AUGUST 6, 2004
I. JULY 2004 COMMENTS...STOCKS WEAK...BONDS LITTLE-CHANGED...UNCERTAINTIES LINGER
- While the flow of earnings reports provided support for a bullish view of stock market prospects, the weight of other factors dragged stock prices down in July. Foremost was the price of crude oil, where supply problems, low inventories, and record demand from various regions of the world combined to raise crude oil to $44 per barrel by early August. Rising crude costs are not yet fully reflected in gasoline prices but are certainly in the producer price chain and can be expected to dampen consumer spending during the third quarter.
- Economic trends hit a soft spot during June-July, as retail sales, auto production, and an array of consumer-driven statistics were weak. Business capital spending remained strong, but strength in residential construction may fade as interest rates rise.
- Rising oil prices and presidential election uncertainties resulted in a weak stock market and subdued bond market. Trends may be more discernable after the Republican Convention late this month. Major changes in the balance of power do not seem likely in the House or Senate. As uncertainties diminish this fall, expect investor focus to return to economic growth.
- July ended with terrorist concerns voiced over various financial sites in New York, Washington, and New Jersey. The reaction of the financial market was subdued.
II. ECONOMIC OUTLOOK ...3% GDP GROWTH...CONSUMER CONFIDENCE STRONG...BUSINESS CAPITAL SPENDING LEADS GROWTH
- Softer business conditions in June held real GDP growth in the second quarter to 3%. In spite of major sales incentives, vehicle sales were depressed. Retail sales have been slow as adverse weather conditions in various parts of the U.S. dampened demand. The rise in oil prices was also a depressant. Employment gains remain strong; consumer surveys show optimism as homeowners continue to see their residences increase in value; business capital spending on equipment, technology, and structures is rising. Trends are mixed but still positive.
- During the last quarter, layoff announcements were at their lowest level in four years. Average hourly earnings are modestly higher but compensation including benefits is up nearly 5% over the past year. Unemployment is at its fifty-year average of 5.6% of the work force.
- Japanese growth is at its best rate in years. In China, growth is returning, as suggested by rising freight rates, recovery in scrap steel prices, and higher demand for crude oil. Oil prices are headed higher in light of the difficulty of quickly bringing additional supplies to market, periodic bombing of pipelines in Iraq, and the troubles affecting a major Russian producer.
III. FIXED INCOME OUTLOOK ...BOND INVESTORS POSITIONED FOR HIGHER RATES
- With an historically wide spread between the Fed Funds rate and normal GDP growth, we expect the Federal Reserve to continue on its path of gradual rate increases. Slower domestic economic growth will enable the central bank to stick to its policy of gradual and moderate rate hikes.
- Employment costs continue to mount, but more due to benefit costs than wage increases. The Employment Cost Index for June rose 0.9% with wage and salary costs up 0.6% and benefit costs up 1.8%. Over the past year, compensation costs rose 3.9% and benefit costs surged 7.2%.
- June producer prices fell by 0.3% as food and energy fell, but the core rate rose 0.2%. Intermediate and crude materials continued to rise sharply. Consumer prices rose 0.3%.
- The current trend of rising short-term rates is the most widely anticipated such event in recent memory. Bond investors, in general, seem well prepared for Federal Reserve action, having reduced maturity structure steadily during the past year. This contrasts with conditions at the beginning of the last interest rate run-up in 1994. Investors appear better prepared this time.
IV. STOCK MARKET OUTLOOK ...EARNINGS REPORTS STRONG...CAPITAL SPENDING UPSURGE...SECTOR DIVERGENCES
- Corporate profit reports are strong. Positive surprises outnumbered negative surprises by a ratio of 6 to 1 and S&P 500 earnings appeared to rise by about 25% for the second quarter. Management comments suggested further gains in the current quarter.
- Energy company results have been particularly strong, as few analysts anticipate a return to $25 crude oil. Non-residential construction has recovered, adding to the capital spending boom previously centered on industrial equipment and software. As the economy produces rising quantities of goods, packaging and transportation companies benefit.
- Concerns over interest rate increases have dampened enthusiasm for the financial services group, as well as such credit-using sectors as housing, autos and home furnishings. Consumer durable goods offer few attractive opportunities, outside of media and advertising. Business and consumer services offer better prospects, the former reflecting rising earnings and the latter rising employment.
- While valuation issues favor pharmaceutical companies, the drug stocks face political uncertainties and patent expirations that may disrupt earnings growth. Household products and packaged goods offer greater stability. Recent dollar weakness could help technology stocks recover but rising interest rates will hinder the marginal companies in this group.
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