ALM First Financial Advisors
Second Quarter 2004 Economic Outlook


Prepared by: Lisa K. McDaniel, CFA

April 13 , 2004

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

First Quarter Review

After a heady 2003 and a strong start in early 2004, stocks stumbled in February. The major equity indices finished almost unchanged for the first quarter. The Dow Jones Industrial Average fell 0.9 percent, while the more volatile Nasdaq compos-ite fell 0.5 percent and the S&P 500 eked out minor gains of 1.3 percent (primarily in the house-hold products sector).

February and March can often be difficult months for stocks, however, and many analysts are forecasting a recovery for the remainder of the year. Few, though, expect the kind of gains we saw last year.

The low-key outlook for the rest of the year is the result of continued geopoli-tical worries as unrest and fighting persist in Iraq , along with more general terrorism concerns.

Another factor is a lower corporate earnings outlook than last year. Now that the economic recovery is maturing, earnings growth is likely to be more modest than during the initial phase of the recovery.

The bond market continued to rally over the last quarter, despite bearish predictions for the past several months. The benchmark 10-year Treasury note experienced a total return of 4.7 percent in the first quarter, more than triple its performance for all of 2003.

The gains in the bond market during the first quarter were not so much the result of what changed, but more the result of what stayed the same. Job growth remained subdued for most of the quarter, inflation remained low and the Fed showed no signs of changing its stance.

Another factor that kept Treasury yields down during the first quarter was the seemingly insatiable appetite of Asian central banks for U.S. securities, especially in the one- to two-year area. Japan 's central bank purchased heavily over the last six months to keep the yen from appreciating against the dollar. Indeed, Japanese investors increased their holdings in U.S. Treasury securities by 50 percent in the 12 months ended January 30, 2004 .

For the past three years, companies have focused on cutting costs and cleaning up their balance sheets, while terrorism and corporate scandals raged overhead. Now, companies are turning their attention back to growth; hence, mergers and acquisitions are beginning to re-enter the picture.

In one of the largest merger deals announced, J.P. Morgan acquired Bank One. Among public-company deals, telecommunications and banking occupied six of the top 10 global slots. Cingular acquired AT&T Wireless, and BellSouth Corp. of Atlanta sold off its Latin American wireless assets for $4.2 billion. However, one of the potential blockbusters – Comcast's bid for Disney – stills looks shaky.

Nonetheless, the recent past continues to hang over us like a cloud. The March 11 train bombings in Madrid rekindled talk of terrorism risk. Companies are still weighing the long-term value of deals cut during the '90s boom – many of which failed to reach their advertised potential. Company boards and chief executives are cautiously vetting transactions, often turning the process of due diligence of a potential target into a months-long affair, as opposed to just days of such scrutiny before the recent spate of corporate scandals.

The statistics from the first quarter portray a merger and acquisitions market gaining confidence, but still wary of the new rules of the road. U.S.-based deals came to a total of almost $290 billion, the most since the fourth quarter of 2000, when U.S. companies announced $346 billion of transactions, according to Thomson Financial.

Monetary Policy

As expected, the Federal Reserve remained on hold for the quarter and maintained its economic assessment as balanced. The majority view from recent Federal Open Market Committee (FOMC) speeches continues to indicate that employment will strengthen substan-tially this year, but that downside risks to inflation still slightly outweigh the upside risks.

The Fed continues to stress that it can be “patient” in raising interest rates. Patience could mean waiting a long time to act at all, or it could mean moving very slowly once tightening does begin so the Fed can assess the impact on potentially volatile financial conditions.

During his monetary policy testimony, Federal Reserve Chairman Greenspan said that wage pressures are not likely to build until the unemployment rate nears 4 percent. That equates to 1.7 percentage points and more than two million jobs.

The most recent economic reports have brought the possibility of tightening this year back to the forefront. One month's data does not make a trend, though. The Federal Reserve appears inclined to wait for further evidence and keep rates low until resource utilization rises are sustainable.

Fiscal Policy

The Congressional Budget Office (CBO) recently released its projection of the March budget deficit. The CBO estimates a $70 billion deficit, up from $59 billion in March 2003. This would imply a 12-month cumulative deficit of $418 billion through March 2004, up from $374 billion in fiscal 2003.

