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ALM First Financial Advisors
Fourth Quarter 2003 Economic Outlook
Prepared
by: Lisa K. McDaniel, CFA
October 9, 2003
TOPICS
COVERED
Third
Quarter Review
After
the past few years, the stock gains of the past few months seemed almost
too good to be true. Plenty of people still are hoping that 2003 will
become the stock market’s first up year since the end of the booming
1990s. Investors were enthusiastic until the last week of the quarter,
pushing major stock market indexes to double-digit increases so far this
year. They especially flocked to technology stocks, driving the NASDAQ
Composite Index up 60 percent from its low last October.
Despite its stumble
late in September, the Dow Jones Industrial Average has jumped 27 percent
in just under a year, from the low it hit on October 9 of last year. Although
it rose only 3.2 percent over the quarter, it is up 11 percent since the
year began. The NASDAQ Composite Index, whose many technology stocks have
confounded the skeptics, is up 60 percent since its low last October,
and 34 percent for the year to date.
There were several
reasons for optimism over the past three months. This quarter is the fourth
in a row with decent earnings. Credit spreads are narrowing. Exports are
picking up. And recent scandals involving Freddie Mac or the New York
Stock Exchange have caused barely a ripple in the stock market.
The global economy
also is showing signs of life. Global stock markets rose sharply for the
second consecutive quarter, and strategists maintain that a reviving world
economy could mean more gains in the final three months of the year.
Nevertheless, pundits
warn that the fourth quarter probably won’t be as strong as the
past two. The Dow Jones World Stock Index, excluding the United States,
climbed 8.9 percent in the third quarter, following a 17 percent surge
in the previous three months. The outlook for stock markets in the fourth
quarter is not “outrageously bullish.”
After several years
of providing a haven from the uncertainties of buying stocks, the bond
market turned on investors. Treasury securities turned in one of their
worst quarters in years as the long-predicted rise in interest rates finally
came to pass, leaving those picking up the pieces to wonder whether the
difficult period is behind them. Few expect a return to the heydays of
bonds in the 1990s, when interest rates kept falling to give bond investors
handsome gains well above their historical average. But the question is
whether there will be further losses this quarter and into 2004.
Last quarter’s
Treasury rout actually started near the end of the second quarter, when
the Federal Reserve cut its target short-term interest rate by a smaller-than-expected
0.25 percentage point. The Fed also downplayed the likelihood that it
would take unconventional measures, such as large bond purchases, to help
stave off deflation, or falling prices.
Most of the damage
to Treasuries occurred in July, when investors in the bellwether 10-year
note lost 7.08 percent of their value. Treasuries and other bonds tumbled
as traders reacted to fears that incipient economic growth would lead
to inflation and eventually higher interest rates that would hurt bond
returns. But that performance – the worst monthly return for Treasuries
in more than two decades – was followed by a rebound last month
that cut investors’ losses for the quarter by more than half. By
the end of the quarter, the benchmark 10-year Treasury had lost 1.87 percent,
with the yield rising to 3.93 percent from 3.51 percent.
The GSEs continued
to make headlines during the quarter. Freddie Mac postponed the release
of its much anticipated earnings restatement until the end of November.
The U.S. Federal Home Loan Bank (FHLB) system came under increased scrutiny
after some of its regional branches announced losses in recent weeks.
New York’s regional
branch announced losses in securities pooling manufac-tured-housing loans.
Those losses, held in the New York FHLB’s investment portfolio,
resulted in the New York branch’s announcement that it would not
pay a dividend to its member banks. Shortly after this announcement, the
system’s Office of Finance said its Pittsburgh and Atlanta Federal
Home Loan banks expect to report a loss for the third quarter.
In the wake of the news about the New York regional FHLB branch’s
lack of dividend payments, industry participants increasingly believe
the FHLB, along with Fannie Mae and Freddie Mac, will eventually be regulated
by the U.S. Treasury Department.
Monetary
Policy
As expected, the Fed remained on hold throughout the third quarter; and
at this point, it is likely to do so until at least the middle of next
year. While the U.S. economy is on track for solid growth, according to
Federal Reserve officials, low interest rates are needed to ensure the
recovery is fast enough to generate jobs, according to top Federal Reserve
officials.
“We will need to see job growth before we can say that we have a
sustainable recovery,” said Kansas City Federal Reserve Bank President
Thomas Hoenig in an otherwise upbeat address to business leaders in Tulsa.
