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ALM First Financial Advisors
Third Quarter 2003 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
July 8, 2003
TOPICS
COVERED
Second
Quarter Review
Many
economists were hoping the economy would bounce back quickly after the
uncertainties associated with the Iraqi war dissipated. In the early spring,
many firms cited the war with Iraq as a reason for restrained capital
spending and a reluctance to hire new workers. However, since the end
of the military conflict, there really hasn’t been much sign of
significant post-war rebound.
For much of the second
quarter, the stock and bond markets went their separate ways. The stock
market has been more than willing to dismiss bad news and has shown no concern
about the absence of a post-war increase in capital spending. Instead,
investors have hopefully, focused ahead to stronger growth in the second half
of the year. In contrast, the bond market was less enthusiastic about
growth prospects and bought into the Fed's deflation-fighting stance.
The Standard &
Poor's 500 Index surged 15 percent this quarter, its largest quarterly advance
since the end of 1998, as investors anticipated corporate profit growth
will accelerate in the second half of the year. Some investors are betting
the lowest interest rates in 45 years and a $350 billion package of federal
tax cuts will spur spending by consumers and businesses.
The Dow Jones Industrial
Average finished the quarter at 8985.44, a gain of 12 percent for the past three
months. That was the blue chips' strongest quarterly percentage gain since
the fourth quarter of 2001.
The Dow industrials
are now up 23 percent since hitting what money managers hope was a long-term
bottom last October. The industrials are up 7.7 percent since the year began,
and hopes are spreading that stocks finally could turn in a gain this
year after three years of losses. The volatile Nasdaq Composite Index,
full of technology stocks, is up 46 percent since October and 22 percent for the year
so far.
But now, stocks have
to get through the summer, and companies have to start announcing some
real improvements in their business. First-quarter results were better
than expected, and since then, there have been a few mild indications
that business activity is no longer declining. But the profit gains so
far have been based more on cost cutting
than on any sharp pickup in sales. Consumer spending growth has widely
outpaced aggregate wage growth. We can't count on mortgage refinancings
to fuel consumer spending growth forever, and there still aren't many
indications that business conditions are improving a lot.
For
the last two years, investors bought up stocks in hope of a second-half
business recovery that didn't materialize, and stocks wound up falling
to new lows. That has left many people, especially individual investors
who were burned by past downturns, with a healthy dose of skepticism about
the latest rally.
If
the economy and business performance are truly turning around now and
getting ready for some steady growth, then people should be plowing money
into stocks. Bond yields, after all, are at historical lows, making bonds
look like a poor alternative. But if the economy is going to keep limping,
then stocks will have trouble showing many more gains, and could be due
for at least a partial pullback from their astounding spring rally.
Treasury
prices continued to rally in the second quarter, for a return of 3.5 percent
on the bellwether 10-year note. The 10-year Treasury yield, which moves
inversely from the price, ended the quarter at 3.51 percent, down from 3.8 percent at
the end of the first quarter.
Throughout
the quarter, the Fed sent the message that it would keep rates low as
long as necessary to get the economy growing faster. Taking their cue
from the Fed, investors became more concerned about deflation, a condition
of generally falling prices and stifled demand, which fueled the latest
leg of the rally in Treasuries. When the Fed cut its target short-term
interest rate by a quarter percentage point in June and left open the
possibility of another cut, bond prices fell, as many investors were hoping
for a half-point cut.
After
the gains in the second quarter, the 10-year Treasury has returned 4.6 percent
so far this year and 11.3 percent per year during the past 36 months. U.S. government
bonds don't have much more room to rally, but most investors don't yet
see a catalyst for prices to fall drastically.
Nonetheless,
some suggest Treasuries may remain a safe bet for investors. A slow global
economy with unemployment inching higher and scant pricing power has been
a recipe for stability in bonds. Many investors in Treasuries are standing
pat, knowing that if the economy takes another turn for the worse, one
of the best places to be will be in the safest bonds.
Mortgage-backed
securities trailed Treasuries as consumer prepayments of mortgages hurt
returns, along with the surprise management shake-up at government-sponsored
mortgage company Freddie Mac amid disclosures of accounting irregularities.
Freddie Mac's problems caused the spread between yields on mortgage-related
debt and Treasuries to widen, a sign that investors perceived more risk
in those instruments.
