SEPTEMBER 9, 2003
I. AUGUST 2003 COMMENTS…STOCKS RESUME UPTREND…BONDS REMAIN WEAK…ECONOMIC SIGNALS ENCOURAGING
- Equity prices moved steadily higher in August after little
net change the prior month. Buyers have been encouraged by steady
improvement in the domestic economic outlook, better prospects
for world GDP growth, and the positive trend in corporate earnings
reports for the second calendar quarter.
- Bond investors also believe that a stronger economy is at
hand but fear that such developments will lead to higher inflation
and restrictive monetary policy by 2004. Bond buyers were correct
in 2001 and 2002, viewing forecasts of economic recovery as premature:
this time they are forecasting strength rather than weakness.
II. ECONOMIC OUTLOOK …STRONG RETAIL SALES…HOUSING MOVES HIGHER…ORDER RATES MOVE UP…EMPLOYMENT TRENDS DISAPPOINT
- July retail sales rose 1.4% and June data was revised upward.
We believe that retail strength reflects the recent tax cut,
residual effects of mortgage refinancing and better stock market
conditions. All of these factors contributed to improved durable
goods orders and to optimistic consumer sentiment readings.
- In the housing sector, mortgage refinancing applications
dropped sharply as rates rose, but new construction remains strong.
July housing starts rose to a 1.87 million rate although permits
fell to a 1.78 million pace.
- The labor market remains a question. We expect broader gains
by the stock market and much higher consumer confidence readings
when the U.S. economy begins to create rather than eliminate
jobs. The economic sequence of events leading to jobs creation
is already in place: higher corporate profits, expanding capital
investment, and recovery in temporary help. Recall that demand
for workers tends to lag the general economy and that the recent
recession/ unemployment level was one of the shallowest in the
post-war era.
- In early September, the Labor Department reported that non-farm
payrolls shrank by 93,000. Economists had expected a small gain.
Stock prices fell when the data was released but have since rallied
to new recovery highs, suggesting that investors are looking
to later in 2003 for improvement in the job market. We do not
think that this confidence is misplaced.
III. FIXED INCOME OUTLOOK…INFLATION REMAINS LOW…FEDERAL RESERVE LEAVES RATES UNCHANGED
- Producer prices rose 0.1% in July. Excluding food and fuel,
the PPI rose 0.2%. Consumer prices rose 0.2%, both overall and
core.
- The Federal Reserve's Open Market Committee (FOMC) met in
early August and, to no one's surprise, left rates unchanged.
The Associated Press release reinforced the view of most observers
that no rate hikes would be forthcoming until the recovery was
firmly rooted. The FOMC however again referred to deflation risk.
We see no such risk in future periods, especially with the massive
monetary and fiscal stimuli seen to date.
- A preliminary estimate of third quarter GDP growth is about
5%, in our view. Expected gains will be somewhat lower in this
year's final quarter as auto production and residential construction
will slow somewhat. An early estimate of 3% seems reasonable,
more if capital spending picks up steam. These estimates should
support stocks without too much worry on the part of bond buyers.
IV. STOCK MARKET OUTLOOK …ROTATIONAL MARKET INTEREST…STRESS DIVIDENDS AND QUALITY…EARNINGS REPORTING SEASON AHEAD
- When the stock market history of 2003 is finally written,
the year will be seen in two parts: the first half, when low-priced,
speculative, non-dividend payers led the market; and the second
half, when quality companies with strong earnings and reasonable
dividends began to outperform. This expectation is supported
by recent bond market trends, tax law changes, and the logical
inference that broader economic gains will be accompanied by
broader market participation in rallies.
- In addition, U.S. companies are issuing third quarter earnings
warnings at a slowing pace. September will be warnings season
and October will see reporting season. Near-term beneficiaries
of consumer spending should report positive results for the third
quarter. As existing capacity is returned to production and corporate
cash flow improves, capital spending will follow. We're beginning
to see this pattern already, with machinery, construction equipment,
farm equipment, heavy trucks and engines, and similar groups
reporting stronger order rates in recent months.
- Commodity producers of virtually every type have shown relative
strength, as have energy stocks more recently. As world GDP growth
increases, the energy producers will be a prime beneficiary.
- World growth will also help the producers of branded consumer
goods, ranging from foodstuffs to household products to personal
products. Demographic factors continue to favor the oversold
pharmaceuticals group together with the market-leading financial
stocks, especially the asset managers, insurers, and regional
banks.
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