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ALM First Financial Advisors
Fourth Quarter 2002 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
October 7, 2002
TOPICS
COVERED
Third
Quarter Review
The
economic recovery continued to struggle in the third quarter,
much like the second quarter. Final second quarter GDP growth
was 1.3%, which is quite a slowdown from 6.1% in the first
quarter. Third quarter GDP is expected to have picked up again,
with estimates around 3% – 3.5%.
In spite of the estimated increase in growth during the third
quarter, it was a rough period all around. We came into the
quarter hoping things would get better, but instead, they
continued to get worse.
Investor
faith has been shaken by a series of events, beginning with
the terrorist attack last year and pursuant threats of additional
attacks, and following with corporate accounting scandals
and now the possibility of war with Iraq.
Instead
of the turn-around we were looking for, the Dow Jones Industrial
Average finished down 17.9% for the third quarter, not only
defying all hopes that stocks would begin a recovery by late
summer, but calling into question the possibility of a recovery
at all this year. This was the largest quarterly decline in
the index since the fourth quarter of 1987, after the October
market crash. The 12.4% September decline was the worst September
for blue chips since September of 1937, 65 years ago.
Many are
now resigned to the idea that 2002 could be the third consecutive
year of declines for the stock market -something we haven’t
seen in more than 60 years, since stocks fell from 1939 to
1941. Some investors are even speculating on the odds of a
fourth negative year in 2003. This would be an extraordinary
streak that has happened only once in the past, from 1929
to 1932, during the Depression.
In case
those statistics aren’t depressing enough, here are
a few more. Since the beginning of 1995 through the peak of
the bull market in early 2000, the Dow surged 7889 points,
more than tripling its value, to 11,723. Two years later,
the index has given back more than half that gain. The S&P
500 index has given up two-thirds of its 233% gains over this
same time period.
The major
problem during the quarter just ended was corporate profits.
The profit gains that were supposed to fuel the recovery simply
haven't turned out as we hoped. That, together with the uncertainty
about an impending war with Iraq, produced a stock sell-off
that ran from late June through late July, gave way to a very
short-lived rally, and then started again with a vengeance
in September.
As is
often the case when stocks tumble, bonds have been the star
performer, posting their best quarterly performance since
1989. Treasuries have racked up cumulative gains since 1999
of 34% while the S&P 500 lost more than 43%. The bond
rally has pushed yields to their lowest levels in over 30
years with the two year Treasury ending the quarter at a historic
low yield of 1.69%.
Treasuries in particular
were the investment that investors scoffed at during the bull
market, but now there seems to be an unquenchable appetite
for them. Investors fled to Treasuries because they offer
safety and liquidity and because they are about the only asset
class that performs when the global markets are crumbling.
The overriding
question on investors' minds now is what it will take for
the stock market to find a long awaited bottom and how much
longer we will have to wait for that to happen.
Fiscal
Policy
The budget shortfall for the fiscal year 2002 (ended September
30) looks like it will be $165 billion, a stunning swing of
nearly $300 billion over the past year.
Fiscal
year 2003 looks even worse. Estimates indicate a deficit of
$225 billion absent increased military spending. A conflict
with Iraq could increase the shortfall to $300 billion or
higher.
It is
clear that revenues from capital gains were an important factor
in the budget surpluses over the last four years. However,
the stock market is extremely unlikely to resume its bull
market pace of the 1990s. Tax revenues will continue to fall
short of expectations, and it will be increasingly difficult
for the government to trim spending over the next several
years. Therefore, federal budget deficits are likely to be
with us for quite some time.
Monetary
Policy
The Federal Open Market Committee (FOMC) remained on hold
once again during the third quarter, in spite of speculation
that it would actually ease the Federal funds rate in order
to further stimulate a faltering economy.
The bond
market and Fed funds futures have both given strong signals
that easing is in order. However, the Fed has so far been
adamant in their view that interest rate policy is already
accommodative and no further action is needed.
This stand-firm
policy is actually reinforcing the bond market and keeping
yields low because many investors view the Fed as falling
behind. However, from the Fed’s point of view, the economy
will gradually overcome the factors dragging it down because
of continued strength in productivity and the ongoing effects
of stimulative fiscal and monetary policy.
Economic
Indicators
Despite
better data at the end of the third quarter, there are still
concerns in the financial markets that the U.S. economy has
ground to a halt. Forward-looking indicators point to a slowing
in overall growth after the third quarter pick-up.
In the aftermath
of September 11, 2001, the biggest threat to the economy was
another terrorist attack. The absence of any further attacks
should have helped both consumer and business sentiment. However,
other concerns, such as corporate scandals and the possibility
of war with Iraq, have drained consumer confidence; furthermore,
the global recovery has been disappointingly soft in 2002.
Household spending
habits have changed, but there was fortunately no sharp retrenchment
in consumer spending thanks to the lower interest rates, which
have boosted sales of homes and autos.
Business sentiment,
which was already weak, has softened further amid the continuing
uncertainty. This is due to poor profit visibility that is
weighing on businesses in spite of low rates, ample liquidity,
tax incentives and other such stimuli. The corporate sector
has done a great deal of restructuring and has better positioned
itself during its retrenchment. The major hold-up seems to
be fear rather than the actual problems of a few industries.
