SEPTEMBER 3, 2004
ECONOMY MOVES FORWARD IN SPITE OF UNCERTAINTIES
I. AUGUST 2004 COMMENTS...STOCKS RISE SLIGHTLY...BONDS RALLY...CROSSCURRENTS AND UNCERTAINTIES REMAIN
- Stocks began the month relatively weak as economic growth was slowing, oil prices were nearing $50 a barrel, the Federal Reserve was expected to continue raising interest rates, and the growth rate of corporate profits was expected to decelerate in coming quarters. Favorable oil inventory reports brought crude oil down towards $42 amid tempered supply disruption concerns over Russia, Venezuela and Iraq.
- President Bush’s showing in the polls rose. Inflation worries receded a bit. The economy should expand at a 3% annual pace. The realization that economic strengths still outweigh weaknesses resulted in stock prices rallying toward month end.
- This is not to say that business conditions are robust; merely that growth is on a 3% annual pace that appears sustainable. In the months ahead, expect many uncertainties to be resolved and stock prices to resume a tempered advance.
II. ECONOMIC OUTLOOK ...GDP GROWTH SLOW...CONSUMER CONFIDENCE WEAKENS WITH JOB PROSPECTS...CORPORATE CASH FLOW VERY STRONG
- GDP grew at an estimated pace of 2.8% in the second quarter, in line with our 3% forecast. There is little reason to expect third quarter results to differ materially, considering that oil prices are up, consumer sentiment has declined, residential mortgage activity is lower, auto production schedules have been cut back and employment gains are sluggish. On the positive side, business investment is sharply higher for both equipment and structures. Inventory growth and government spending also contributed positively to GDP.
- As August ended, there were indications that the period of economic softness may be nearing an end. Chinese authorities have more recently refrained from further efforts to slow their economy. Gasoline prices are well below their June highs; bonds have rallied, new unemployment claims have dropped, money supply is growing and recovering stock prices may encourage sentiment measures. In general, commodity prices have stabilized after rising sharply in prior quarters.
- Until consumers adjust to higher energy prices or the Fed telegraphs its intent to raise rates very slowly or employment growth strengthens, we foresee a continuation of modest GDP growth.
III. FIXED INCOME OUTLOOK ...PRICES WELL-BEHAVED...SIGNS OF LOWER INFLATION...PRODUCTIVITY & COSTS FAVORABLE
- Producer prices rose a scant 0.1% in July. Consumer prices declined 0.1% in July while the core rate rose a modest 0.1%. Energy prices, to the consumer, were lower and food prices were modestly higher. Consumer inflation expectations dropped due to generally slower growth of GDP.
- In coming months, growth in credit-using industries such as homebuilding and automobiles will be slowing and this may reduce pressure on interest rates. The Federal Reserve might also raise short-term rates more slowly than earlier expected.
- Investors will continue to pay close attention to the monthly employment report. We expect better trends in this measure: small business hiring has picked up, temporary employment trends are strong, new layoffs are very low and weekly new unemployment claims data continues to improve. In addition, we would note that payroll employment surveys of the BLS are subject to considerable revisions after the initial releases (especially in economic recovery phases). New job data may even be the dominant influence on the election.
- The August Payroll report showed a 144,000 increase in jobs (the most since May). The unemployment rate fell to 5.4%, the lowest since October 2001. The July Payroll report was revised up by over 100% (to 73,000 jobs created). A strong hurricane season has created more uncertainties in these monthly numbers.
IV. STOCK MARKET OUTLOOK ...LEADERSHIP...STRENGTH...PROFITABILITY & GROWTH...CHARACTERISTICS AND ATRIBUTES THAT SUCCESSFUL STOCK PORTFOLIOS SHOULD EMBODY
- Given recent tax law changes, market interest has returned to companies with strong earnings profiles and good dividend records. A global recovery tends to favor multi-national firms that can source capital, markets, labor and raw materials across the globe.
- Financial strength is a function of low capital leverage, low debt levels, pricing power, growth of earnings and revenues, and specific measures of profitability, such as EBITDA margins and return on equity. Successful business models result in substantial free cash flow, which can be used to repurchase stock, finance acquisitions, pay dividends, build new markets or expand product lines.
- Leadership positions can be built on dominant market share, innovation, patent or copyright protection, technological advancement, raw material controls and other such factors, all of which reinforce the durability of a company’s position.
- We use both our own experience and knowledge, as well as various investment services and organizations to measure how well companies meet these desired attributes. This leads to diversified portfolios where these attributes exceed comparable levels for the popular averages.
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