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ALM First Financial
Advisors
Second Quarter 2002 Economic Outlook
Prepared
by: J. Steven Orr, CFA
April 5, 2002
TOPICS
COVERED
First
Quarter Review
What
a difference three months makes. At the end of 2001 the best
we could hope for was positive growth by mid-year. At this
writing most observers are expecting the first quarter of
2002 to show positive growth, perhaps even as high as 4%.
For example, Merrill Lynch has just raised their calendar
year forecast for GDP growth to 3.2%, up one-half of a percent
from December. In the second half of 2002 most industrial
producers in the U.S. slowed production and sold down their
inventories. As Alan Greenspan has suggested in recent testimony,
the budding "recovery" may be limited to restocking
inventories. If the recovery is here to stay, then there will
be cause to celebrate and sell bonds.
With the
data we have so far, the first quarter of 2002 shows the beginnings
of recovery. Consumer spending is almost three-quarters of
our economy. This bell-weather appears to have grown 6.1%
in the fourth quarter of 2001, and a healthy 3% in the first
quarter of 2002. Final demand also appears to have risen at
a 3.5% annual pace. Housing starts and home sales should continue
to show strength, courtesy of the mild winter.
The only
fly in soup so far has been the surly earnings announcements
from corporate America. This is reflected in stock prices,
as the S&P 500's return in the first quarter was basically
flat at -0.06%.
Stocks
are establishing a trading range while waiting on the Fed
and better economic news.
Fiscal
Policy
Instead of a promised fiscal stimulus package we got the usual
sausage mishmash from Congress. The end result is about $90
billion in additional spending for 2002 in the Federal budget.
This should add about one-half of a percentage point to GDP
this year. On the welfare front, corporations realize an earnings
benefit from several depreciation and net operating loss rule
changes. The Joint Committee on Taxation estimates that these
changes will give corporations a $43 billion tax cut. Individuals
got a crack at the pork trough too, with an additional 13
weeks of unemployment insurance payments.
Monetary
Policy
The Fed
Open Market Committee wrapped up its easing campaign for this
cycle in the first quarter. Various Governors and the Chairman
himself made plenty of speeches to that effect. The final
nail in the easing coffin came the first week of March with
Mr. Greenspan's Humphrey-Hawkins testimony. He opined that
the recovery was underway, but worried that it was just an
inventory rebuild. The markets took the hint and bonds were
thrown overboard. The Treasury two-year yield rose from 3.08%
to 3.71% by the end of the quarter. The trend toward higher
rates over the rest of the year is in place. We will experience
brief episodes of lower rates as the economic news ebbs and
rises again.
As the
chart above shows, the Treasury market believes the next move
in Fed funds is up.
Economic
Indicators
A review
of the major indicators released during the quarter shows
the consumer leading the economy toward a rebound.
The Consumer
Price Index rose the last two months on higher gasoline and
tobacco prices, but inflation is not a problem.
There
are several consumer confidence surveys; the two largest are
produced by the University of Michigan and the Conference
Board. The current conditions component of both surveys has
changed the trend from last year.
Turning to the home front, the MBA Refinancing Index surged
briefly in the quarter as rates dipped a final time in the
easing cycle.
Home
sales were the one bright spot during the "brief"
recession. Both existing and new home sales were helped by
mild winter temperatures.
After
falling for fifteen of the last sixteen months, industrial
production actually rose in the first quarter. The bulk of
the change was inventory replenishment, however.
Second
Quarter Outlook
In the
early hours of the second quarter the economic picture is
murkier than last quarter. On one hand there are encouraging
signs of turnaround and upticks in economic data. On the other,
profit warnings from companies, stubbornly high continuing
unemployment claims, and rising oil prices dampen the outlook,
not to mention a volatile world stage. The key to recovery
is final demand. It is one thing for companies to produce
inventory. It is quite another for customers to buy. For customers
to buy, they must have a positive outlook on their individual
or corporate future. Corporate intentions are gauged by projected
capital expenditures. Capex probably grew north of 8% in the
first quarter, as companies bought new machinery and software.
This could prove to be a one quarter boost, but even mid-single
digit growth for the rest of the year will help GDP.
Congress
is unfortunately tied up in Enron knots, and prospects of
further tax relief are dim. On the contrary, look for more
domestic appropriations. An interesting battle is coming in
light of homeland security. This is over Amtrak's appropriation.
They receive around $500 million per year from Uncle Sam,
and have asked for $1.2 billion. The workforce is unionized
and is backing reforms to change the way it does business.
In contrast airports get around $3 billion per year and highways
about double that. Is a national passenger rail system a viable
alternative in an emergency?
Fed watching
is declining in popularity as a sport. The Fed Governors have
made clear that the FOMC will not tighten until they see unemployment
turn south and capacity utilization rise. Middle East uncertainty,
rising crude oil, and middling earnings results will stay
the Fed's hand. We believe good economic releases through
the summer would push the Fed to its first hike in August.
Once it gets going, however, look for serial increases. A
Funds rate of 2.75% is likely.
The recovery
is coming. GDP could hit 3.5% for 2002 and touch 4% in 2003.
Corporate earnings look to be on the rebound, both from productivity
increases and increased sales. Productivity growth is the
key to margins. In the last two quarters productivity topped
5%. At the same time, unit labor costs have declined due to
layoffs and lower raises. This expense reduction sets the
stage for higher earnings margins.
Inflation
usually bottoms at the beginning of a recovery, as falling
prices lag changes in activity. We look for inflation to rise
slightly later in the year, to finish 2002 around 2.5%. The
main drivers are crude oil and services.
Summary
We
look for the economy to hold steady this quarter as a base
for recovery builds. Higher crude oil prices, Middle East
troubles and continued cost cutting in the corporate sector
will keep a lid on GDP growth. Later in the year growth should
pick up, with GDP finishing 2002 around +4%.
Click
here to view Summary Chart
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