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ALM First Financial Advisors
Second Quarter 2003 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
April 8, 2003
TOPICS
COVERED
First
Quarter Review
Economic growth remained soft in the first quarter, as the uncertainty
regarding war with Iraq had a significant impact on both consumer and
business spending. Although the year began on a more optimistic note with
some extraordinary gains in the stock market in early January, those hopes
faded rather quickly.
On Thursday, March
13th, when it became clear that the U.S. would withdraw its bid for an
additional U.N. resolution authorizing force, stocks prices surged higher.
Many investors expected a reprise of the first Gulf War with a quick victory.
The Dow Jones Industrial
Average gained nearly 1000 points, or 13% in seven sessions, ending Friday,
March 21st at 8522. However, the bullish scenario broke down as the coalition
forces ran into difficulties and incurred casualties over the weekend.
On the following Monday, March 24th, stocks plunged, and the Dow lost
307 points in one day.
Since the war actually
started, war-related news and emotion have dominated trading action. Good
news on the military front sends the stock market higher, while any signs
of difficultly send it lower. The Dow ended the first quarter down 4.2%
from the beginning of the year.
Bond yields were range-bound
for the quarter. The flight to quality trade continued early in the year,
with yields drifting downward from early January to early March. Yields
picked up and then leveled off later in March as war became inevitable,
dissolving some uncertainty.
The war's
impact on the domestic economy has been wide-ranging. For example, the
airline industry has warned that a lengthy conflict could result in widespread
bankruptcies. In fact, American Airlines parent AMR narrowly avoided filing
for Chapter 11.
Beyond
war news, the economic data for the latter part of the quarter remained
mixed.
Fiscal
Policy
The Federal budget outlook has deteriorated sharply, even before the cost
of war is factored in. The White House is now forecasting that the federal
budget will never return to surplus.
The latest Congressional
Budget Office (CBO) figures forecast a budget deficit of $246 billion
for this year and $200 billion for 2004. Both figures are approximately
$50 billion higher than the forecasts made only two months ago. About
$30 billion of the recent adjustment reflects lower than expected revenues
year-to-date, while the rest reflects increases in spending due to legislation
passed since January.
The CBO baseline does
not include the budget impact of the war with Iraq, the costs of humanitarian
aid, or the rebuilding that will be at least partially financed by the
U.S. The President recently asked Congress for $75 billion to fund the
war, relief and reconstruction in Iraq, and the antiterrorism effort.
The total cost of
the war is still not certain, and the future cost of development even
less sure. It will depend on both the size and length of rebuilding efforts,
how the costs are divided among various countries, and revenues generated
from the sale of Iraqi oil.
The House of Representatives
passed a tax bill containing the full tax cuts proposed by the President,
$726 billion over 10 years. The Senate voted on its version of the legislation
in late March, cutting Bush’s tax cut to $350 billion. The outcome
to the legislation will not be known for a while, but the compromise that
is likely to emerge will probably be closer to the House bill. Currently,
the speculation is for a tax cut of $550 billion.
Monetary
Policy
In its latest move, the Federal Reserve left interest rates unchanged,
and broke away from its usual procedure by declining to characterize the
balance of risks. While some saw this as a cop out, the Fed stated that
the level of uncertainty was so great, it was not possible to make an
accurate assessment at this point.
The Fed did promise
vigilant oversight of the economy, even as it expressed some optimism
that things would get better when the war was over.
The Fed has maintained
a neutral risk bias for the economy since last November. It has convinced
many investors that it will not cut rates regardless of how bad the data
gets. Some analysts believe that the Fed’s latest policy directive
rules out an ease until July at the earliest.
If risks are skewed
toward weak growth and low inflation, then why doesn’t the Fed go
ahead and ease? The Fed is probably more optimistic about the underlying
trend in the economy than are many economists – this encourages
a wait and see attitude. There is also a high level of uncertainty in
the outlook and there is no point in cutting rates until some information
on the war and its impact is available.
It is also possible
that the Fed also does not want to contribute to the depressing talk about
the economy until it is ready to act. Finally, the Fed may have concerns
about the effectiveness of further rate cuts.
Economic
Indicators
Economic reports for February were rather
ugly, suggesting that the economy had rapidly lost the momentum with which
it began the year. In March, the Chicago-area Purchasing Managers' Index
came in far below economists' already grim predictions. If anything, indications
are that the economy was even worse in March than it was in February.
Roughly 80% of the economic releases that occurred in March came in below
expectations, which weren’t very optimistic to begin with.
Service industries contractions in March were the most since October 2001,
right after the September 11 terrorist attacks, according to the ISM non-manufacturing
index. This came as a surprise to the markets as virtually no one expected
the reading to fall below 50, which signals contraction.
The ISM manufacturing
index also declined for the first time since October 2002. Both surveys
occurred before the war started on March 19.
Corporate layoff announcements
are still trending well above pre-recession levels. Hiring intentions
remain weak. Moreover, average weekly hours are low, suggesting little
chance of a significant pick-up in payrolls anytime soon. Jobless claims
are trending at a relatively high level, consistent with little if any
growth in non-farm payrolls. Indeed, payrolls declined by 108,000 in March
after a loss of 357,000 jobs in February.
Consumer confidence
measures fell sharply over the past year. The Conference Board reported
in March that its consumer-confidence index had fallen to its lowest level
since 1993. It was also the fourth consecutive monthly decline.
But what people say
and what they do are apparently two separate things. Confidence is down
largely due to deterioration in labor market perceptions; however restaurant
sales were up year-over-year, which is inconsistent with the drop in consumer
confidence. Also, the pace of home sales remained brisk.
