ALM First Financial Advisors

ALM First Financial Advisors
Fourth Quarter 2004 Economic Outlook

Prepared by: Lisa K. McDaniel, CFA

October 11, 2004

The stock market began a robust rally in mid-August but then faded in September, as stocks hit some roadblocks, leaving the Dow Jones Industrial Average with its second losing quarter this year. The index declined by 355 points, or 3.4 percent, during the third quarter, its biggest percentage quarterly decline since first-quarter 2003 – even with a slump of 94 points in September, which is historically the year's weakest month. The decline left the blue chips, which rose 25 percent last year, down 3.6 percent year to date for 2004.

Other indices showed the same pattern as the Dow, rising in August and early September, but then fading as the quarter ended. The Standard & Poor's 500-stock index held up better than the Dow industrials, as smaller, less-prominent stocks tended to do better than blue chips this year. The S&P 500 fell 2.3 percent in the third quarter, leaving it up 0.24 percent for the year.

The Nasdaq Composite Index, whose many technology stocks have stumbled after soaring last year, fell 7.4 percent for the quarter, leaving it down 5.3 percent through the first nine months of this year.

Historically speaking, a weak September stock performance isn't unusual. In fact, the typical stock pattern is a rally in late summer followed by a September slump. Although stocks historically show gains for most months, they have averaged a small decline in September since 1900.

One reason for this slump is that September is the last month in what is often a difficult quarter. Many companies tend to slow down over the summer and then come back with strong performance in the fourth quarter.

Nonetheless, the sheer breadth of this quarter's bad news was striking. Oil futures surged to $49.64 a barrel on the New York Mercantile Exchange, near the 21-year high of $49.90 hit on September 28. Hobbled by a soft economy and rising oil prices, more companies warned of quarterly earnings disappointments than in any other month this year. Meanwhile the Federal Reserve indicated its intent to continue gradually raising target short-term interest rates for months to come, the election outcome remained uncertain, and so did the future of Iraq and the dangers of terrorism.

Some analysts believe it is the election uncertainty itself, as much as worries about the outcome, that is contributing to the market weakness because the close race burdens investors with one more unknown factor on top of so many others. According to this view, it matters less who wins than it does that someone emerge with a clear mandate to lead.

Other analysts believe stocks have slumped because the market is adjusting to the idea that the pace of earnings gains is slowing. Profits rose at an annual rate of more than 20 percent in each of the previous four quarters, marking one of just a handful of times in the past 50 years that profits have grown so rapidly. Analysts expect companies to report double-digit profit gains for the third and fourth quarters, too, which would be above the typical average of 7 percent. However, they think the days of 20 percent gains are over.

Whether the market rallies into year's end, as the optimists hope, or sags into defeat, as the pessimists fear, will depend on what happens with all of these factors. These issues will determine whether investors decide to move some money into stocks and out of their bond holdings and cash accounts, or instead keep their money in what they view as a safer place.

The bond market experienced some dramatic swings over the past six months, triggering striking shifts in market direction. In the second quarter, Treasury yields rose sharply (with the two-year yield up 70 percent on a percentage basis) on expectations for strong economic growth, rising inflation, and an aggressive Fed.

Yet, despite three successive interest-rate increases by the Fed, the third quarter saw yields unexpectedly plunge in reaction to weaker-than-expected economic data, new terrorist threats, and the stabilization of key inflation indicators. The yield of the benchmark 10-year Treasury note finished the quarter at 4.125 percent, near a six-month low. In typical bond market fashion, it appears that yields overreacted in both directions.

Behind the bond rally was a growing belief that the U.S. economy faced too many hurdles to expand very quickly. Investors shifted money from stocks and cash with a renewed comfort that yields on long-term debt wouldn't shoot up soon and that current issues would remain attractive.

The steady rally in bond prices during the past three months highlighted a new relationship between bonds and oil. In the past, rising bond yields usually were associated with increases in crude-oil prices. Rising yields indicated a stronger economy, which typically would provoke greater demand for oil.

