the tax code; geopolitical uncertainty; and changes in the rules governing litigation.

The stock market’s initial reaction to Bush’s agenda - a more than 7% rise in the blue-chip Dow Jones Industrial Average since election day - has been bullish. The rally has persisted despite continuing casualties in Iraq and a fresh wave of corporate scandal in such sectors as pharmaceuticals and insurance.

Generally speaking, investors like a president who favors less government spending and encourages investment. Giving Americans more control over such things as how to handle their Social Security savings is an idea that should appeal to the stock markets, which could see an inflow of new capital as a result.

Nonetheless, while the Republicans have majorities in both the House and Senate, Mr. Bush will need the support of influential Democratic leaders if his plans are to succeed.

During his first presidential term, Mr. Bush pushed through a handful of tax cuts. Now he wants to make broader, more permanent changes to the U.S. Tax Code, including capping the top-rate tax bracket for certain types of income at their current levels. For instance, the top rate for most dividends and most long-term capital gains on stocks, bonds and other assets would continue to be 15%, and the top rate for federal income tax would be 35%.

Mushrooming government deficits could make members of Congress hesitant to approve further tax cuts. If they are passed, it isn't clear what the effect would be on the markets. Mr. Bush sees tax cuts as crucial for economic growth, because they might prompt people to spend more money on consumer goods or stocks. Then again, if tax cuts induce people to pay down debt rather than invest in stocks or purchase things, the stock market could see little benefit.

In the near term, persistent budget deficits have significantly less impact on inflation and interest rates than commonly perceived; witness the declines in inflation and interest rates to 40-year lows amid soaring budget deficits so far this decade. Inflation is generated by excess demand relative to productive capacity, while interest rates are determined primarily by real economic performance and inflationary expectations.

Currency
The dollar weakened about 4% to 8% against major currencies last year. In recent weeks, the dollar has fallen to its lowest point in more than four and a half years compared with the yen, and reached an all-time low against the euro. President Bush and officials in his administration have said they are committed to a strong dollar, but leaders in Japan and Europe have expressed concern and said they may take action.

Weighing on the dollar this year will be many of the same factors that contributed to its weakening in 2004, especially the burgeoning U.S. budget deficit and the deficit in the U.S. current account - a wide measure of trade in goods and services.

So, who wins and who loses with a weak dollar? For U.S. consumers there are fewer bargains, as foreign-made goods imported to the country cost more. Manufacturers have a competitive advantage - they don't have to lower prices on exports to boost sales and capture market share overseas. Just by keeping prices steady, they benefit because the weak dollar means foreign buyers won't have to pay as much in their respective currencies.

As far as the U.S. economy, the weak dollar can help narrow the trade gap - a sensitive political issue, whether good or bad for the economy. It also can give a shot in the arm to stagnant growth by giving U.S. companies leeway to raise prices, and boosts demand for exports overseas.

First Quarter Outlook
The economy is fundamentally sound, and should perform well in 2005, with modest but healthy growth, controlled inflation and moderate rises in interest rates.

The call for modest but healthy U.S. growth is based on a number of important assumptions. In particular, economists expect oil prices to stabilize or even decline after their run-up in 2004. That development should help restrain price inflation and bolster the purchasing power of households that was restrained by high gasoline and home-heating costs in 2004.

The second key assumption that last year's decline in the value of the dollar has improved the competitive position of American businesses at home and abroad, helping to tame the nation's out-of-control trade deficit.

These assumptions create strong momentum for the economy heading into 2005. However, growth is likely to slow somewhat. Business investment will slow down from the recent growth rate of about 10% in 2004 due to the elimination of some tax benefits, to close to a 7% rate in 2005. Second, consumer spending might ease a bit. There will be no boost from lower mortgage rates in 2005. Third, higher interest rates may impede the housing sector.

We will have no fiscal stimulus next year. In addition, we will see the lagged impact of the Fed tightening, and feel the brunt of slower global growth.

The outlook for 2005 is for real GDP to grow at about 3.6%, slightly above long-term trends, but down modestly from the growth rate of 2004.

The Fed has made it clear it will raise rates to a neutral rate from the current accommodative posture, but there is much debate as to what that neutral rate is. The Fed does perceive that its monetary policy is still accommodative.

The funds rate is still below year-over-year headline inflation, barely above core measures of inflation, and well below its historic average; the yield curve remains significantly steeper than its average.

We expect the Fed will hike rates at virtually every scheduled FOMC meeting in the first half of 2005, and become increasingly data dependent in its deliberations. It would be forced to tighten more aggressively only if inflation accelerates significantly; stronger real growth alone would not force the Fed to change its current stance. The Fed will pause in its rate hikes only if economic conditions suggested a sustained slow-down in growth.

While the general consensus is positive for stocks in 2005, the strategists see several clouds lurking. Skyrocketing U.S. budget and trade deficits, tepid job growth and weakening corporate profits are all current trends that could hurt the economy and stocks.

Treasuries appear vulnerable to a restoration of above-trend growth. Since many bondholders still appear to doubt the resilience of the U.S. expansion, ten year Treasury yields remain well below the projected pace of U.S. nominal growth in 2005-06.

The yield curve appears unduly steep. Typically, the curve becomes quite flat, if not inverted, a few months before the end of a Fed tightening cycle, and remains that way for a while.

The bond market is vulnerable in two respects. First, the Fed is likely to raise the federal funds rate somewhat higher than what is currently discounted in the market. As this occurs, it will flatten the yield curve and make long-dated Treasuries less attractive. Second, volatility and risk are likely to rise as the year progresses. Not only will there be uncertainty about the Fed’s stopping point, but there also will be more uncertainty about the monetary policy setting process.

We expect that spreads over Treasuries of very high quality will widen moderately in 2005. Generally, a flatter yield curve corresponds to wider swap spreads, while declining implied volatility leads to narrower spreads.

Despite the expectation of a benign economic environment, a number of downside threats from past years linger. These include the possibilities of new acts of terrorism and of broadening Mideast conflict. Even a temporary pickup of core consumer prices could revive exaggerated fears of aggressive policy restraint in the industrial world.

Barring a new set of shocks, we should see healthy economic expansion in the coming year. Higher interest rates likely will be a stabilizing force in the outlook, but unless concerns about inflation intensify unexpectedly, prospects favor moderate increases in market rates accompanied by a further unwinding of accommodative monetary policy that could set the stage for a cyclical soft landing over a two-year horizon.

Several factors support this view. First, productivity trends have been a primary component of higher profitability and these gains should now flow to higher wages. This will enable consumer spending to grow at a healthy 3.3% rate (vs. an estimated 3.7% in 2004).

Businesses investment will also contribute positively to economic growth. Businesses have been maintaining relatively low levels of inventories, despite higher confidence in the sustainability of rising product demand. This provides room for increasing production to replenish inventories.

Job growth is projected to average approximately 175,000 per month. Businesses have been very efficient in constraining operating costs. Rising corporate profits and strong cash flows provide flexibility for expansion, and businesses are gaining confidence that product demand will remain healthy.

We anticipate housing activity to level off, with new and existing home sales and new housing starts to average modestly below 2004’s robust levels.

The largest risks to this outlook are a sustained sharp rise in oil and energy prices and higher core inflation that would push up interest rates significantly.

Summary

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