ALM First Financial Advisors

ALM First Financial Advisors
First Quarter 2005 Economic Outlook

Prepared by: Lisa K. McDaniel, CFA

April 11, 2005

The economy displayed strong momentum through the first quarter, despite persistently higher oil and energy prices.

In a repeat of last year, stocks went into a slump in the first quarter of this year, unable to hold early gains. In fact, the 2.6% decline in the Dow Jones Industrial Average was noticeably sharper than last year's 0.9% first-quarter fall. It marked the third consecutive year that blue chips have had a losing first quarter, a departure from the upbeat mood that spread through the market at the end of last year.

In the final quarter of 2004, the Dow rebounded 7%, reversing the slide that had gripped the index for most of the year and leaving it with a small annual gain. After an early stumble this year, stocks seemed poised for a fresh advance. By early March, the industrials had risen to a 3½-year high of 10,941, seemingly poised to break through 11,000 for the first time since 2001. But as sometimes happens when an index nears a big, round number, the blue chips abruptly fell back, finishing the year's first three months down 279 points.

The Nasdaq Composite Index, which rose strongly at the end of last year on a surge in technology stocks, has been retracing those gains. It is down 8.1% for the year, compared to a decline of just 0.5% in last year's opening quarter. The broader S&P 500 stock index is off 2.6% for the first three months.

Last year, worries about terrorism and the presidential election weighed on stocks for most of the year. The problem this year however is more classic, involving interest rates and inflation.

The combination of two inflation reports and the Fed’s reassessment of inflation risks caused t en-year Treasury yields to rise 26 basis points in the first quarter, to nearly 4.50%. The yield on the benchmark 10-year Treasury note broke through the 4.50% mark on March 9, the first time since July. It hit a nine-month peak of 4.69% during the last week of March and closed the quarter at 4.48%.

We have come a long way since the beginning of February when ten-year yields slipped below 4% following the release of the January employment report. Two-year yields hit a high of 3.91% for the quarter, ending at 3.78%

In February, Federal Reserve Chairman Alan Greenspan told Congress he was perplexed by the resistance of longer-term yields to rise along with short-term ones. Mr. Greenspan's pronouncement midway through the quarter that low long-term bond yields in the face of rising short-term interest rates are a “conundrum” triggered a major sell-off in Treasury bonds. The result was negative returns for virtually every sector of the bond market, from safe-harbor Treasuries to risky emerging-market bonds.

Before Mr. Greenspan's fateful remark on February 15, bond markets were comfortable with the Fed's commitment to gradually raise the target short-term interest rate and the steady pace of growth in the U.S. economy. The Fed increased rates by 25 basis points in each of its meetings in the first quarter, bringing the rate to 2.75%.

Meanwhile, fresh signs of inflation sparked concerns that the central bank would speed up the pace of interest rate increases, a move that likely would push current bond prices lower because newer, higher-yielding debt would be more attractive.

The latest FOMC statement recognized the growing inflation risks and effectively promised appropriate monetary policy action.

Prior to the FOMC meeting there was a lively discussion in the business press about whether the Fed would drop its “measured” language, signaling a high risk of a 50 basis point move.

While the Fed did not drop the often quoted words “measured” and “accommodative,” they may as well have judging by market reaction. Both the stock and bond-market saw huge reversals after the March 22 nd FOMC meeting.

Although the Fed maintained the language that rate increases would likely be at a “measured” pace, much of the rest of the statement was changed to recognize the growing inflation.

There were two particularly important changes in the FOMC’s latest statement. First, in past meetings, the Fed told us unequivocally that “inflation and longer inflation expectations remain well contained.” This time, the Fed replaced that statement with: “Though longer-term inflation expectations remain well contained, pressures on inflation have picked up in recent months and pricing power is more evident.”

Furthermore, the Fed changed the balance of risk language from an unconditional forecast to a conditional assessment based on monetary policy decisions. “ The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. ” In other words, the latest press statement was a major transition - a giant step towards eliminating “measured” altogether at the next meeting on May 3rd and shifting the risk assessment explicitly as opposed to this more-or-less surreptitious change in the growth/ inflation outlook.

The Fed is saying that without any further action on its part inflation will creep higher. If, however, it continues to raise rates at a measured pace of 25 basis points (or perhaps 50 basis points) a meeting, it hopes to keep inflation in check.