The first wave of economic reports for March delivered a very upbeat message. The global economy seems to have ended the first quarter on solid ground, with broad based growth across most sectors and regions.

Fourth-quarter U.S. GDP held at 4.1 percent, consistent with early estimates. The latest report included upward revisions to wage and salary income from third-quarter 2003, and real final sales increased slightly from previous estimates. The profit outlook for fourth-quarter earnings showed strong gains, with pre-tax profits rising at a 32.2 percent annual rate.

The first quarter brought two dismal reports on nonfarm payrolls, followed by a welcome surprise from the March report. In January, the jobs report showed the economy added only 1,000 jobs in December, instead of the widely expected 150,000. Then again in early March, the Labor Department reported that 21,000 jobs were added in February, vs. the expectation for 125,000.

The March report, however, revised both the previous months upward and reported a whopping 308,000 increase in jobs for the current month. Some of the increase can be attributed to one-time factors such as the end of an unusually cold winter and the return of California grocery strikers. Nonetheless, the report may well have indicated a turning point in labor conditions and was certainly the catalyst for a change of sentiment in the fixed-income market.

Layoffs are declining, but hiring remains moderate. Even so, the fundamental signs are still pointing to better hiring conditions. The gradual improvement in most indicators should support an acceleration to more than 100,000 per month (on average) by the summer.

The improvement in factory surveys since the middle of last year is showing up in the hard output data. Industrial production grew 0.7 percent in February and has risen at a 6.8 percent annualized rate over the past six months – the fastest growth rate since early 1998.

The Institute for Supply Management's (ISM) March survey of manufacturers hummed along during the first quarter, rising to 62.5 in March from 61.4 in February. Measurements for both new orders and production are demonstrating strong growth, and the employment index component rose to the highest level since December 1987.

The ISM non-manufacturing survey, which covers the larger share of the economy (the service sector), was also quite strong in March. The progression toward a sustainable recovery will involve more of a rotation in demand from goods to the service sector.

The February data on durable goods orders indicated signs of potential slowing in the industrial sector. Although total orders rose 2.5 percent, the increase was skewed toward bookings of defense equipment and civilian aircraft.

Home sales are showing the effects of the recent decline in interest rates. Sales of new homes surged 5.8 percent in February, while existing home sales increased 2 percent.

Long-term mortgage rates backed up after the March employment report, however. Mortgage rates are approximately 35 basis points above the March average, but still slightly below levels seen in the third quarter of 2003. This suggests that a modest rise in mortgage rates may not put much of a dent in housing activity.

Commodity prices surged across the board through much of the first quarter; the lagged effects of the raw materials increase on prices of final goods should continue to flow through for several months to come.

Oil prices have increased in recent months, but the effect on the economy has so far been muted.

During the energy shortages of the 1970s, expensive crude created widespread inflation and stomped out economic growth. The situation is different today, with the change attributable to the increasing importance of technology and services in the U.S. economy, which in turn reduces depen- dence on the old-fashioned, oil-intensive industry.

Energy consumption now makes up a much smaller portion of overall expenditures than in prior decades. This is primarily because we have discovered how to be more efficient with oil. For example, even though SUVs flourish on the roads today, they are still more fuel-efficient than the gas-guzzling cars of the 1970s. It is also important to keep in mind that the energy-dependent manufacturing sector has shrunk as a percentage of GDP.

Despite the shrinking importance of the energy sector, oil prices still matter. While prices have eased somewhat recently (to almost $38 a barrel on the New York Mercantile Exchange), oil is still far from cheap by any historical standard. Prices still are more than 50 percent above their 10-year average and approximately 13 percent above the average since the outbreak of war in Iraq last year. Furthermore, gas prices are expected to continue to rise over the next few months.

Meanwhile, it seems as if stock-market investors have hardly noticed. While the major indices saw little change over the first quarter, neither were there any noticeable signs of jitters.

As a share of gross domestic product, energy spending peaked in 1981, and then declined more than 47 percent through 2000, driven by the increased efficiency of many everyday devices, such as air conditioners, heaters and refrigerators. As a result, many stock investors have been less prone to worry about ripple effects from fluctuations in energy prices.