The cause-and-effect relationship should have oil prices and bond yields rising together. As higher oil prices create inflation, bond prices should discount that inflation and fall, causing yields, which move inversely to prices, to rise. This relationship actually has worked well over the past several decades, especially in the 1980s. But beginning in the 1990s and accelerating in the past couple of years, the two went their separate ways.

During the past two years, oil prices have surged higher without much of a rise in the 10-year note's yield. At the end of 2002, the 10-year Treasury yield was approximately 4 percent and the price of oil was around $31 a barrel. Since then, the price of oil has risen more than 50 percent, but bond yields have been on a roller-coaster ride to nowhere.

In announcing the opening shot in its “measured” program of policy tightening June 30, the Federal Open Market Committee (FOMC) released the following statement related to its first rate hike in four years:

“The evidence accumulated over the intermeeting period indicates that output is continuing to expand at a solid pace and labor market conditions have improved.”

Yet the ink had barely dried on that statement when economic activity turned softer. By mid-August, the ever-fickle markets were beginning to think the FOMC might pause, perhaps as early as the September 21 meeting.

Nonetheless, the Fed continued to tighten at the August and September meetings. The committee's statement noted that the FOMC believes the stance of monetary policy remains accommodative and is providing ongoing support to economic activity. It continued that after moderating earlier in the year partly due to higher energy prices, growth appears to have “regained some traction” and labor market conditions have improved modestly. The most recent inflation data confirmed the Fed's view that a portion of the rise in inflation earlier in the year was transitory.

Against this backdrop of current softness but underlying optimism, the FOMC's focus remained on the amount of tightening left to return policy to a neutral stance. Given the current low level of short-term rates, especially when judged against the recent level of inflation, members noted that significant cumulative policy tightening would likely be needed.

Thanks to the Fed's transparency, the financial markets widely expected the third consecutive 25 basis point (b.p.) rate hike, along with the language in the accompanying policy statement. Noting that economic conditions had improved while inflation had cooled, the Fed maintained it neutral assessment on both sustainable economic growth and stable low inflation.

The Fed maintained key language from its prior meeting, stating that “the stance of monetary policy remains accommo-dative,” despite the rate hike, and that policy accommodation can be removed “at a pace that is likely to be measured.” The Fed also remains ready to “respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”

While this statement is also a repeat from previous announcements, it should not be taken lightly. By leaving the language in place, the FOMC signaled its comfort with expectations of a 25 b.p. hike in November.

By deciding to start tightening when it did, the FOMC essentially concluded that the U.S. economy no longer needed the anti-deflation shield its deliberately accommodative policy had provided over the preceding year. Although upside surprises on inflation may have played a role in reaching this conclusion, the main factor was evidence of significant labor market improvement. This strengthened committee members' confidence that the economy would continue to expand even as policy turned less stimulative. Thus, when the economy – and the labor market – appeared to stumble, financial markets began to think the FOMC would stop tightening.

The market's hypersensitivity to fluctuations in the data misses two key points: first, Fed officials think they are a long way away from a neutral monetary policy posture. Members of the FOMC generally believe a neutral fed funds rate is within the 3 percent to 5 percent range. With the fed funds rate currently well below the bottom end of this range, they regard monetary policy as highly accommodative and can justify additional tightening even if growth fails to meet their optimistic forecasts.

Second, if concerns about labor costs are well-founded, then the rationale for Fed tightening will probably change to include warding off inflation. So far, Fed officials have been fairly relaxed about the inflation outlook in the belief that the productivity trend will remain strong.

If Fed officials do pause, December would be a logical time to take a breather. They could pass at that meeting, as they often do anyway because of seasonal flows of funds in the credit markets and uncertainty about holiday sales, and then decide a month later whether or not to extend the breather into a longer pause.