Until the March 22 nd meeting, the Fed had described the risks to the economy strictly in the here and now. For about two years, policy makers have been saying they perceive “the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal.”

The Fed’s more hawkish language is signaling a potentially longer tightening cycle than many economists originally predicted. With inflation creeping higher, the Fed is unlikely to stop tightening until it sees significant signs of restraint in the economy or financial markets.

Economic Indicators

Until quite recently, the U.S. economy had achieved what is known as a “Goldilocks” quality - not too hot, not too cold, but just right. The economy was growing at slightly above-trend rate, but that was all right because it still had excess labor and industrial capacity. Over the last few months, however, as the economy has picked up steam, market participants and Fed officials have become more worried that the economy could soon overheat.

Real GDP rose at a 3.8% annual rate in the last quarter of 2004, according to the government’s final estimate. Consumer spending rose at a 4.2% pace. Business fixed investment rose 18.4%. The report’s inflation gauges were revised higher.

After a blockbuster third quarter, growth slowed to an annualized rate of 4.1 percent% in the fourth - quarter 2003 and 3.9 percent% in the first - quarter of 2004 as the stimulus to disposable income from tax cuts and mortgage refinancings eased.

After-tax corporate profits increased 11% on a year-over-year basis. Profit growth should slow over the next year, however, as top-line growth decelerates and wage inflation begins to move higher.

The U.S. labor market is gradually improving; recent jobless claims have hit their lowest levels since late 2000, and nonfarm payrolls increased 262,000 in February.

Payrolls rose a disappointing 110,000 in March (about half the estimate), and prior months were revised lower. Payrolls averaged a 159,000 monthly gain in the first quarter, a more than sustainable pace, but slower than expected. T he unemployment rate dropped to 5.2%, which was the lowest level since September 2001, as household employment surged by 357,000. Average weekly hours were unchanged.

Consumer confidence has eased slightly of late. The Conference Board’s measure fell to 102.4 in March from 104.4 in February. Job market perceptions were little changed as the job outlook improved, but household income expectations softened. This drop was likely the result of the ongoing sharp increases in fuel costs. Nonetheless, the results remain consistent with gradual labor market improvement, a part of the healthy growth in U.S. production that has been evident in recent quarters, and for the most part since mid-2003.

Consumer spending remains strong as reflected in the 4.2% annualized increase in real spending in the fourth quarter. The strength reflects improvement in the labor market and favorable conditions in financial markets. A persistent rise in interest rates should finally slow household spending later this year. Consumption growth should slow to 2.6% in 2006 from 3.8% in 2004, with residential investment moving to a decline of 5.8% in 2006 from growth of 9.7% in 2004.

Capital spending remains strong, with double-digit (annualized) growth in each of the past three quarters. This reflects a consistently positive set of fundamentals - high returns, rising utilization, strong cash flow, and favorable terms of financing. The strong fundamentals should continue (with the exception of financing terms) and help maintain robust capital spending in 2005.

Housing was extremely strong in the first two months of the year as housing starts averaged 2.19 million units vs. 1.98 million in the fourth quarter.

Housing starts in February surpassed January’s upwardly revised 20-year high, which was spurred by hurricane reconstruction. Low mortgage rates and an improving labor market have kept demand for housing at high levels, but with interest rates rising, housing activity should soon subside.

New home sales jumped 9.4% in February, rebounding to their December level after a sharp dip in January. Existing home sales eased a mere 0.3%. With interest rates significantly higher over the past few weeks, home sales are likely to sag later this spring.

The February durable goods report was somewhat softer than expected, with orders up only 0.3%, shipments down 1.6%, and inventories rising. Nevertheless, the overall trend of investment spending remains strong. Core capital goods shipments (non-defense capital goods, ex-aircraft) are tracking at a 15%-20% annualized pace in the first quarter, even after February’s 2.6% drop.

The ISM Non-Manufacturing index rose to 63.1 in March, vs. 59.8 in February. Growth in orders remained strong. Employment growth was moderate. Input price pressures remained high. Comments from supply managers were generally upbeat.

Although business activity remains robust, a closer look reveals a weaker picture. The inventory component of the manufacturing survey rose to 54.1, the highest since 1988, suggesting that production growth is running ahead of demand. This is consistent with the recent renewed pickup in inventory accumulation seen in the hard numbers and suggests the manufacturing sector may still be poised to slow a bit further in coming months.

