Economic Review and Market Perspective

October 16, 2003

Commentary and Planning Ideas, Market Perspective, and Market Review are
written and published quarterly by Preston Caves, CPA, CFA, MBA

We started 2003 wondering what new economic and geopolitical shocks might derail improvement of business conditions and corporate profits, and with them, stock prices.  So far, world stock markets have responded very well to some evidence of global economic recovery and the relative geopolitical calm since cessation of major hostilities  in Iraq in early spring.

The bulk of data released during the third quarter indicated a steadily improving U.S. economy, although there were just enough discouraging reports to suggest that the recovery would remain choppy.  At the broadest level, GDP was revised to have risen better than 3% in the second quarter.  The growth was reported to have come from several sources, including consumer spending (+3.8%) and capital spending (+7.3%).  More contemporaneous data suggested much of the same.  Back-to-back monthly gains in retail sales and a record level of existing home sales in August diffused fears that a rise in interest rates and end of mortgage refinance opportunities would kill consumer spending.  Indeed, personal spending increased 1.7% in July and August (a 7% annualized rate), which would boost third quarter GDP.  The only negative report came from the Conference Board, which noted that consumer confidence fell in September.  Manufacturing activity, meanwhile, picked up during the third quarter, thanks in part to rather lean inventories.  Through August, orders for non-defense capital goods were 3% higher than where they were a year ago.  While not a large gain, it did indicate progress in investment spending.

The euro-zone, U.K. , and Japanese economies also showed varying degrees of improvement.  A euro-zone manufacturing survey indicated marginal expansion in September for the first time in seven months, although unemployment remained extremely high.  The German economy, the region's largest, remained in recession, but the German Economics Minister suggested in September that his nation’s economy had started to improve.  In Britain , the pace of economic recovery grew so that investors began to fear a Bank of England rate hike.  Finally, in Japan business leaders reported in the September Bank of Japan tankan survey that business conditions improved for the first time in three years.  This came on the heels of a 3.9% annualized rate of economic growth in the second quarter. 

Looking ahead, it is fair to say that many observers are at least cautiously optimistic that U.S. and global economies are poised for a sustained recovery.  The U.S. economy, buoyed by continued monetary easing by the Fed due to the benign inflationary environment, very substantial fiscal stimulus of tax cuts and increased government spending, and a weak dollar, is expected to resume a familiar role as engine for global economic growth.

Market Perspective

Last quarter we reviewed the positive impact on equities markets of reduced uncertainty.  We also reviewed the case being made by the bulls then, which included a reliance on positive economic trends just mentioned above.  Although market bears also had good arguments three months ago, we feel a continued reduced level of uncertainty and positive economic and stock price momentum bode well for global equities markets for at least the short-term.

The bright people at PIMCO, renown for their fixed income management, present a good case for staying the course in bonds by noting economic imbalances that suggest a pick-up in economic growth is not inevitable.  They note the as yet unresolved worldwide excess of supply over demand (i.e., excess capacity); too much debt by individuals, companies, and governments; a U.S. trade deficit that will sooner or later force Americans to save more or face higher interest rates; underfunded pensions which will divert corporate cash; weak economies abroad and a China continuing to export deflation with its low cost manufactured goods and undervalued currency; and on-going geopolitical risks.  Overall, the PIMCO insights tend to be intermediate-term in nature and provide appropriate perspective to deter over commitment to stocks and abandonment of bonds. 

The PIMCO outlook includes the assessment that the 10-year U.S. Treasury yield should remain near current levels of about 4% for the next 6-9 months and then climb towards 5-6% if world central banks successfully reflate the global economy.  The implication is little or no risk for the near-term of a recurrence of capital losses on fixed income positions, as occurred early this summer, but an increasing risk by the middle of next year.

As usual, opposing opinions abound, and good arguments are lined up on both sides of the issue of near-term markets performance.  As is our custom, Caves & Associates is reluctant to disseminate short-term forecasts because they are so unreliable.  In general, our sentiment has gone from bullish at the beginning of the year, contingent on Iraq news; to bullish at the start of the second quarter due in fact to Iraq "good" news; to cautious in July, due to the strong Spring rally relatively unsupported by underlying improvement of investment fundamentals. 

During the third quarter, there was an improving, welcome correspondence between economic\fundamental data and the performance of the markets.  Therefore, we are cautiously bullish on equities markets for the near-term.  Clearly, continued news of an economic rebound and corporate earnings growth is crucial for current prices to be sustained and even advance further.   Finally, we would caution that non-economic threats (war, terrorism, political, etc.) remain real. 

It is important to note that markets are very forward-looking, usually acting on conditions as they are expected to be in 6-12 months.  We expect that some of the benefit of economic and stock price momentum, and what may be called the "consensus" bullish global economic forecast, is already incorporated in current equities price levels.  Also, resolution of the economic imbalances noted by PIMCO presents challenges to the outlook that may soon have much more prominence on the market's radar screen.  Consequently, we think it is prudent to maintain a market neutral posture and wait for a better understanding of intermediate-term conditions.  Therefore, we are again recommending investors maintain allocations at strategic targets for the time being, but we are also recommending reduction of bond durations below typical levels.