GDP for fourth quarter
2002 grew at a rate of 1.4%, about a third of the previous quarter’s
pace. The increase was not enough to generate noticeable job growth. Consumer
spending cooled and business spending remained flat. These trends appear
to have carried over into 2003.
Nine months ago, the
consensus expectations for 1st quarter GDP growth were 3.5%, but now they
are down to 2%. All of the key sources for GDP have been soft: retail
sales, capital goods (non-defense), automobile sales and total work hours.
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.
Cash from home refinancings added a half percentage point to GDP growth
last year, as households spent part of their $7.5 trillion in home equity.
The stimulus from refinancing is expected to only be half as large in
2003 as it was last year, adding less than 0.3% to growth.
Once the war ends,
a sharp decline in oil prices and a restoration of consumer and business
confidence should help propel GDP growth in the second half of the year.
Energy prices rose
sharply and a cold winter boosted energy consumption. Higher energy prices
are taking a toll on many sectors. While crude oil prices retreated at
the start of the war, oil has since moved higher again, and remains far
above its level a year ago; it's now about $30 a barrel, rather than $20.
Higher petroleum prices are hurting a wide range of energy-intensive manufacturers,
as well as the transportation sector, which includes railroads and truckers,
in addition to the airlines.
The longer the war
lasts, the greater the chances that oil prices will extend gains, eroding
business and consumer confidence further. Brent crude for May settlement
rose to almost $27 per barrel, and gold, which has gained 11% over the
past year, rose to $335.25 an ounce.
Second
Quarter Outlook
Unless there is a postwar reaction of great optimism, 2003 could be yet
another challenging year for investors. The global economy is now facing
the risk of a second recession in three years. Even if that does not come
to pass, estimates suggest that over the three-year period from 2001 through
2003, world economic growth will have fallen 3.5% short of its long-term
trend. As a result, unemployment is high or rising in most major segments
of the industrialized world. Even as hopes soar for a quick end to the
war in Iraq, there's also a growing expectation that central banks around
the world will cut interest rates - even after the war ends. Many economists
think that a messy post-war clean-up in Iraq, other geopolitical tensions,
and the SARS virus in Asia will prove to be damaging to global growth.
What happens if the
war does end quickly? Looking back at the first Gulf War, the near-term
effect was a significant effect on confidence and spending. After the
initial bounce, however, things came back down to earth rather quickly
as the euphoria subsided. The overriding theme of 1991 – correcting
the excesses of the late 1980’s – was disrupted, but not derailed.
This time around, the issue is stretched balance sheets, and the repair
process is likely to last well into 2004.
Recent economic news,
including the decline in the ISM indices, has led many economists to think
plenty of damage has already been done to the U.S. economy - which is,
for better or for worse, the world's economic driving force- and that
the Fed will need to act, possibly even before its policy-makers next
meet on May 6.
Furthermore, Iraq,
a country ruined by decades of war, economic sanctions and the neglectful
rule of Saddam Hussein, will have to be rebuilt and stabilized. Some experts
have estimated the task could cost $100 billion.
Getting rid of Saddam Hussein is not going to magically transform Iraq
into a democracy, and it's not going to immediately raise the dismal standard
of living of the country's 24 million people, who have suffered a 90%
drop in gross domestic product (GDP) and a doubling of the infant mortality
rate in the past 20 years.
Though an end to the
war will probably send stock prices higher and oil prices lower (at least
initially), some economists believe the continuing risk of terror attacks
and fighting between the various factions in Iraq during the years-long
rebuilding effort may keep pressure on the global economy.
On the other hand, some investors are worried about a repetition of 1994,
when the Fed tightened 2.5% in a year. At this point this scenario doesn’t
seem very likely as long as inflation remains muted.
Once we get past the
current uncertainty, accommodative fiscal and monetary policy should gain
some traction, adding stimulus to the economy. Spending is expected to
pick up once the war is behind us. How robust economic growth will be
is debatable given the recent rash of weak economic data. Growth should
pick up in the second half of 2003.
The markets currently expect the Fed to ease further. Bond yields are
likely to continue to rise once the war ends; however, perceptions are
shifting rapidly, generating significant volatility.
At some point, most
investors will have to focus once again on the domestic picture. That
point, however, has not yet arrived, so investors find themselves in a
situation that has become all too familiar – waiting. In the months
leading up to the war, investors were waiting to see whether or not there
would be war or a diplomatic solution. Now, with war under way, investors
are waiting for its conclusion – and then there will be the ongoing
rebuilding efforts.
The waiting game has
impacted businesses too, as they wait to hire, wait to launch capital
spending projects, wait to make acquisitions. This situation crimped an
already fragile economy and made the outlook for 2003 dimmer than it was
earlier. The prospect of a fourth consecutive down year for stocks, something
that hasn’t occurred since the Great Depression, looms out there
as a possibility.
In the coming weeks,
signs of improvement in consumer spending and confidence will be imperative.
Labor markets are expected to remain weak through mid-year; however if
jobless claims stay within recent ranges, then they will allay fears that
job losses in February and March are the beginning of a retrenchment.
Home sales declines
in February largely reflect bad weather. March indicators should rebound,
confirming that the sector will not be a drag on growth in the coming
months.
The pessimistic scenario
is looking less likely as our troops move into Baghdad. We expect the
outlook to improve if the war continues to go well, due to 50 year lows
in interest rates and massive fiscal stimulus on the way. Expectations
for a recovery should improve and provide a modest boost to business investment
and hiring later in the year.
Summary
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