The recently announced U.S. payroll numbers indicated a strengthening labor market that is likely to lead to an interest rate increase of a quarter of a point in June at the next Federal Reserve Board meeting. The Federal Funds futures market is now indicating that the Central Bank will raise interest rates by 100 basis points or a full percent by the end of 2004. This would bring the Federal Funds rate to 2% from the present 1% level. Moreover, by the end of 2005 the market is anticipating a rate of 3.5% thereby bringing the Federal Funds rate, according to Federal Reserve Board Governor Robert Parry of San Francisco, from a 45-year low to the minimum level considered to be at the low end of a neutral interest rate range. If the period of cheap money is over, it is possible that the market has not completely priced in either the extent or the duration of this new interest rate cycle.
China’s Economy
At the same time that U.S. interest rates are rising, China has begun tightening its monetary policies in order to slow its torrid growth rate to a more manageable 8% level. Investors and economists are also trying to decide whether China’s economy will undergo a hard or soft landing as its leaders attempt to cool down the growth rate. Because China has contributed significantly to world growth, a soft landing of the Chinese economy is important to prevent the world economy from markedly slowing.
A Significant Rise In Energy Prices
Considering the significant rise in energy prices with oil costing over $40 a barrel and natural gas more than $6 per mcf, an increase in inflation rates beyond the expectations of the Federal Reserve cannot be ruled out. Oil prices are now at the highest levels since the 1980s. Prices at the pump for gasoline are expected to peak well above $2.00 a gallon in June, up substantially from previous Energy Department estimates.
The Market’s Reaction To Higher Interest Rates
The market’s reaction to the rise in interest rates, and this includes the currency markets, commodities markets and stock and bond markets, has been a consequence of the reversal of the carry trade. The implementation of the carry trade involved the purchase of commodities, equities, currencies and high-yielding securities with short-term borrowed funds at almost no cost because interest rates were so low. This was also considered to be a re-flation trade, where an investor could profit from the aggressive attempt of the Federal Reserve, through its cheap money policy, to re-flate the U.S. economy, thereby creating an economic upturn. The Federal Reserve, in its recent communications, has taken pains to provide the markets with the knowledge that its moves will be measured so that the unwinding of the carry trade could take place over a period of time rather than suddenly, which would be destabilizing. With over $1 trillion in more than eight thousand hedge funds this investment strategy had wide-ranging appeal, but could only work as long as monetary policy stayed decidedly stimulative. As monetary policy becomes less accommodative, all these transactions must be reversed. Initially these transactions often involved selling dollars to purchase foreign currencies and securities where rates of return were higher than in the U.S. The effect of these transactions was to force the U.S. dollar down and to strengthen major foreign currencies; it propelled commodity prices higher and made high yielding securities in general rise in price. Now the effect of reversing these transactions has tended to strengthen the U.S. dollar against major foreign currencies and put downward pressure on some commodities as well as high-yielding securities.
While we are on the subject of the strengthening of the dollar, it is important to note that the appreciation of the dollar against the Japanese yen has removed the need for the Japanese to embark on currency intervention to prevent their currency from rising. The effect of the Japanese intervention had been to increase demand for U.S. Treasuries, which had the effect of putting downward pressure on our interest rates. Since the Japanese demand for U.S. Treasuries has been reduced, U.S. deficits now need to be financed from other sources thereby tending to put more upward pressure on U.S. interest rates.
Hedge Funds and Individual Speculators
Hedge funds and individual speculators have relied on borrowed money to leverage their capital. As we described earlier, hedge funds employ carry trades by borrowing dollars at low interest rates and investing the proceeds in higher-yielding assets. However, with interest rates rising, many of these trades are threatening to become unprofitable. As a consequence of reversing both the carry trades and other speculative strategies, some investors are being forced into making hastened and sometimes irrational investment decisions that can needlessly drag markets down.
U.S. Monetary Policy Has Shifted
The Federal Reserve has clearly signaled a change in monetary policy. The Federal Reserve has acknowledged that a stronger U.S. economy, higher energy prices and the recent up tick in inflation could soon lead them to lift interest rates. We think the Federal Reserve will go slowly and move cautiously on any policy shift. We do not expect any sharp rate hikes that could choke off the U.S. economic expansion, but we now expect one or more rate hikes in 2004.
