ALM First Financial Advisors

ALM First Financial Advisors
Third Quarter 2004 Economic Outlook

Prepared by: Lisa K. McDaniel, CFA

July 15 , 2004

The first half of the year held a few surprises for the financial markets. Profits were generally stronger than expected, and nonfarm payrolls finally began to post solid gains again. Real gross domestic product (GDP) grew at a 3.9 percent annual rate in the first quarter and is expected to have grown 3.7 percent in the second quarter.

The biggest surprise was inflation. The year-to-year change in the core consumer price index (CPI) hit rock bottom in December 2003 at 1.2 percent, but it soared to 1.7 percent in May of this year.

However, growth appears to have ended on a weaker note in the second quarter, with retail and auto sales coming in well below their recent trend.

Stock indexes finished the quarter with small gains. For the latest three-month period, the Dow Jones Industrial Average rose 77.78 points, or 0.8 percent. The broad Standard & Poor's 500-stock index ended the quarter at 1140.84, up 1.3 percent. The technology-heavy Nasdaq rose 2.7 percent, to 2047.79.

It appears that big companies overall will report profit gains of more than 20 percent for the fourth quarter in a row – a trend that has occurred only five times in the past 50 years.

The hope is that the stock market will now be free of two huge worries that had been holding equities back for months: the prospect of a Federal Reserve interest-rate increase, and the handover of power in Iraq . Both of those much-anticipated events finally occurred at the end of June.

After several false starts, the much anticipated trend toward higher yields and a flatter yield curve appears to be underway. Treasury yields have climbed by as much as 125 basis points (b.p.) in the middle of the curve since mid-March as the missing ingredients for a Fed tightening cycle (namely, employment growth and rising inflation) have been added to the mix. Despite a rally in the last week of the quarter, the benchmark 10-year Treasury note fell 4.93 percent in the latest three-month period.

The 10-year Treasury note's yield, which is used to set interest rates on home mortgages, began the quarter at 3.84 percent and at one point rose to 4.90 percent, the highest level since June 2002.

The second-quarter decline in Treasuries followed their biggest quarterly advance since 2002 in the first quarter, leaving them little changed year to date.

This year's surge in yields began April 2 with the release of the monthly employment figures for March. The U.S. Department of Labor report showed that U.S. employers, after cutting jobs at a rate of approximately 62,000 a month in the past three years, had added 308,000. This was more than double the median forecast of economists surveyed by Bloomberg News. The March job gain was later revised upward to 353,000.

Late in the quarter, bond investors became more concerned about inflation than jobs. Prices of oil and other commodities were hitting new highs. Commodity prices settled down a bit in June, as did bond yields.

The Federal Open Market Committee (FOMC) increased its federal funds rate target to 1.25 percent on June 30, 2004 . In the statement accompanying this action, it described both inflation and growth risks as balanced.

Just three short months ago, few saw the rate increase coming. Weak jobs numbers and relatively harmless levels of inflation kept bond yields low. Many investors were predicting the Fed wouldn't need to boost rates to cool the economy until 2005.

That perception was jolted on the second trading day of the quarter, with the release of the March employment report causing discussions of a jobless recovery to suddenly evaporate.

The growth in employment and accelerating inflation during April quickly prompted the Fed's monetary policy committee to change its tune. Its March 16 statement had said the policy committee “believes that it can be patient in removing its policy accommodation.” Then, at its next meeting on May 4, the committee said it “believes that policy accommodation can be removed at a pace that is likely to be measured.” This was the signal that the Fed was ready to enter a tightening cycle.

Disinflation has now run its course, and the pace of job growth is sufficient to reduce labor slack over time. The key issue is now how rapidly the Fed will need to tighten. The baseline scenario remains a “measured” pace of tightening. In addition to price and economic growth developments, the policy rate trajectory will depend on financial conditions and their anticipated impact on aggregate demand (relative to supply).

Under Federal Reserve Chairman Alan Greenspan , the Fed has had a strong preference for gradual policy changes, particularly in the early stages of a rate cycle. In not one, but three places in its recent statement, the FOMC voiced its skepticism about the acceleration in inflation: (1) “although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors;” (2) “the upside and downside risks to the attainment of both sustain-able growth and price stability for the next few quarters are roughly equal;” and (3) “underlying inflation is expected to below.”