The February inflation reports for PPI and CPI show firmly rising core inflation trends for the last six months. The producer price report for February showed only a 0.1% increase in core finished goods prices; however, core prices increased a very significant 0.8% in January.

The consumer price index surprised investors with a stronger-than-expected increase in February, resulting in a 3% increase for the preceding 12 months. An inflation rate of 3% isn't disastrous, but it is something the U.S. economy hasn't seen on any regular basis since 1993.

The core consumer price index, which excludes food and energy, rose 2.4% in February from a year ago, up from a 1.1% year-over-year increase as recently as January 2004.

Unit labor costs are expected to rise faster as productivity growth slows. Labor cost pressures, which have long been anticipated, have actually developed more slowly than expected. In particular, increases in hourly wages have been remarkably steady at about 2.5%. It is difficult for inflation to rise sharply when the economy still possesses excess slack in both labor and industrial capacity.

Why is core inflation rising? The rise in core goods prices mainly reflects two developments. First, the rise in energy and other commodity prices has pushed up producer price inflation - both at the finished goods level and further back in the pipeline.

Second, the persistent decline in the dollar has caused import prices to rise. Import goods prices, excluding energy, are now rising at a 2.9% rate on a year-over-year basis. This compares to year-over-year declines as recently as late 2002.

That said, current inflation anxieties seem a bit overdone. Moreover, the core PCE (Personal Comsumption Expenditure) price index has been much more stable. This is the Fed’s most-watched indicator of inflation.

In February, core PCE prices rose 0.2%, which kept the year-over-year inflation rate steady at 1.6%, and over the last seven months this inflation rate has stayed in a narrow range of 1.5% to 1.7%. Over the same period, however, the core CPI inflation rate has risen from 1.7% to 2.4%.

The major risk to the inflation outlook lies not in energy prices, but in wage compensation. The risks here are rising for two reasons. First, the labor market is tightening. Thus, workers should gain more bargaining power to negotiate higher wage gains. Second, the rise in headline inflation has lasted long enough to have become persistent.

Crude oil prices rose to more than $55 per barrel in March. Long-term oil futures contracts are also higher. Higher oil prices tend to encourage more production and discourage consumption, resulting in an eventual reduction in prices.

For the markets, the biggest worry regarding high oil prices is of course, the effect on inflation. However, increases in oil and other commodities are largely transitional - not part of the underlying inflation trend.

High oil prices tend to damp consumer spending and economic growth - a circumstance where the Fed would normally want to keep interest rates low. But higher oil costs also could fan core inflation, which would call for higher rates.

The impact of higher oil prices arrives with a lag and hits households on the lower end of the income scale the hardest. Households with middle incomes and above are not likely to see a significant squeeze from high energy costs. However, there is some risk that oil will dampen business attitudes and lead to reduced hiring in the months ahead. There has been generally little evidence of that so far.

Just how high would oil prices have to rise in order to tip the U.S. economy into recession? Last summer, one-third of economists who participated in The Wall Street Journal Online's economic forecasting survey said a recession would follow if crude-oil stuck in between $50 and $59 a barrel - exactly where futures prices have traded since late February.

Yet the economy isn't in danger today and the latest forecasting survey shows that economists have changed their minds. None seem to feel that $50 oil prices will trigger a recession. Thirty-one percent said they feel oil would have to be sustained at $80-89 a barrel to stifle growth, while 48% believe crude would have to top $90.

One reason that high oil prices haven't had as detrimental an impact on the economy as initially predicted is that there is a "plentiful amount of liquidity" in the economy thanks to the Federal Reserve's accommodative monetary policy. Despite rate increases over the past 10 months, borrowing costs for business and consumers remain low relative to historical standards.

The economists say they would shave their GDP forecasts by about 0.75% if oil prices were sustained in a range of $60 to $69 a barrel. Oil between $70 and $79 a barrel could reduce GDP growth by 1.25%, $80 to $89 oil could cut GDP nearly 2% and a move above $90 a barrel would potentially knock down growth by 2.5 %.

The economy appears to have started 2005 with plenty of momentum. Growth is expected to average over 4% in the first half, benefiting from a pick-up in business spending and still vibrant consumption and residential investment.

