|
ALM First Financial Advisors
Third Quarter 2002 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
July 5, 2002
TOPICS
COVERED
Second
Quarter Review
The
economic recovery, while still alive, struggled in the second
quarter after a roaring comeback in the first quarter. First
quarter GDP growth was very strong at 6.1%, the fastest in
more than two years, but the outlook for the second quarter
is a much more moderate 2.7%.
The economy
hit a soft spot in the second quarter, as the consumer retrenched
and worries about corporate integrity flourished. After two
quarters of solid gains, the consumer took a breather. At
the same time, a series of high profile corporate accounting
scandals took their toll on the equity markets, raising the
cost of capital. While corporate profits are on the mend,
companies are still exercising great caution regarding spending
on labor and capital investment.
Recent
economic releases indicate that May was the trough of a second
quarter slow-down in growth and that activity picked up again
in June.
Stocks
took a dive on fears of terrorist attacks and a slow-down
in the recovery, as well as accounting restatements and bankruptcy
news. The S&P 500 Index is down 13% through the first
six months of the year, the largest first half decline in
three decades.
For the
third year in a row, bonds are beating stocks. This is a result
of mixed economic releases, terrorist fears, worries about
corporate integrity and an ailing stock market.
On the
heels of the Enron debacle, we saw a wave of companies crumble.
WorldCom, Global Crossing, ImClone Systems, Tyco and Xerox
are just some of the companies into which investigations were
launched, or some form of impropriety has been alleged.
Fiscal
Policy
Nearly $100 billion was added to federal spending this year,
indicating an increase in the double digit range. The budget
deficit is estimated to be at least $130 billion in 2002.
Government spending increased at a 6.6% annual rate in June,
and was up 6.7% in May. Spending on national defense rose
18.3%.
Monetary
Policy
The Federal Open Market Committee (FOMC) remained on hold
during the second quarter, and expectations are that they
will continue to do so until the fourth quarter at the very
least. Low inflation has allowed this accommodative stance,
giving FOMC officials time to be sure that the recovery is
on track.
Fed Chairman Alan
Greenspan has been pretty direct in stating he is looking
for the labor market and consumer and business spending to
improve. One of the key phrases coming out of recent FOMC
meetings has been that the degree of stronger demand as a
result of sustained expansion “is still uncertain.”
Currency
The
dollar has suffered this year as a widening deficit and a
slowing inflow of foreign capital appear to have ended a six
year climb. The U. S. currency has lost value against 14 other
major currencies this year, the most since the first half
of 1987. Foreign investors have shied away from U.S. stocks,
further weakening demand for the dollar.
The
prospects do not look much brighter over the next few quarters
either as the economic rebound will bring in more imports
at the same time the equity markets’ underperformance
discourages investment in the U.S. It looks as though the
decline will continue until corporate earnings pick up in
the fourth quarter.
The
good news in the dollar’s descent is that it should
stimulate exports, growth, and the overseas earnings of U.S.
based multi-national corporations.
Economic
Indicators
Inflation, while
up slightly, is still virtually non-existent, as indicated
by the Consumer Price Index.
The CPI index is
up 1.6% from one year ago. Inflation lags the business cycle,
so it usually declines in the first year of a recovery. This
is particularly evident in the PPI, or Producers Price Index.
U.S. consumer confidence hiccoughed in the second quarter,
but odds are that the consumer will hang in there, helping
to cement the economic recovery.
Consumers are responsible
for two-thirds of economic growth, so consumer confidence
is closely watched. It is likely that the perceived loss of
wealth in the stock market, along with the corporate accounting
scandals, is the factors behind the recent decrease.
Despite
strong growth in the first quarter, and milder, though still
positive growth in the second quarter, the labor market has
yet to show any sustained signs of improvement. Unemployment
is still up, rising to 5.9% in June.
The slow
improvement in the labor markets resulting from the mild recovery,
corporate profit concerns, excess capacity and strong productivity
growth argue that a turn lower in the unemployment rate may
be more than a quarter away.
The mortgage refinancing
wave has finally tapered off, ending the strongest refi boom
in history. The lower rates that homeowners were able to take
advantage of should save them $70 billion in interest payments
in 2002 alone, giving them more discretionary income to spend.
With interest rates
low, housing remains very affordable. Home sales continued
to set new records, and new home sales for May reached an
all-time high.
Manufacturing
activity (which was the first area of the economy to dip into
recession) is turning up, initially because of inventory investment
and then due to stronger final demand. Industrial production
rose 1.9% between December and May. Contrary to popular belief,
high-tech industries have seen the fastest growth, with production
increasing 9.8% through May.
Capacity
utilization is starting to rise again as sustained consumer
demand and a need to replenish inventory has boosted production.
While the utilization rate is still low, this is not uncommon
during the early stages of a recovery.
Third
Quarter Outlook
As we begin
the third quarter, the immediate outlook is for more of the
same. Most are convinced that the recovery is in place and
that the U. S. will not slip back into recession;
however a pervasive
atmosphere of caution and distrust is hanging like a cloud
over the equity markets, and keeping bond yields low.
There are encouraging
signs of turnaround and upticks in economic data. However,
accounting issues and continuing high unemployment claims
dampen the outlook. The key to the recovery is the consumer,
and the labor market remains the key to their outlook. Once
job growth improves, then consumer spending gains will resume.
The probabilities
of Fed tightening have been overstated in the forward markets
all year. Recent developments suggest that the Fed may be
on hold for the remainder of the year.
Despite recent
setbacks, overall financial conditions support a slow but
sustained growth trend. We are seeing a productivity led profit
rebound that will eventually encourage greater risk taking
in the capital markets and by businesses. GDP growth is expected
to be around 3.5% for the second half of the year.
As the factors
weighing down the equity markets begin to dissipate and stocks
halt their downward slide, upward pressure on interest rates
should resurface. Real yields remain unsustainably low, making
bonds richly overpriced and vulnerable to positive economic
surprises.
Summary
Click
here to view Summary Chart
|