The FOMC did leave a back door open, however. The statement also highlighted the Committee's willingness to act aggressively if price pressures unexpectedly intensify in order to fulfill its obligation to maintain price stability.

Many investors expect U.S. fiscal policy to tighten in 2005, either by reduced government expenditure, or (the more likely scenario) by increased taxes.

Congress is unlikely to enact a budget resolution this year. Individual appropriation bills have begun to move ahead on their own, particularly those related to defense. However, without a budget resolution, Congress likely will be forced to sweep whatever bills remain into omnibus budget legislation, to be passed in a lame duck session following the election.

Economic Indicators

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

Productivity growth accelerated dramatically over the past decade, averaging nearly 5 percent in 2002-03. This rapid pace kept inflationary pressures at bay. But now the typical early-expansion boost to productivity is waning, with productivity growth likely to average approximately 2 percent in the first half of 2004. Lower productivity means a poorer growth/inflation tradeoff and may cause inflation to remain sticky even if growth slows in the coming quarters.

Nonfarm payrolls have expanded rapidly the past few months, averaging 223,000 over the past quarter. Rapid employment growth should continue through 2004 as productivity growth slows. The jobless rate remained at 5.6 percent in June .

After three months of strong growth, the June payrolls report was disappointing. It showed that the number of new jobs grew by a weaker-than-expected 112,000 and average hourly earnings rose a slower-than-expected 0.1 percent. However, other labor market indicators look stronger than the June payroll report. The level of initial jobless claims in June looks more consistent with payroll growth of 200,000 than the June reading of 112,000.

Consumers are showing signs of curtailed spending this summer. May spending data show that second-quarter spending is tracking at a 2.3 percent annualized rate, down from an average growth rate of 3.5 percent over the last two quarters.

Major retail chains reported lower sales for the month of June; same store sales rose only 2.9 percent. Likewise, auto manufacturers saw a decrease in demand following an extremely robust sales pace in May. June auto sales fell 15 percent despite ongoing rebates and incentives.

The ISM non-manufacturing survey edged down in June to 61.1, but this level is still near its highs of the past 20 years. Even with the latest declines, readings for new orders and production were still at high levels.

The rise in Treasury yields during the second quarter curtailed opportunities for homeowners, companies and municipal-ities to save money by refinancing debt. The Mortgage Bankers Association's Refinancing Index is down 85 percent from its May 2003 peak.

The price of crude oil soared early last month to a 21-year high of more than $40 a barrel. Since then, oil has pulled back into the $30s, easing some of the pressure on inflation. Still, the fear is that oil could remain above $30 for some time, keeping inflation rates from softening much.

Energy prices remain a big risk factor to the economy. During the first half of the year, soaring gasoline prices cut into household purchasing power. If prices stabilize or decline, consumer spending should bounce back. Further price hikes, however, will likely cause growth to come in below expectations.

Core consumer prices increased at a 2.9 percent annual rate in the first five months of this year, compared with 1.3 percent in the same period last year. Including food and energy, they rose at a 5.1 percent rate, compared with 2.3 percent last year.

The inflation scare that gripped U.S. financial markets so far this year shows signs of lessening. Over time, however, higher unit labor costs will feed into core inflation, as firms start to defend their margins more aggressively.

The inflation outlook has quickly emerged as a central focus of financial market participants, as most inflation measures have accelerated. While acknowledging the upside risks to inflation, however, Fed officials are resisting a creeping suspicion in markets that they will have to abandon their initial policy tack of measured tightening in favor of more aggressive action.

Some of the most recent economic reports have been weaker, including payroll employment, durable goods orders, and early indicators for consumer spending in June. However, other indicators either have remained strong (the household measure of employment, manufacturing indicators such as industrial production and the ISM) or have surged higher.

The slowing over the last few months is largely the result of a cost squeeze on households and businesses, associated with higher energy prices. This surge in energy prices slowed real income growth and held back consumer spending, which slowed to a 2.5 percent annual pace for the three months ended May 31.