Remember, the Fed's near-term objective has been to eliminate the monetary accommodation without undermining the economy or driving bond yields too high. In this context, everything has unfolded in nearly perfect fashion for the Fed since its first rate hike on June 30, as bond yields have fallen, the economy has rebounded following a soft patch, and the stock market has dropped only slightly. At 1.75 percent, the fed funds rate is now equal to core inflation (year-over-year, the CPI and PCE deflator excluding food and energy are up 1.7 percent and 1.5 percent). The Fed has made it clear that a negative real funds rate is inconsistent with healthy economic growth and its long-run objective of price stability. There are likely to be several more rate hikes into early 2005, before the Fed becomes more data dependent in its monetary policy deliberations. The primary factor that would change this anticipated pattern would be a significant economic “soft patch” as a consequence of rising energy prices.

A 25 b.p. rate hike in November is largely priced in, and fed funds futures currently put a 50 percent probability on another 25 b.p. in December.

The U.S. federal budget balance has deteriorated sharply over the past several years resulting from a combination of recession, a sharp decline in the stock market, and expansionary fiscal policy. The good news is that the deficit appears to be peaking in fiscal 2004 and is likely to move lower going forward.

In fact, federal fiscal policy is already on a slightly restrictive path after implementation of the last tax cut, and this will extend into 2005 unless Congress acts to extend several components of recent tax cuts currently due to expire at year-end. Over the past few months revenues have started to grow faster than outlays, and it is reasonable to expect this pattern to continue next year.

While both presidential candidates hope to cut the deficit in half over the next few years, neither has adopted deficit reduction as a top priority. Indeed, the budget implications of the competing programs of the two candidates seem broadly similar.

President Bush wants all personal tax cuts to be made permanent and to restrain nonmilitary spending. His proposals for a second term focus on programs, such as tax reform, that would have a much more neutral effect on fiscal policy. Senator Kerry wants to roll back tax cuts for upper-income households and use the funds to move toward universal medical insurance and other social goals.

While the candidates have very different agendas, their proposals yield similar outcomes in terms of the budget balance. Each candidate is proposing policies that will have a limited effect on the deficit in the coming two years. Nevertheless, there could be important differences in the structures of the budgets. Kerry's proposals would produce higher levels of spending and taxes, and place a greater tax burden on upper-income households.

In addition, implementation of proposed initiatives will depend on the support of Congress. A President Kerry would have trouble enacting his proposals without substantial modification if, as seems likely, the Republicans retain control of one or both houses of Congress.

Economic Indicators

The U.S. economy has grown at a healthy rate, with GDP estimated at an average 4 percent over the past four quarters through September 30, 2004 .

The Commerce Department revised its measure of second-quarter GDP growth up to a 3.3 percent annual rate, higher than the preliminary estimate of 2.8 percent reported in late August. A major factor in the improvement was a jump in inventories. Businesses increased inventories by $61.1 billion, up from the earlier estimate of $57.7 billion and much higher than the $40 billion in stock added in the first quarter. Business spending added 12.5 percent, up from a previously estimated 12.1 percent increase. Equipment and software spending climbed 14.2 percent.

Capacity utilization in manufacturing has been rising, and bottlenecks have cropped up in some areas. For the business sector overall, the level of gross investment has risen strongly from severely depressed levels, but it remains below its previous peak (reached nearly four years ago).

The labor market has improved considerably. While hiring growth slowed over the summer, it appears to have picked up again more recently, and business surveys point to continued growth in employment in the months ahead. Contributing greatly to the pickup in hiring has been an apparent slowing of growth in labor productivity, from amazingly high rates during the past two years to rates more in line with a longer-term trend.

Perhaps the most significant weakness was the abrupt slowing in net hiring that occurred in June, reported less than 48 hours after the FOMC's first tightening move. It was an ironic turn of events, as the surge in payrolls during the preceding three months was the missing piece of the recovery puzzle that Fed officials had been waiting for to start their tightening campaign. From 295,000 on average in the March-to-May period, payroll gains slowed to a mere 85,000 average for June and July.

