JULY 6, 2004
I. JUNE 2004 COMMENTS...STOCKS RECORD A MODEST POSITIVE MOVE...BONDS STABILIZE...POLITICS AND POLICY TAKE CENTER STAGE
- As June drew to a close, the Federal Reserve finally moved to raise interest rates. The increase of 0.25% in the federal funds rate was perhaps the most widely-anticipated rate hike of modern times. Importantly, the Fed’s accompanying statement continued to suggest that the monetary authority would remove its accommodative policy at a “measured” pace.
- June also saw the U.S.–led coalition transfer sovereignty to Iraq’s civilian authorities. There were preliminary moves to bring Saddam Hussein to trial in an Iraqi court.
- In the U.S., the pace of economic growth seems to be slowing. Forecasts of real GDP growth for the third calendar quarter are moving down to a healthy 3%. There is some evidence that prices of goods and services may be growing more slowly than experienced in the first half of the year. The weaker than expected jobs report for June confirms a slower growth pace. Oil prices have also backed off recent highs.
- Election year developments remain unclear due to a close race for the Presidency. This situation may clear somewhat after the conventions and post Labor Day as the campaigns intensify.
- Thus, at least some of the major uncertainties confronting the stock market are beginning to resolve themselves. Rising interest rates had largely anticipated the Fed’s initial action in late June. Some further weakness appears likely in bonds as future rate hikes are expected. Movement towards resolution of uncertainties should, however, push stock prices upwards in the months ahead.
II. ECONOMIC OUTLOOK ...JOBS GROWTH CONTINUES...CONSUMER SPENDING IS STRONG BUT SHIFTING...CHINA GROWTH SLOWS...CAPITAL SPENDING STRONG
- The March-June four-month period saw more than 1 million jobs created. Virtually every sector, including manufacturing, added workers. Inventories remain historically low. As such, businesses are adding to capacity using high and rising cash flow to finance capital spending.
- Consumer spending is being supported by rising employment and wealth. As interest rates rise, it seems likely that the major credit–using sectors, housing and auto sales, will slow. New mortgage applications have already dropped. Rebates and low interest rate financing will likely continue for autos.
- Chinese authorities claimed success in their efforts to slow China’s economic growth and thereby reduce inflationary pressures in that country. Slowing Chinese growth has caused many commodity prices to back off their earlier highs. In addition, ocean shipping rates are down from their spring averages.
- Reflecting employment gains, consumer confidence measures are at two-year highs. Going forward, trends in consumer spending will be supported by employment data, rather than the pattern of tax cuts, mortgage refinancings and falling interest rates that represented the foundation of consumer outlays in 2003 and early 2004. Strong corporate earnings and profit margins continue to rise faster than inventory. Efforts to increase capacity are a natural consequence of these developments.
III. FIXED INCOME OUTLOOK ...INFLATION PICKS UP...GDP GROWTH SLOWS
- Overall consumer prices rose 0.6% in May although the core rate, which excludes energy and food prices, rose a more modest 0.2%. Producer prices rose 0.8% but, again, the core rate rose only 0.2%.
- At this point, the U.S. economy appears to be expanding at a rate of about 3%, but growth in China is slowing. This in turn, may lessen the pace of inflation, allowing interest rates to rise gradually.
IV. STOCK MARKET OUTLOOK ...QUALITY IS ALIVE & WELL...DESIRABLE VALUATION FEATURES...SECTOR GUIDE AND CAREFUL STOCK-PICKING
- Over the next few years, we expect that corporate profit growth will remain strong but below the torrid pace of the past twelve months. At the same time, interest rates will probably have an upward bias. As short-term uncertainties, such as election results, Iraqi independence, Fed policy, and inflation move toward resolution, equity prices should move higher.
- Future stock performance may relate more to company-specific developments, placing a premium on careful stock selection. Factors such as financial strength, dividends, raw material and labor sourcing, demographics, pricing power, industry structure, government regulation, currency and capital spending plans will probably have a significant influence on equity valuation levels.
- Over the past six months, stocks that have performed well exhibit such characteristics as rising dividends, high free cash flow yields, strong balance sheets, and the ability to manage in a period of rising interest rates. In addition, the relative outlook of consumer and industrial stocks favors the business spending sector of the economy.
- In light of prospective conditions, there is less emphasis on the financial, consumer staple, telecommunication and health care sectors. In contrast, positive economic outlook makes the energy, industrial, technology and material sectors more attractive. Finally, within the consumer discretionary sector, expect strong earnings from publishing, restaurants, entertainment and advertising. Within these groups, careful selection will drive performance.
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