Nonetheless, the slight economic slowdown that is being indicated by the data needs to be taken in context. For example, even though ISM declined somewhat, it remains at a historically elevated level.

While still very stimulative, global financial conditions have receded since March, amid rising U.S. market rates and inflation disappointments among the European Union nations and the United States . Continued job and income creation should sustain a solid U.S. recovery through 2005. However, tightening financial conditions suggest a temporary ebbing of growth later this year. Developments in the U.S. labor market, prices and financial conditions will be key for the pace and magnitude of Fed tightening. How much the Fed finally raises rates will depend primarily on how resilient inflation proves to be.

Investors should not be surprised if the rapid expansion of the U.S. economy moderates later this year, at least temporarily, in response to changed financial conditions.

If profits, and the companies' forecasts of the business outlook for the rest of the year, continue to surpass expectations, stocks could move higher. But sooner or later, rising expectations tend to surpass companies' ability to deliver. When that happens, it may pose a serious obstacle for stocks because strong earnings gains have been the main thing sustaining the stock market recently.

As a result, earnings are likely to occupy center stage for the next several weeks. Once earnings-reporting season begins to wane, however, the market could to turn its attention to other, less-cheery subjects: inflation, terrorism and the presidential election.

Despite their sell-off, Treasuries still appear vulnerable, as job creation reduces slack (and a buffer against inflation risks). In addition, the chances for a clash between public and private borrowing needs likely will grow in 2005, when investment outpaces corporate profit gains. The 10-year Treasury yield probably will climb to the 5 percent-5 ½ percent range later this year.

U.S. profit growth has been quite strong, but the pace of profit gains is likely to moderate going forward.

Most of the productivity slowdown is probably just the flip side of the prior, massive cyclical boost. In early recovery, production picks up while businesses are still in cost-cutting mode. Eventually, firms need to hire more workers to keep expanding output, and the cyclical productivity boost ends. Slower productivity growth is inflationary because it forces firms to raise prices if they want to protect their profit margins.

An abrupt surge in interest rates and a 35 percent rise in gasoline prices likely will trim growth somewhat over the next year. However, recovery appears increasingly durable following an impressive profit rebound and a return to normal hiring patterns, which have buoyed wage and income gains. While the Fed is poised to assist the rise in market interest rates now that downside risks to inflation have been put to rest, overall monetary and financial condi-tions continue to provide a tailwind for demand as recovery transitions to self-sustaining expansion.

With large budget deficits looming, the potential for “crowding out” will also tend to rise as the economy approaches full capacity in the course of 2005.

In developing investment strategies for the second half of 2004, it is important to consider the outlook for the bond market from both a short- and long-term perspective. As the Fed tightening cycle unfolds over the next 18-24 months, we look for a continued ascent in short-term bond yields and a significantly flatter yield curve.

The outlook for inflation depends on how quickly the “transitory” factors cited by the Fed begin to fade. Commodity prices already have begun to stabilize, and it seems, for now, that wage pressures remain muted. Going forward, the factors that have driven inflation up in 2004 – notably the rise in commodity prices – should either wane or reverse in 2005. On the other hand, slower produc-tivity growth is inflationary. The longer the productivity slowdown lasts, the bigger its effect on inflation.

Much of the strength in household spending over the past three years appears to reflect a sharply positive wealth effect from higher home prices.

The obvious explanation is the decline in nominal mortgage interest rates from 8 percent in 2000 to 5 ½ percent in early 2004, which has kept housing affordable. Slower house price growth and less mortgage refinancing are likely to take between ½ and 1 percentage point off the growth rate of household spending.

Since the fall of 2003, a swing toward faster inventory accumulation has contributed an estimated ¾ percentage point to annualized real GDP growth. Although inventory building might pick up somewhat further from the $25-billion pace seen in the first quarter, its growth contribution has likely peaked.

The combination of rising employment and slowing output growth points to a sharp slowdown in the productivity growth pace from 5.4 percent over the last year to about 1 ½ percent over the next year.