Monetary
Policy
After thirteen cuts since the beginning of 2001, the Federal Reserve’s
target for the federal funds rate is at a 45-year low of 1.0 percent. The latest
0.25 percent cut occurred on June 25. However, the bond market had factored
in a more aggressive fight against deflation, causing yields to rise when
the move was announced. The markets are currently pricing in a 1.0 percent fed
funds rate by the end of the year and a 1.25 percent funds rate by the middle
of next year.
The statement accompanying
the release indicated that the Fed was more upbeat about the current state
of the economy, with signs of a firming in spending and stabilizing labor
and product markets. The data released since the meeting have been supportive
of this view.
The FOMC policy statement
retained wording that identified both upside and downside risks to economic
growth as being “roughly equal,” but it also stated that the
probability of a substantial fall in inflation, while minor, exceeds that
of a pickup in inflation. Furthermore, the statement said that the possibility
of deflation, rather than higher inflation was “likely to predominate
for the foreseeable future,” indicating that the Fed is not likely
to act to suppress above trend growth in its early stages.
On the other hand,
the Committee also seems willing to tolerate some further disinflation
without easing policy, as long as the economy grows solidly. Thus, further
easing is likely only if growth disappoints, and tightening will come
only when disinflation concerns have eased.
For all the talk,
deflation has been seen as only a remote possibility. A self-fulfilling
price decline is the deflation scenario very few expect but that the Fed
is guarding against it. Simply put, if consumers expect prices to fall
(for example, autos) the purchaser waits for a still lower price or added
discounts. Given reduced sales, businesses are forced to cut costs - which
leads to weaker demand and eventually brings still lower prices as competition
tightens further. And the process repeats again and again.
Meanwhile, the Fed
has been studying additional options for boosting the economy, and Mr.
Greenspan has offered assurances that the central bank will not run out
of monetary ammunition. Its most effective alternative is to convince
investors about its intentions through carefully chosen words –
otherwise known as the Fed’s “open-mouth” operations.
Another option would be for the Fed to buy massive quantities of long-term
Treasuries (10-year and 30-year bonds). This would raise bond prices and
lower their yields, leading to a flatter yield curve.
Fiscal
Policy
In January, President Bush proposed a $768 billion 10-year tax reduction.
The package finally approved by Congress was only half the President’s
proposal, but it actually provides more stimulus up front.
Some key elements
to the plan include the following: (1) accelerated reductions in marginal tax rates
that were already scheduled for 2004 and 2006 (reductions in marginal
tax rates are one of the most effective ways to apply fiscal stimulus);
(2) capital gains and dividend tax rates cut to a maximum of 15 percent through
2008; (3) accelerated marriage penalty relief; (4) business tax credits,
which should help shore up earnings and provide some incentive for capital
spending; and (5) funds for states, half of which is earmarked for Medicaid.
The $350 billion tax
reduction is small relative to a $10 trillion economy, but it is likely
to provide some support to overall growth. The stimulative effect will
be offset somewhat by a larger federal budget deficit, which will draw
savings away from business fixed investment and put further downward pressure
on the dollar. The deficit for the current fiscal year is now estimated
to be over $400 billion ($550 billion excluding the current surplus in
Social Security). In comparison, non-defense discretionary spending will
be over $400 billion. At some point, something has to give – higher
taxes, cuts in entitlements, or both.
Economic
Indicators
The pre-war drags on the economy, such
as the dismal pace of business investment and the ailing labor market,
haven't disappeared with victory in Iraq. As a result, GDP for the first
quarter came in at 1.4 percent and is not expected to differ much for the second
quarter.
Economists
reined in their earlier forecasts for this year's third and fourth quarters,
to 3.5 percent and 3.7 percent, respectively based on the median forecast of 60 economists
surveyed by Bloomberg News. The estimates are up, however, from 3.2 percent and
3.5 percent in last month's survey.
Chicago-area
manufacturing expanded less than forecast in June, suggesting a slow recovery
for the nation's factories following the war with Iraq. The National Association
of Purchasing Management-Chicago said its factory index rose to 52.5 from
52.2 in May. Economists had expected an increase to 53, according to a
Bloomberg News survey.
The ISM manufacturing index
edged up to 49.8 in June (vs. 49.4 in May), consistent with lackluster
factory sector growth. New orders and production continued to advance,
but at modest paces.
On the other hand, the ISM
non-manufacturing index jumped 6.1 points to 60.6 percent in June, well above
expectations. This was the third consecutive increase in service activity
and its fastest expansion since September 2000. Moreover, it exceeds its
average of 58.5 percent from mid-2000 when the economy was particularly strong.