Just because oil's role is changing, however, that doesn't mean the risks traditionally associated with an energy run-up have been erased. Those dangers may manifest more slowly, or in less obvious ways than they did previously, but they continue to lurk beneath the surface and can still cause grief – even to the point of causing serious damage.

A sustained run of high oil prices could continue to create pitfalls for the economy and stock market. Expensive crude could drain corporate earnings, nudge the Federal Reserve to raise interest rates more quickly and divert money from consumers' pockets that they otherwise would spend elsewhere.

Another issue to consider is the increasing role of the Organization of Petroleum Exporting Countries (OPEC). Until the late 1990s, OPEC members often cheated on their own production-cutting quotas. But as commodity prices sagged during the late stages of the dot-com boom, oil exporters began acting as a more cohesive cartel. As long as they stay cohesive, they can cut production even in a high-price environment and still be effective. That may be the scenario the markets now face, as OPEC recently confirmed plans to cut its output by approximately 4 percent.

Consumer and producer prices have accelerated somewhat over the past few months, but have yet to follow the magnitude of the rise in commodities. Recent price data suggests the decline in core inflation may have ended, thanks to higher commodity prices and the weaker dollar. However, although the business environment became less regulated and more global in scope, competitive pressures haven't allowed companies to pass through higher energy prices to consumers.

The Producer Price Index rose only 0.1 percent in February, slowing from a 0.6 percent increase in January even though the cost of crude goods was 2.5 percent higher.

The Consumer Price Index rose 0.5 percent in March after rising 0.3 percent in February and 0.5 percent in January. Inflation is still expected to be less than 2 percent for the year. Also, any increase in core inflation would be starting from extreme lows and the movement is usually quite slow, especially in the early stages.

There are two powerful forces exerting downward pressure on inflation today. In the highly inflationary 1970s and early 1980s, the degree of unionization in the workforce was almost twice as high as it is today. Only 10 percent of the total workforce is currently unionized – the lowest reading in the post-World War II era. In this environment, wage growth outpaced productivity gains, putting upward pressure on labor costs.

The second force that is a factor is the change in demographics. Back in the 1970s and early 1980s, the “spending” segment of society (baby boomers aged 25-34 years) comprised an ever-rising share of the population. During the following decades, this segment has shrunk as baby boomers grew older. In fact, the first of the boomers are set to retire in 2005, so spending should shift more toward saving.

Second Quarter Outlook

The economic outlook is consistent with steady improvement in the labor market. The manufacturing sector continues to grow, as witnessed by the surge in industrial production in February. Conditions are expected to remain favorable for business through the end of the year, with easy financing and the possibility of further dollar depreciation. Consumer spending also should show solid gains in the first quarter and housing activity should be robust.

Large tax cuts, mortgage refinancings, low inflation and aggressive discounting all boosted real consumer spending in the past several years. However, at the end of May, the tax stimulus is scheduled to end and gasoline prices are higher. Job and income growth hold the key for consumption in the second half of the year.

While growth should remain at or above trend, productivity is apt to slow somewhat, which is to be expected. Most of the cost savings available to businesses have probably been captured by now.

Inflation is stabilizing and some FOMC members are now leaning toward an upside risk to inflation. However, the language coming out of FOMC meetings continues to be cautious, emphasizing that the Fed can afford to be “patient.”

Concerns are spreading that the current unusually low interest rates, which provided the stimulus necessary to facilitate a shallow recession and restart the economy, will begin to create an inflation problem if some tightening doesn't occur before long.

On the other hand, some investors believe both the rate of economic growth and the pace of inflation will remain subdued enough that the Fed will wait to raise interest-rate targets until after the election.

The March employment report put the prospect of Fed tightening back on the table during 2004.The December fed funds contract is currently yielding 1.59 percent – this implies a 50 basis-point move in the fed funds rate this year.

Fed officials are likely to want to see a consistent pattern of pickup in the labor market before they consider tightening interest rates. Nonetheless, if inflation and payroll numbers continue to rise in coming months, the Fed could decide to move.

The bond market will typically begin to move months ahead of any Fed decision. This will produce higher bond yields, which will have a major impact on the stock market and on economic growth.

Summary

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