Dallas Fed chief Robert McTeer also focused on labor market weakness while
delivering a speech in New York.
McTeer told a Wall
Street crowd that rapid gains in productivity – the amount any given
worker can produce in an hour – were the main reason job growth
was lacking.
After the last two FOMC meetings in August and September, Fed officials
said they believed rates could be kept low for a “considerable period,”
which for the U.S. central bank marked an unusually candid assessment
on the course of policy. The latest comments from McTeer and Hoenig served
to underscore that message.
Some believe the Fed
is waiting on three sets of conditions before it changes current policy.
First, growth must be judged as self-sustaining, with spending, production,
employment and income moving in a virtual loop. Second, Fed officials
would have to be convinced that the policy is unnecessarily accommodative.
Third, there will have to be consensus that inflation risks have turned
upward and unemployment is falling convincingly (signs the economy is
overheating).
Fiscal
Policy
The Congressional Budget Office (CBO) is projecting a record deficit of
$401 billion in fiscal-year 2003, which ended on September 30. The CBO’s
latest projected baseline deficits are much larger than the agency’s
March forecast. The CBO increased its estimate for the FY2003 deficit
by $155 billion and for FY2004 by $280 billion.
Most of the change comes from legislation adopted since March, including
higher spending and the tax cut President Bush signed into law in May.Given
the recession, slow recovery, the 9/11 terrorist attacks and subsequent
need to beef up homeland security, and the war in Iraq, it certainly makes
sense that the United States would run deficits for a few years. The problem
is that the nation is likely to see large, persistent budget deficits
even when the economy returns to strong growth.
The CBO baseline assumes
that the tax cuts adopted in 2001, and moved up this year, will expire
at the end of 2010 as called for under current law. Under these assumptions,
surpluses return at the end of the CBO projection period. The reality,
however, is likely to be quite different.
Congress and President
Bush also are eager to enact a Medicare drug benefit that would add $400
billion in spending over the next decade. Adjusting spending and revenues
for these assumptions adds another $2.8 trillion to the deficit over the
next 10 years, including debt service.
Currency
The dollar’s
renewed decline against the yen and the euro sent stock markets reeling
following the September meeting of finance ministers from the Group of
Seven leading industrial countries, which bluntly called for “flexibility”
in exchange rates. Europe’s gains for the entire year nearly melted
away in just seven days. The dollar ended the quarter at 111.47 yen late
Tuesday, while the euro stood at $1.165.
Stronger
currencies make it harder for exporters in those countries to capitalize
on a global recovery because their own products become less competitive
against those priced in dollars. It’s particularly worrisome for
the countries in the euro zone, where growth remains anemic, and stock
markets have lagged.
The U.S.
currency accumulated by the Bank of Japan – as it sold yen for dollars
– has been lending a pop to Treasuries in anticipation of the bank’s
need to stash those bucks. All told at $96B, the BOJ has been the largest
net buyer of Treasuries over the last year.
As long as the dollar declines at a genteel pace, such currency moves
are a powerful tailwind. A weaker dollar will probably have very little
impact on U.S. growth and inflation. Corporate earnings should benefit
as the combination of low interest rates and tax cuts works to increase
demand, and a lower dollar ensures that local U.S. companies get the orders.
But some
fear that a dollar decline could become a free fall. A plunging dollar
also could force interest rates up to compensate foreign investors for
the risk of buying dollar investments. Any rise in interest rates might
then lead companies to postpone spending once more.
Economic
Indicators
GDP growth, exceeding initial expectations, rose at a 3.1 percent
annual rate in the second quarter, with solid gains in both consumer spending
and business investment.
ISM manufacturing
index edged down to 53.7 in September after reaching a near high of 54.7
in August. Despite the dip, this survey continues to show an expanding
manufacturing sector. New orders jumped to 60.4 in September, a nine-month
high. Production fell back to 57.3 but still remains the second-highest
level since last June. Inventories and employment remain the sore spots
in this survey. The ISM report did show growth in manufacturing, and a
separate report on the job market said the pace of layoffs slowed markedly
in September. Overall, the ISM survey continues to point toward improvement
in manufacturing activity over the next few months.
The market’s
reaction to the ISM survey was telling; although it fell short of Wall
Street’s official forecasts, it wasn’t quite as bad as many
traders thought it would be, based on a gloomy report on Chicago-area
manufacturing from that region’s purchasing managers a few days
earlier.
