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Economic
Review and Market Perspective
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August
5, 2004 |
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Commentary
and Planning Ideas, Market Perspective, and Market Review are
written and published quarterly by Preston Caves, CPA, CFA, MBA
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The
economy did slow somewhat toward the end of the second quarter, but the
overall positive trajectory remains in place. Inflation is generally under
control, with the exception of energy prices. Investors had few opportunities
to realize gains during the first half of 2004. |
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Economic
Review* |
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Economic
data released during the second quarter remained upbeat. Growth was reported
to have come from sources aside from the consumer, particularly from investment
spending. Nevertheless, there is a gap between corporate profitability
and wage growth which may explain why many Americans think that the economy
is not doing as well as it is. The unemployment rate remained stable at
5.6%. The U.S. employment picture is likely to continue to tighten but
will very likely underperform past recoveries, due to this imbalance of
corporate growth vis a vis domestic labor growth (something we touched
on in our previous economic review). Some job creation coupled with tame
inflation has kept consumer confidence relatively stable, although thin
wage growth and continued high gasoline prices have started to cut into
lower-end retail spending. Thus, consumer spending slowed from its recent
torrid pace, but it still remained a net contributor to aggregate economic
growth. |
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During
the first half of 2004, a more measurable rise in overall inflation was
the (mostly) unwelcome counterpart to the economic strength, but the increase
was largely due to energy prices. Productivity was again touted for its
role in keeping prices down. Nevertheless, inflation did begin showing
up in places other than the gas pump. The Consumer Price Index excluding
Food and Energy (a traditional measure of “core” inflation) spiked in
March at .4% (non-annualized) but fell by .1 percentage point in each
successive month. Notwithstanding the improving news on core inflation,
fearing that overall inflation could be heading higher, and perhaps noting
that energy price increases do reverberate through the economy, the Federal
Open Market Committee sent clear messages to the financial markets that
its next action would be to tighten the money supply in the hopes of reigning
in inflation. This was confirmed by its decision in late June to raise
the Federal funds rate by 0.25%, to 1.25%. |
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The
question for the second half of the year is whether the stimulus to spending
from employment gains, coupled with hoped for improvement in energy prices,
will shift consumer spending growth back into higher gear. Without a consumer
reacceleration, or the substitution of increased business investment, overall
growth could slip back towards or even below 3%, and the Fed would have
to reconsider whether even a “measured” schedule of rate hikes is too aggressive. |
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Outside
of the U.S., news was more reserved, although still positive. One of the
key components of the positive news was China, where the pace of economic
expansion has been extraordinary. So much so that Chinese leaders have made
policy revisions in an attempt to reign in growth and subdue what could
become raging inflation. Thus, expectations for future global economic growth,
particularly in the Asian region, must be tempered with an eye towards policy
deliberations in China. In Japan, where economic activity has been stagnant
for over a decade, there were further signs of a healthy recovery. Japan
announced an unexpectedly good quarter of economic growth, bringing the
world’s second largest economy to a 2.2% annualized rate. In Europe, headlines
focused on the formal addition of 10 new countries to the European Union,
although the fact that the European Central Bank refrained from raising
policy rates despite a measurable increase in inflation highlight the tenuous
position of the region’s economic recovery. |
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Market
Perspective |
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Rising
interest rates and energy prices, lagging wage growth and consumer spending,
uncertainty surrounding Iraq and national security, and the impending
election, all worked to temper economic growth and financial market valuations
in the first half of the year. |
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While
it seems clear to most that interest rates, in aggregate, are heading
higher, there are a number of factors that could change the pace and trajectory
of that rise. Also, since rates do not rise in a vacuum, it is dangerous
to assume a linear relationship between rates and the performance of financial
assets. Even bonds may offer opportunities, as a rise in rates that is
tied to an improving economy may lead to improving credit quality and
corporate bond returns. |
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It
is unclear whether the absolute level of economic activity will increase
or begin to stagnate as interest rates rise and the simulative effect
of U.S. tax cuts wanes. The comforting news on core inflation will reassure
financial markets, and provide the Fed with more flexibility in maneuvering
expected rate hikes. |
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Caves
& Associates believes the deceleration of economic growth and core inflation
should be favorable for financial markets. Bond markets should be relieved
by the reduced pressure on the Fed to raise rates. Short and intermediate
term growth prospects for the U.S. and global economy should be adequate
to support company earnings and stock prices, which also benefit from the
improved outlook for interest rates over the short-term. Asian central banks
seem determined to support their export driven economies, so the U.S. dollar
should hold value reasonably well over the foreseeable future. In conclusion,
this period of high uncertainty is not ideal but neither is it really atypical,
and investors should earn reasonable premiums for prudent risk-taking. |
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Bears
point to another stock market warning light, investor sentiment, which measures
whether investors are gloomy or enthusiastic. A common measure of investor
sentiment is a survey conducted by market research outfit Investors Intelligence,
which monitors whether investment newsletters are bullish, bearish, or in
between. That survey shows that bulls now represent about 70% of those who
are clearly bullish or bearish, an unusually high percentage. Three weeks
ago, before a brief market pullback, bulls were almost 80%, the highest
level since the spring of 1987, a period that preceded the crash of 1987.
In case there is a need for clarification, the measure is interpreted inversely.
Thus, a high percent of bullishness is actually negative for market performance,
indicating newsletter writers are also capable of "irrational exuberance". |
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As
usual, good arguments are lined up on both sides of the issue of near-term
market 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 start of the second quarter,
to cautious, due to the recent strong rally relatively unsupported by underlying
improvement of investment fundamentals. Given there remains a significant
amount of uncertainty in the world, from all regions including the Middle
East, we think news of an economic rebound and corporate earnings growth
is crucial for current prices to be sustained and even advance further.
So we are glad for recent strongly positive market results but only partially
persuaded the time is at hand to herald a new bull market. We think there
are good reasons for bullish investors to see light at the end of the tunnel
and be optimistic that global economies are recovering. We also recognize
the market is very forward-looking, usually acting on conditions as they
are expected to be in 6-12 months. And the market is usually right. Nonetheless,
we are maintaining a market neutral posture and waiting for some confirming
fundamental economic news before considering some overweighting of stocks.
Therefore, we are recommending investors maintain allocations at strategic
targets for the time being. |
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*
Thanks go to the Managers, Alger, and PIMCO Funds for their reviews of global
economics presented here. |
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