The August jobs report restored the sense of labor market improvement that had been called into question in the two preceding reports. Non-farm payrolls rose 144,000. Hourly wages rose a sturdy 0.3 percent in August, on top of upward-revised gains in June and July (an added 0.1 percent apiece).

In September, payrolls increased by 96,000, expanding for the 13th consecu-tive month. Over the last four months, payrolls have expanded at a moderate rate of 101,000 per month on average.

Real consumer spending growth in the first two months of the quarter rose at an annualized 4.8 percent pace from the average level of spending in the second quarter.

Consumer spending slumped in June, however, pulling the second-quarter growth rate in this all-important component of GDP down to a 1.6 percent annual rate. Although spending is on a much better track this quarter – rising at an estimated 3 percent to 3.5 percent – it owes much to an incentive-induced rebound in vehicle sales in July. These sales subsequently retreated in August, and sales of other goods were also weak. Hurricanes have probably hurt business to some degree in the southeast, but they are too localized to have an overriding effect on the national data.

The factors that historically have driven consumer spending continue to be positive. In particular, real disposable personal income has risen 4 percent in the last year, well above inflation, and its growth continues to be supported by increases in employment and hours worked, along with modest wage increases.

In the industrial sector, the indicators have been mixed. Although orders for U.S. factory goods rose more than 1% in both June and July, bookings for civilian aircraft - a volatile category - accounted for all of the July increase. For other non-defense capital goods, orders in July were still below their March peak. Although growth in manufacturing output has been firm, inventories have been rising rapidly as well.

Real business fixed investment returned to double-digit growth in the second quarter, rising at a 12.1 percent annual rate following a 4.2 percent first-quarter increase.

In the past year, business fixed investment has taken over as the engine of growth, averaging more than double the nearly 5 percent growth in real GDP over the past four quarters.

Construction spending surged in August to the highest level on record, while manufacturing grew at a slower pace in September, offering mixed signals about the economy's strength.

The 0.8 percent advance was twice as big as the 0.4 percent economists had forecast. In more encouraging news, July's performance turned out to be even stronger than previously estimated. Revised figures showed that construction spending jumped by 1.1 percent in July from the previous month.

The inventory build-up continued in the second quarter, with revised data showing about a 0.7 point contribution to real GDP growth. However, this stimulus may now be close to over, judging from the behavior of the inventory/sales ratio. Changes in the I/S ratio are a good indicator of impending shifts in the growth rate of manufacturing activity, with recent signs of stabilization pointing to a slowdown. The August drop in the ISM index, to 59 from 62 in July, probably marks the first leg of the slowing.

Even so, the major manufacturing indicators indicated that factory activity expanded at a rapid pace in third quarter. The ISM manufacturing survey reported that its manufacturing index registered 58.5 in September. An ISM reading of 50 or above means that the manufacturing sector is expanding, while a figure below 50 suggests activity is shrinking. For the quarter, the ISM manufacturing index averaged 59.8, which historically has also been consistent with above 5 percent real GDP growth.

Durable goods orders dipped 0.5 percent in August, following sizable gains in the two prior months. However the tone of the August durable goods report was positive as the decline largely reflected a partial restatement of civilian aircraft orders, following a huge bulge in July. Excluding transportation, durable goods orders rose a healthy 2.3 percent. Non-defense capital goods orders excluding aircraft, a proxy for future equipment investment, fell 0.5 percent in August after increasing by 0.6 percent in July.

Declines in mortgage rates over the past few months provided a lift to residential construction, judging by the unexpectedly strong report on August housing starts. Single-family starts reached a pace of 2.0 million for the first time since last November, and total starts for July-August are up at an annual 20 percent rate above their second-quarter average.

