MAY 10, 2004
I. APRIL 2004 COMMENTS...ECONOMY STRONG...PROFITS SOAR...INTEREST RATE WORRIES
- Stock prices edged lower in April despite a steady stream of excellent corporate earnings reports for the first quarter, illustrating once again the old saw, “Buy on the rumor, sell on the news”.
- Bond prices as well eroded during April as investors considered the probable impact of a strong recovery in job creation. Federal Reserve officials held rates unchanged but made it clear that historically low rates could be raised at a “measured pace” in the periods ahead.
- Economic strength has become broad-based and sustainable. The key pieces of the puzzle have fallen into place: job growth has returned and business investment in capital goods is rising in line with surging corporate profits.
- Prices are now rising for a broad range of goods and services. This will tend to hasten the day when the Fed moves to increase interest rates in order to slow the pace of expansion. The markets are now caught in a proverbial tug of war between strong earnings and other beneficial effects of the economic expansion and the potential negative effect of rising interest rates.
II. ECONOMIC OUTLOOK ...CAPITAL SPENDING STRONG...PRICING POWER...CONSUMER A MODERATE PLUS
- Real GDP advanced at a 4.1% pace during the first quarter, aided importantly by higher business capital spending. Leading economic indicators suggest further growth lies ahead. Purchasing managers report slower supplier deliveries and higher prices paid for various inputs, including commodities and transportation. Efforts by Chinese authorities to slow the pace of Chinese growth will have a modestly depressing effect on items such as ocean shipping rates, copper, nickel and commodity semiconductors, but prices remain above year earlier levels.
- Since pricing power is returning, it is logical to believe that capacity utilization rates have risen significantly after the past few quarters of strong growth. Both continuing and initial claims for unemployment insurance have dropped steadily since early 2003. Wage growth has been modest. But benefit costs have risen steadily and have contributed to the lag in job growth vs. GDP growth.
- Consumer spending remains positive, reflecting wage and benefit increases, the stock market recovery and falling unemployment rates. Residential construction continues strong although some fall-off seems likely later in the year. Auto sales are mixed but higher interest rates would be a problem for both sectors as well as other consumer durable goods. Consumer electronics and personal computer sales may also be peaking. Rising gasoline prices have attracted much media attention and have much the same effect as a tax increase. While consumers should continue to spend in the periods ahead, most GDP growth will stem from business spending, exports and inventory change.
III. FIXED INCOME OUTLOOK ...RISING RATES LIE AHEAD: HOW FAR AND HOW FAST?
- Producer prices rose 0.5% in March. Intermediate and crude goods rose more rapidly. Consumer prices also rose 0.5%. Core rates for both producer and consumer prices were modestly lower but price increases seem likely to accelerate in the months ahead. Anecdotal evidence suggests a wide array of consumer and producer goods where sellers have new-found pricing power.
- The financial positions of states and localities are much improved over the past year. Federal budget deficit estimates are $100 billion lower than at year-end.
- Banks, which had been major buyers of bonds, may be generators of business loans for inventory and working capital. Foreign central banks have also been heavy buyers.
- Federal Reserve policy is likely to become steadily less accommodative during the next two years. Ultimately, the income needs of aging baby boomers and relatively low inflation limits imposed by globalization and productivity growth will limit the upward movement of interest rates. In the meantime, we continue to emphasize maturities shorter than relevant benchmarks.
IV. STOCK MARKET OUTLOOK ...STRONG EARNING REPORTS...RATE FEARS...POSSIBLE SHIFTS IN LEADERSHIP
- Higher interest rates are probably inevitable but a repeat of the bond bear market of 1994 seems unlikely unless the dollar loses value rapidly and inflation rises more sharply than anticipated.
- In this environment, we still advise exposure to improving cyclical business conditions. Industrial manufacturing, materials production, energy and select segments of healthcare and technology continue to offer appeal for growth.
- With rates likely to rise, the consumer discretionary and utility sectors may continue to underperform.
- The financial sector has moved lower as rate worries unnerved the market. Typically, interest margins compress when interest rates rise and mortgage volume declines as rates move higher. On the other hand, banks prefer to make loans rather than buy Treasurys, and loan demand is moving up as inventory and working capital needs increase. Asset managers with families of equity mutual funds should continue to thrive. As in the past, selectivity is the watchword among financials.
- Publishing and broadcasting stocks will tend to benefit from recovering advertising spending. Food stocks should benefit from enhanced pricing power as consumers pay up for quality and convenience.
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