The recent back-up in long-term interest rates suggests that the economy will eventually lose some steam, with interest-sensitive sectors, notably housing, autos, and household and business durables, likely to slacken. By the second half of the year, GDP growth may decelerate to the 3.5% range. Several potential factors could speed the deceleration: a dollar crisis, a steep decline in national home prices, and the prospect of a sharp spike in long rates.

Optimists are hoping that the economy will remain in “Goldilocks” mode - not too hot, not too cold - with moderate growth and moderate inflation. Still, corporate profit gains, the main driver of stock prices, are likely to slow substantially. Analysts think profits at the companies in the S&P 500 rose around 8% in the quarter that just ended, according to Thomson First Call, which tracks analyst estimates. That is less than one-third the gain of 27.5% posted in last year's first quarter, and less than half the 20% rate for 2004 as a whole. The forecast for 2005 as a whole is just 10.7%.

While no one is happy to see profit gains slow, no one expected the red-hot 20% gains to continue. In fact, the pace of gains remains faster than the average for recent decades, which is closer to 7%. The real question is whether inflation will stay tame, and whether interest-rate increases will be mild enough to permit companies to meet the market's reduced expectations.

Needless to say inflation remains the main focus of investors, with concerns reinforced by the prices-paid component of ISM, the FOMC statement and minutes, as well as the fact that both oil prices and the near-full-employment levels are increasingly perceived as inflationary.

The Federal Reserve hasn't had to worry about inflation for years, but now it is becoming a concern. If it doesn't quiet down, the Fed may decide it has no choice but to raise interest rates more sharply. Fears are growing that inflation and interest-rate worries could produce a choppy market this year, with no guarantee of a late-year recovery. At worst, a sharp rise in inflation and interest rates could put an end to the bull market, sending stocks sharply lower.

While market participants continue to worry about oil and other commodity prices, the key path of inflation is through the labor market. Commodity prices do matter, but only in that they could boost inflation expectations, leading to higher wage demands, which then get fed through to consumer prices, reinforcing inflation expectations, and so on. So far, we haven’t seen much inflation coming through the labor market. Yet, while higher oil prices haven’t exhibited noticeable second round effects, they could still leak through at some point.

Solid economic growth, adequate job creation, and increasing inflation concerns suggest that we remain in a structural bear market for interest rates. In the near-term, however, fixed income markets are likely to continue looking for direction.

Bond yields could reach 5% by the early fall and rise a bit further in 2006. Against the revised pattern of short-term interest rates, this forecast implies a flattening in the yield curve to below its long-term average for periods of low inflation. This makes sense given the additional transparency of Fed policy and the likelihood that inflation will remain well contained. However, concerns about Chairman Greenspan’s replacement and the persistence of a large structural federal budget deficit pose obstacles to even more flattening.

Although financial markets have begun to price in a notable probability of a 50-basis-point move in the near term, this seems highly unlikely, for three reasons. First, retention of the “measured pace” language on March 22 strongly implies a commitment to stick to the gradualist approach, at least for the time being. Second, and more fundamentally, inflation is not enough of a threat to warrant a larger move. Finally, although Fed officials would like to see financial conditions tighten further, they do not want this to happen in a disruptive fashion. Their mantra is that slow and steady wins the race.

While consumption growth has remained strong despite higher energy prices since mid-2004, consumer spending should decelerate in coming months. The higher oil and energy prices reduce real purchasing power. The slowdown in consumer spending will tend to be more pronounced if crude oil prices rise still further, and less severe if crude oil prices partially retrace.

Higher oil prices may dampen growth more significantly in the next few months. A slowing in productivity growth would boost unit labor costs unless firms respond by trimming their workforces.

It is likely that higher energy prices will have a greater restraint on growth, but probably enough simply to slow the economy, not throw it into a recession.

Household balance sheets are generally in good shape. On average, businesses have enjoyed robust growth in profits and cash flows in the last couple of years. Thus, the economy should be able to withstand higher oil prices.

Employers are expected to add, on average, 189,000 jobs a month to nonfarm payrolls over the next 12 months.

The Fed will remain vigilant in its pursuit of stable low inflation and have a heightened sensitivity to signs of cost and price pressures as standard measures of “economic slack” suggest the economy is moving closer to potential: the Fed will continue to take its cues from real time data - both official and anecdotal; and will tend toward gradualism, carefully weighing the costs and benefits of each policy change under consideration.