The report confirmed
what has been said for some time: we’re on the road to recovery,
and we’ve seen the slowest growth behind us – but this recovery
is going to proceed in fits and starts. “It’s not going to
be a one-way street,” said former Federal Reserve economist Lara
Rhame, now a senior economist with Brown Brothers Harriman.
The ISM non-manufacturing
index also edged down slightly in September. New orders advanced at a
moderate pace, but again, the employment index remained soft.
However, the employment
picture is finally showing signs of improvement. The civilian unemployment
rate remained unchanged at 6.1 percent in September.
Non-farm payrolls
rose 57,000 in September for the first time in eight months. The increase
was attributed to broad additions among the service industries, as well
as fewer factory job reductions.
Initial jobless claims
fell the last week of September to the lowest in more than eight months,
suggesting companies are retaining workers as the U.S. economy strengthens.
First-time claims dropped to 382,000 from 405,000 a week earlier. That’s
the lowest since 378,000 in the week ended Feb. 8, 2003. Economists had
estimated that claims would fall to 395,000 from the 399,000 originally
reported.
Corporate layoff announcements
fell to 76,506 in September, vs. 79,925 in August. Layoffs are trending
lower, but have remained well above pre-recession levels. Job losses have
been more for permanent than cyclical positions.
The labor market is
viewed as a lagging indicator of the economy, but 22 months into an economic
recovery, we are usually much further along. Job growth is essential to
sustainable economic growth. The economy is likely to continue to expand
at a good clip, but (due to robust gains in productivity) overall economic
growth must be much stronger to be consistent with sustainable job growth.
The increase in employment
was barely half the 125,000/month needed to keep up with the influx of
new labor-force entrants and thereby keep the unemployment rate from rising.
Indeed, such a small increase could easily get revised away. Employers
have cut 2.8 million since the last recession began in March 2001, and
nearly 2 million people have been out of work for more than 27 weeks.
While the recent employment
numbers do not establish a trend, many leading indicators within the employment
report suggest that the employment decline has bottomed out.
Although the economy has been growing for several quarters, the mixed
data suggest that we are still in the early phases of recovery. Once we
see more consistent trends in the same upward direction, the recovery
will be assured and we will be headed toward economic expansion.
The Conference Board’s
consumer confidence index declined again in September after a brief uptick
in August. Undoubtedly, consumers are concerned about labor market conditions,
which are dampening optimism.
Consumer confidence
fell to 76.8 in September, from 81.7 the previous month. Labor market
perceptions also declined; 10 percent said jobs were “plentiful”
while 35.3 percent said jobs were “hard to get.” The sluggish
consumer confidence figures led to a drop in equity prices, making September
end on a weak note.
Although consumer
confidence has waned recently, the lower federal income tax withholding
rates, tax-refund checks and the home-refinancing frenzy have lifted consumer
buying power. In August, U.S. personal income rose by 0.2 percent from
July, says the Commerce Department. Personal spending grew a healthy 0.8
percent, and personal disposable income growth rose at a 10 percent annual
rate in the third quarter.
Consumer spending
was helped along by tax credit checks and cash from mortgage refinancings.
Manufacturing activity has been growing for several months in a row, and
corporate credit conditions have improved, setting the stage for a pickup
in business spending.
Retail sales rose
3.4 percent over the last four months, while retail payrolls fell by 41,000
(or 0.3 percent). Clearly, there are significant structural changes underway.
Much of the recent improvement in business sales has come out of inventories,
boding well for future production. However, we may see a shift toward
leaner inventories relative to sales.
Capital goods orders
improved, with shipments rising at a 14.2 percent pace in August. These
increases, particularly the increase in shipments, suggest that the long-awaited
turnaround in capital spending may finally be underway.
On a less optimistic
note, durable goods orders fell 0.9 percent in August, well below expectations,
although July numbers were revised upward to 1.5 percent from an initial
reading of 1.0 percent. On a year-to-year basis, orders are down 1.9 percent;
if it weren’t for a surge in defense bookings, they would be down
2.6 percent.
OPEC surprised the
market recently by announcing its decision to cut production quotas by
900,000 barrels per day or roughly 3.5 percent.
OPEC’s announcement
came at a time when commercial crude oil stocks are critically low in
the United States and throughout the industrialized world, and when the
price for the basket of seven crudes is well within OPEC’s target
band.