Any improvement
in business fundamentals is mainly due to the boost in productivity.
Consensus third quarter numbers project that productivity
has increased more than 5% in the past year.
This rate of productivity cannot continue indefinitely however.
Either job growth will improve as demand grows, or spending
will have to slow as consumers are forced to cut back.
While
inflation has increased slightly this year, it still remains
very benign. The Consumer Price Index rose 2.7% during the
first eight months of 2002. This compares with an increase
of 1.6% for all of 2001. The index for energy, which declined
13% percent in 2001, increased at a 13.5% percent rate in
the first eight months of 2002.
Core inflation
is likely to remain steady or move down gradually over the
next year, while energy prices remain sticky. In the interim,
higher oil prices may temporarily boost inflation, but these
effects should be short-lived.
U.S. consumer
confidence fell again during the third quarter, after recovering
to some extent during the first part of the year.
The University
of Michigan Index of Consumer Sentiment was 86.1 in September
2002, recording its fourth consecutive monthly decline. It
is now just 4.3 points above last September’s low and
10.8 points below the 2002 high recorded in May. One brighter
spot is that nearly all of the weakness recorded in September
was in consumers’ evaluations of current economic conditions,
not in how they judged future economic prospects.
As in
the second quarter, the labor market has yet to show any sustained
signs of improvement. Wages are softening in response to the
weak labor market. While layoffs and job losses are diminishing
somewhat, new hiring is thin. Initial jobless claims have
remained above 400,000 in recent weeks, indicating continued
weakness. However, the unemployment rate has fallen in the
last two months, from 5.9% to 5.7% in August, and then 5.6%
in September.
Renewed strength
in the job market is still one of the keys to economic growth;
the recovery is destined to have a limited upside until we
see sustained improvement here.
Although
housing activity slowed in July, both sales and housing starts
remain at high levels. After a slower second quarter, the
mortgage refinancing wave took off again during the third
quarter to unprecedented levels.
Consumers have continued to benefit from the strength in government
bonds, because mortgage rates often are pegged to the yield
on the 10-year Treasury. As these yields continued to plummet,
mortgage rates followed suit, permitting consumers to refinance
mortgages at lower than ever rates which helped keep consumer
spending and housing sales strong.
According
to Freddie Mac, the national average commitment rate for a
30-year, conventional, fixed-rate mortgage was 6.29% in August,
down from 6.49% in July and 6.95% in August 2001. August was
the lowest monthly interest rate since Freddie Mac's series
began in 1971.
The annual pace
of existing home sales is close to last year's record of 5.30
million sales.
Without the low
interest rates, analysts say, the economy and the stock market
could be suffering even more.
Industrial production fell in August, for the first time since
December 2001. It is, however, still 2.8% above its December
2001 trough.
Manufacturing
remains very lean as businesses remain reluctant to build
inventory or increase capital spending convincingly.
Capacity utilization has remained essentially flat at 76%
for the last three months after increasing for the first half
of the year. It is expected to grow at only a moderate pace
in 2003 if the economy grows at a pace of 2.5% - 3.0%.
Fourth
Quarter Outlook
In light of the fading momentum of the business sector recovery
and the possibility of military conflict, many economists
have adopted a more cautious forecast than earlier in the
year. Energy price spikes or other unexpected consequences
of the Middle East conflict are potential event risks that
could result in an even more pessimistic view.
We have
seen the largest declines in business inventory and capital
spending in post-war history. Earnings are cyclically depressed,
and are likely to recapture their peaks over a period of several
years.
U.S. earnings
are growing moderately right now and should post a significant
year-over-year advance in the second half of this year.
Since
vehicle sales and housing never tanked during the recession,
they cannot add stimulus by rebounding during the recovery.
The Iraqi
situation seems to be proceeding according to plan from President
Bush’s perspective. First, by seeking a U.N. resolution,
the U.S. placated the Security Council countries who previously
would not support an attack on Iraq. Secondly, Bush has maintained
his willingness to go it alone if, after seeking resolution
through the U.N., he does not get the results he is looking
for.
While
we are at this point uncertain whether a war will occur, we
can be certain that preparation for war will continue, at
least in the short run. A build-up to war affects the global
economy through oil prices, equity risk premiums, and military
expenditure.
Oil prices
are likely to climb into the first quarter of next year, but
the negative effects of any oil price increase is expected
to be moderate. One reason is that Iraq exports less than
one million barrels of oil per day, compared with a combined
4 million barrels for Iraq and Kuwait prior to the Gulf War.
A war
build-up and higher oil prices will mean continued high equity
risk premiums, which could prevent a sustained rally in global
stock markets.
As far
as military spending, the U.S. is likely to continue already
high spending levels rather then increasing substantially.
Therefore
we expect a war (assuming the conflict is relatively brief)
to have only a moderate impact on global growth.
However,
the prospects of war do have a negative psychological impact
on the economy, which we have already seen during September.
Such uncertainty encourages conservative behavior on the part
of both consumer and businesses.
Fed watchers
and the forward markets have gone from overstating the probabilities
of Fed tightening to overstating the probability the Fed will
ease. While the current consensus is for easing, it is still
possible the Fed could be on hold for the remainder of the
year.
Summary
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