This suggests that the non-manufacturing sector is booming, which is a
conclusion largely at odds with every other indicator of business activity.
However, it may indicate that economic activity has stabilized and, with
the monetary and fiscal stimuli in place, will accelerate during the second
half of the year.
Labor markets are
still struggling. The June employment report was weaker than expected.
The unemployment rate jumped to 6.4 percent, from 6.1 percent in May.
New claims for unemployment
benefits are still high and the number of people who have to keep collecting
unemployment checks because they can't find a job reached its highest
level since November 2001.
Corporate layoff announcements fell to 59,715 in June, from 68,623 in
May, but these months typically mark the low point in the year for layoffs.
The trend, while lower, is still relatively high.
High initial claims
indicate that the pace of layoffs remains elevated. Jobless claims jumped
to 430,000 the last week of June, well above expectations. Although it
was the first increase in claims in four weeks, it was the 20th consecutive
week that initial claims have been above 400,000, which is the longest
such stretch since the 1990-91 recession.
Payroll employment
fell by 30,000 in June, which was worse than expected. Both April and
May numbers were also revised lower, by a cumulative 75,000. Jobs have
now declined for five consecutive months.
Since February 2001 when payroll
employment peaked, nearly 2.6 million jobs have been lost with more than
2.3 million of those in manufacturing. The bottom line is that the economy
is not yet growing fast enough to generate new jobs. The key question
now is whether the massive monetary and fiscal stimulus, vigorous mortgage
refinancing, equity market rebound, and sliding dollar will propel the
economy more quickly during the second half of the year.
We need to see monthly gains
on the order of 120,000 per month to declare a self-sustaining recovery.
Job growth could pick up in the second half of the year. However, the
economy is still experiencing structural changes, particularly in the
manufacturing sector, and global economic weakness will likely offset
most of the benefit of a weaker dollar.
The housing market
remains strong. May new home sales surged 12.5 percent to a record high and the
trend in weekly mortgage applications points to another gain in June.
Builders were cautious through the first quarter, but now look ready to
boost construction activity in response to a step-up in demand.
Consumer confidence
hit a six-month high in May, according to the closely-watched report from
the New York-based Conference Board. The primary reason that the Consumer
Confidence index rose to 83.9 in May from 81.0 in April is that the expectations
index jumped sharply. In other words, people are hoping and believing
the economy is going to be healthier six months down the road. The consumer
confidence index fell slightly to 83.5 in June.
Consumer spending rebounded,
and reports on household outlays point to a convincing upturn in spending
since the end of the Iraq War. The reasons for the turnaround in spending
include falling energy prices, lower interest rates, rising stock prices,
and improved confidence. Tax cuts should further lift disposable income
at the beginning of the third quarter.
Business investment did not
rebound immediately after the war, as many predicted, but anecdotal evidence
suggests some improvement in June.
Tax cuts for businesses
will help somewhat, but the cost of capital is only one factor in business
investment decisions. Firms will not expand and hire new workers if the
demand is not expected to be there. Business attitudes have not been pessimistic,
but they have generally not been optimistic either. However, firms may
have grown a bit more enthusiastic about the outlook in late June. The
pace of business fixed investment should pick up in the second half of
the year, but it is likely to remain moderate.
Currently, capacity
utilization stands at 74.3 percent, which means that 25.7 percent of business resources
are idle. Although this level is admittedly low, there have been two times
in modern US economic history when business spending, and the stock market
for that matter, have rebounded from even lower levels of capacity utilization.
Capacity utilization measured at 73.9 percent in 1975 and 70.7 percent in 1982, yet
business spending rebounded in the subsequent quarters.
Energy prices have
remained at relatively high levels. Because oil is a global commodity, it
is priced in dollars, and a weaker dollar implies that the price of oil
will be higher (in dollar terms) than it would have been otherwise.
Inflation has continued
to weaken. Core consumer price inflation has slipped below a 1 percent annualized
rate so far this year. Growth in the core consumer price deflator is also
slowing. This weakness prompted the Fed and therefore investors to focus
on deflation, which is a decline in the prices of goods and services.
Deflation is a meaningful threat,
largely because the economy continues to struggle so significantly. Employers
are still cutting payrolls, and consumers are growing increasingly cautious.
The rest of the global economy is in disarray. U.S. businesses are under
intense pressure to further reduce prices for their wares in order to
simply maintain their sales.