What’s worse,
OPEC decided to cut quotas as the U.S. economy is still in a fragile state,
nursing a recovery that’s yet to prove it is self-sustaining. Increases
in oil prices are widely viewed as the equivalent of a tax increase to
the economy.
Inflation remained
benign for the third quarter, while speculation regarding deflation decreased.
Despite forecasts for faster growth, the consensus is that inflation is
likely to remain well contained.
Fourth-Quarter
Outlook
Two themes emerging from the most recent economic data are that the recovery
is making strides, with encouraging news on the employment front, and
that inflation continues to inch downward, mostly due to the surge in
productivity and its effects on labor costs.
The fourth-quarter
outlook includes a far stronger economy dependent largely on the pace
of business investment. The short-term interest-rate outlook remains neutral
as the Fed will delay any tightening until the economy is firmly back
on both feet in mid 2004 and core inflation trends turn with the stronger
growth. The weak labor market, manufacturing, business investment, and
core prices are the Fed’s focal points. The outlook for the second
half is decidedly stronger, given the tax cut, low interest rates, improved
financial markets and a strengthening in business investment. We expect
that improving economic growth will dissipate deflation concerns, but
long-term rates shouldn’t move much above 4.75 percent by year end,
given the weak core inflation. Fed tightening has been pushed off to mid-to-late
2004.
The question for the
stock market now is whether the cracks that appeared at the end of last
month – worries about the falling dollar, rising oil prices and
the still-uncertain prospects for the economy and corporate profits –
will mend themselves over the next few months, as the optimists expect.
The clearest evidence will begin to trickle out in about a week, as more
companies begin disclosing third-quarter earnings.
Stocks typically enjoy
a strong performance in the fourth quarter, but analysts say the next
three months may be an exception. That’s because it is unusual for
the market to go into the final quarter having already rallied for six
months. Wall Street’s major stock indexes could stay within a tight
trading range during the fourth quarter.
The stock market hasn’t
recorded four consecutive yearly declines since 1932, and investors are
hoping it won’t do so again now. Investors face two big concerns:
first, the economic recovery, while it seems to be continuing, is doing
so at a slower-than-normal pace, weighted down by high levels of debt
and excess production capacity that is a hangover from the stock-market
bubble. Second, stock prices have risen a lot, so future gains will depend
on strong earnings growth. Even some of the optimists believe stocks are
overdue for a pullback of 10 percent or even 15 percent, which would suggest
further declines from here. The real bears think it could be worse.
Bond yields may see
some pressure from concerns about the runaway federal budget deficit and
from (unfounded) worries about inflation, but ample liquidity should prevent
long-term rates from rising too rapidly.
The Fed continues
to signal that rates will be kept low “for a considerable period.”
In policy speeches, Fed officials have indicated that they want to see
a mopping up of current excesses (higher capacity utilization), a turn-around
in the labor market, continued strength in business spending, and some
return to pricing power. The Fed’s commitment to low rates has made
the bond market nervous. The market is likely to expect an eventual increase
in inflation.
Deficits in the United
States are likely to be quite large for a very long time. To fund these
massive deficits, the Treasury will be forced to continue increasing supply
across the curve. If foreign demand for Treasuries is decreasing, or just
not increasing as fast as the supply, it will create a supply/demand imbalance
that will put upward pressure on yields.
However, the increase
in yields on the short end of the curve is currently limited by Fed policy
that is on hold. Longer-term yields can rise substantially until equilibrium
is reached.
The outlook for bonds
depends on the developing economy as the market today better respects
expectations for stronger second-half growth. Some estimates for third-quarter
GDP stand just shy of 6 percent; stronger growth expectations could drive
the long end of the yield curve higher. The continued ballooning in Treasury
supply adds another push higher to long term rates.
The market has now
priced out any expectation for additional Fed easing in 2003. The disinflation
won’t end until growth tops 4 percent for a few quarters and demand
strengthens pricing power. However, improving economic fundamentals are
likely to carry stronger weight than current core inflation as far as
bond yields are concerned.
While some tend to
go unspoken, there are potential problems. Inflation and interest rates
remain near their lowest levels in decades, and fears of another terrorist
attack are gradually being put aside. Investors are feeling more comfortable
and are beginning to believe in a steadily improving world again. But
there’s no guarantee the world will remain so tranquil.
Summary
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