A change in household cash flow has occurred however, in the form of a reduction in mortgage equity withdrawal, as refinancing has fallen off in response to higher interest rates. At the point that refinancing peaked in the summer of 2003, its contribution to household cash flow was about 2 percentage points more than in the preceding year. This contribution has since stabilized. However, the lags in spending the proceeds could be fairly long, and refinancing rebounded in early 2004 as long-term interest rates dipped.

New single-family home sales fell 6.4 percent in July and were revised sharply lower in the prior two months. However, mortgage applications for purchase remained strong in August, with the fundamentals of solid income growth and low mortgage rates continuing to support housing. The disruptive effects of Hurricane Charley are likely to restrain an August rebound.

Oil prices rose nearly $8 per barrel during September, and have since risen over $50 per barrel. The run-up has been partly due to political unrest in Nigeria , partly due to some forecasts of a colder-than-normal winter, and importantly due to a drop in stocks of petroleum related to the disruption of production and distribution of oil in the Gulf of Mexico during the recent hurricanes.

Over the past 12 months, oil prices have soared by more than 90 percent, and gasoline costs have risen by 16 percent. Higher oil prices can both weaken the economy and cause inflation. However, the magnitude and suddenness of the rise in oil prices remains rather moderate in real terms relative to the price spikes in the 1970s. Oil shocks are less disruptive than in the 1970s because low inflation expectations reduce the need for monetary policy restraint, energy efficiency is higher and the inflation adjusted price of oil remains much lower. Some analysts have pointed to $50 per barrel oil as a key threshold, but even at $50 this would still be a moderate shock by historic standards. Oil would need to go to about $80 per barrel to match the major shocks of the past.

Financial conditions have weakened in response to high oil prices, but generally remain stimulative. In line with the 1990s experience, investors appear to view oil spikes as likely to diminish growth prospects, rather than raise inflation. As a result, oil prices and Treasury yields have been negatively correlated since mid-2002, in contrast to the positive correlation that prevailed in most of the past 25 years.

Inflation remains fairly tame. Recently, the Fed's favorite inflation gauge – the core personal consumption deflator – came in flat for the second month in a row. The Fed is believed to have an inflation “comfort zone” of 1 percent to 2 percent for the 12-month change in this measure of prices. In the spring, the core PCE looked like it might rocket through this range and many analysts predicted a 1994-style Fed tightening in response. More recently, the core PCE has leveled off in the middle of the zone.

The moderate inflation readings are not a fluke. They confirm that commodities are not important enough in the economy to spark a serious inflation acceleration unless there is tight capacity in the economy. They also show that the Fed is reaping the rewards of its long and successful war against inflation. In the 1970s, commodity costs were quickly passed through to final goods prices as companies had little faith in the Fed's anti-inflation resolve. Today, firms believe they can not pass the price increase through and they focus on finding ways to offset the costs.

Troubles at Fannie Mae

The Justice Department opened an investigation into possible accounting fraud at Fannie Mae in the wake of a federal regulator's report that the mortgage giant may have manipulated its books to meet earnings targets. The criminal investigation, still in a preliminary stage, is the latest in the government's intensifying scrutiny of the fourth-largest U.S. financial-services company.

The Office of Federal Housing Enterprise Oversight (OFHEO) accused Fannie Mae of manipulating its results in recent years, allowing senior executives to get multimillion-dollar bonuses. Officials also have said that some Fannie Mae executives may have misled regulators, which in some cases would be an added criminal offense.

Fannie Mae has agreed to increase minimum capital surpluses over a nine-month period to 30 percent of the minimum capital requirement due to the uncertainties in the financial statements and operational weaknesses. OFHEO imposed a similar capital surcharge for Freddie Mac in January 2004 because of increased operational risk.

Fannie Mae also agreed to appoint a chief risk officer, whose duties will be crafted in consultation with OFHEO and will be independent of other corporate responsibilities. The Fannie Mae board will hire an independent counsel and independent accounting consultant to review accounting policies and practices and then report back to the board and OFHEO. The board will direct and oversee changes based on that review.