This is perhaps best seen in the vehicle market. Buyers no longer seem
to believe that they need to buy now to take advantage of lower prices
or incentives.
If this psychology takes hold
more broadly, then spending and the economy will weaken further, putting
even more pressure on businesses to continue cutting their prices. A deflationary
cycle will have begun.
A deflationary cycle is economically
debilitating because it feeds on itself. Businesses scrambling to maintain
their profitability in the face of weak demand and falling prices are
forced to continue slashing costs. The loss of jobs and rising unemployment
reinforce the decline in demand. Under the most virulent strain on deflation,
employers may even begin cutting workers' wages.
Under the most severe deflation
scenario, household bankruptcies and foreclosures would rapidly rise,
undermining the capital position of the nation’s banking system.
A credit crunch would ensue.
Further heightening the angst
over such a scenario is the realization that policymakers have increasingly
fewer and less effective tools to combat deflation. With the federal funds
rate target so low and the federal budget deficit so high after several
years of massive monetary and fiscal stimulus, it will be difficult for
policymakers to short-circuit a deflationary cycle.
All of that said, deflationary
scenarios remain highly unlikely. Odds remain high that the economy will
be able to avoid sliding back into recession. The recent strong rallies
in the stock and corporate bond markets and improving business and consumer
confidence suggest that the economy should soon find its footing. The
job losses are expected to abate and give way to job gains later this
year.
Moreover, while policymakers
have less latitude to maneuver, they are not completely helpless to jump-start
the economy before it unravels into recession and a deflationary cycle.
Third-Quarter Outlook
While post-war economic improvement has been muted, economists
are forecasting a rebound in the second half of 2003. Massive fiscal stimulus,
in the form of tax cuts, and improving business profits should lead to
a long-awaited economic rebound in the second half of the year, according
to 54 economists surveyed by The Wall Street Journal.
Of course, the same group of economists has been predicting better times
for nearly three years, only to find the path marked by disappointments.
GDP growth is likely to improve in the second half of the year, but should
remain below potential. The nation's gross domestic product - the broadest
measure of economic activity - is projected to grow at a 3.4 percent annualized
rate in the second half of the year. The economy is projected to grow
at a rate of 3.8 percent during the first half of 2004.
While there is widespread hope for a pickup in growth, the economy remains
in an awkward place. Overall growth has been moderate, but healthy productivity
gains have resulted in continued weakness in the labor market.
There are several reasons to expect growth to improve in the second half
of the year. However, the upside appears limited and the downside risks
are unsettling. As long as growth remains sufficiently below potential,
the economy will be subject to downside shocks.
The unemployment rate is expected to remain unchanged through the end
of the year, and then decline slightly to 5.8 percent by June 2004 from 6.4 percent
in June. Corporate profits, meanwhile, are expected to rise 7.7 percent this
year and 12.3 percent in 2004 while the currently red-hot housing sector is expected
to cool somewhat.
With nearly $200 billion in federal tax cuts being thrown at the economy
in the next 18 months and with short-term interest rates near zero, now
is the time to see economic results. The tax cut package is one more item
in a long list of positives for the economic outlook. The war is behind
us, energy prices are down, consumer confidence is up, banks are in good
shape, and there is plenty of liquidity. However, the global economy remains
very weak, and a continued lack of business optimism could impede business
spending in the months ahead.
It’s likely that the economy will grow at a moderate pace in the
second half of the year. However, the longer growth remains below potential,
the longer slack will continue to build in the labor and product markets
– and the longer inflation will decline. The longer inflation declines,
the closer we get to deflation. The tax cut package could boost business
sentiment and fuel capital spending, but there is no guarantee. The cost
of capital was already low and capital spending decisions are based largely
on expectations of future demand. We have yet to see much of a lift in
those expectations.
The outlook for the second half of 2003 includes a strengthening economy
dependent largely on the pace of business investment. The Fed will delay
any tightening until the economy is firmly back on both feet in 2004.
Long end deflation concerns may also prove longer lasting as the competitive
global markets continue to chip away at pricing power. The weakening dollar
will provide some relief. The weak labor market, manufacturing sector
and business investment are the Fed’s focal points. The economy
still waits for business investment to aid resilient consumer spending
as most leading indicators are aligned for stronger economic growth.
We expect modestly improving economic growth will soften the deflation
concerns over time. Fed tightening has been pushed back to mid 2004.
Summary
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