Fannie Mae will separate economic modeling and accounting functions, and separate business planning and forecasting functions from the controller's function.

Even with these concessions, it appears Fannie Mae will fight the OFHEO charges. The process will most likely be long and drawn out, with no conclusion in the immediate future. People familiar with the situation say a criminal probe of widespread accounting problems at Freddie Mac is winding down with no indictments, even though the company agreed to pay $125 million as a civil penalty.

Economic growth looks to be on more solid footing heading into 2005; but a variety of vulnerabilities remain. Consensus estimates for third-quarter GDP growth are now 3.8 percent, per Blue Chip Financial Forecasts .

Equity markets have moved mostly sideways this year. We don't anticipate much stronger performance next year, with prospects for corporate earnings gains diminishing as the labor market improves further, compensation growth picks up and labor share of income recovers at the expense of profit share.

The outlook for corporate profits has become more mixed than a year ago. The positive news is profits, particularly operating profits, are at an all-time high. However, for the first time in well over a year, earnings expectations going into the fourth quarter are being adjusted lower, not higher. The bottom-up consensus is now looking for 14.3 percent EPS growth in the third quarter.

The deceleration in profit growth is apt to continue for two reasons: First, unit labor costs will start to trend up as productivity growth slows; some of this will eat into profit margins. Second, the federal tax depreciation bonus expires at year-end. In combination, these factors are likely to cause a modest setback in profits in 2005, estimated at 5 percent.

The pickup in job growth and wage inflation doesn't appear to offset the loss of tax stimulus, the effect of higher interest rates on refinancing, and higher energy prices. With asset returns apt to be fairly low as well, personal saving should also rise, although the timing is hard to figure.

Worries over the jobless recovery remain and investors still worry about household indebtedness. While the risk is over- stated, the evidence points to slower consumer spending growth going forward. Another worry is that further substantial dollar depreciation could disrupt financial markets.

On the upside, capital spending and inventory restocking could turn out to be stronger in the United States . This could boost hiring and give a second wind to consumer spending growth.

Yet there are a number of risks to the outlook for growth and inflation in 2005. Key among them is the widening current account deficit, which should put downward pressure on the dollar. The household sector's balance sheet, which has become more sensitized to interest rate movements, has become more worrisome lately as debt growth continues to outstrip income growth. The widening budget deficit and absence of fiscal restraint from either party pose additional risk. Higher energy prices threaten to jeopardize both growth and inflation. Thus, while we look for blissful growth and inflation, in 2005 the economy may have a bumpy ride.

The FOMC is widely expected to continue tightening by 25 b.p. per meeting into early 2005, although market expectations of a year-end pause are not unreasonable. This view is based on two considerations: First, Fed officials see monetary policy as quite accommo-dative; and second, inflation could become more worrisome as time passes.

Based on this outlook for Fed policy, the bond market is vulnerable to a sell-off. As the Fed continues to tighten, the yield curve will flatten, as bond yields rise only modestly. The extent to which bond yields rise as the Fed raises short-term rates, and the extent of the curve flattening, depends crucially on inflation and inflation expectations.

Unless the equity market or business confidence suffers, the oil spike should not prevent a return to trend-like growth. Financial conditions are favorable, income gains solid, margins high, and inflation low. Businesses with healthy balance sheets should return to normal hiring patterns. Even with increased debt, households' exposure to rising short-term rates is limited, following the massive refinancing of recent years.

Higher energy prices remain a risk to the economic outlook – potentially boosting inflation and reducing spending. The expectation is that pressures in the oil market will ease as disruptions from the recent hurricanes are resolved. However, the probability of a higher-than-expected path for oil prices has risen. This could give us somewhat slower growth and higher inflation than has been projected. Under normal circumstances, it would also cause the Fed to raise rates a bit faster.