Recent data showed that the U.S. economy’s gross domestic product rose a healthy 4.2% in the first quarter of 2004. Growth would have been even stronger had it not been for a deceleration in inventory investment. Inventory accumulation will likely help the U.S. economy’s growth going forward, as production ramps up to meet a projected strong seasonal shopping period in the second half of the year. Corporate earnings in the first quarter were strong, with profits generally better than forecasts. The May 7th report of a rise of 288,000 people in April’s non-farm payrolls is also further evidence of the U.S. economy’s strength.
The outlook for Federal Reserve Board policy is very straightforward. If the employment data continues to remain strong, the Federal Reserve Board will raise interest rates. If, on the other hand, the employment data starts to show some weakness, they probably will be hesitant to raise interest rates. To make matters a little disconcerting, financial markets are beginning to reflect the influence of a significant increase in energy and commodity prices. Companies are starting to pass on some of the increased costs of energy and raw materials. Therefore deflationary pressures have begun to moderate. Rising commodity prices are increasing the costs of finished goods, and price deflation from China has now given way to an accelerating inflation.
Keep in mind that Federal Reserve Chairman Alan Greenspan has said repeatedly that strong productivity growth and falling unit labor costs have been key factors allowing the Central Bank to keep interest rates low. Labor costs in the U.S typically represent about two-thirds of the overall cost of producing goods and services. Unfortunately the first-quarter saw an increase in labor costs due in part to the rising costs of providing healthcare and pension benefits to workers. If this trend persists, the rise in unit labor costs is another reason for the Federal Reserve Board to raise interest rates.
The Oil and Natural Gas Industry
In the most immediate time frame the energy sector probably offers investors one of the best possibilities for substantial capital gains. The pace of global economic expansion in 2004, the business recovery in the U.S., China’s booming economy with soaring auto sales and construction, and Eastern Europe’s brightening prospects are all putting considerable upward pressure on energy prices. Turmoil in some of the oil producing countries is also leading to higher energy prices. The petroleum and natural gas industry is now benefiting from much higher price realizations, and we believe they will likely continue to do so in the months and years ahead. It is interesting to note that many of Wall Street’s senior energy analysts did not anticipate rising energy prices and have been reluctant to increase their earnings estimates for oil and natural gas companies fearing that high-energy prices may only be an anomaly. We believe that global energy demand has outstripped supply, and this condition is likely to last for the foreseeable future. Alternative energy sources, more efficient use of oil and gas, infrastructure investments, and a different national policy will be required to prevent further upward price pressures over time. Although the price of oil and gas can decline we believe a new level has been put in place.
The Food Processing and Alcoholic Beverage Industry
We like the valuations and fundamentals of the Food Processing and Alcoholic Beverage industries. These industries are likely to post solid revenues and profit gains in 2004. They are benefiting from pricing power, volume gains and successful cost cutting. The food processing, beer, wine and liquor industries are reaping the rewards of a favorable price environment and volume improvement due in large part to a shift in consumer preference toward more upscale, premium products. In addition, branding and product innovation will remain a central theme to their success. Companies that are able to fashion their products to reflect the realities of modern living and the international markets can grow their sales and earnings considerably. We find current valuations attractive, and the fundamentals should keep improving in these industries as companies seek savings by leveraging fixed distribution networks, demanding better deals from retailers and expanding their businesses abroad. The low-carb craze likely only represents a mild negative for the companies that we favor.
Conclusion
For several weeks investors have struggled with the impact of a stronger economy and higher interest rates. Equities now face many obstacles, including sagging bond prices, which have pushed up the yield of the 10-year Treasury note to close to 5.0% from recent lows of 3.71%. While renewed economic strength means better corporate earnings, it also means higher interest rates that will tend to reduce price-earnings multiples on common stocks.
If interest rates continue to rise this year, the financial markets could experience an unusual degree of volatility. In an attempt to reduce their risk exposure financial institutions sell their long-term fixed-income securities. Borrowing short and investing long often works well when interest rates are falling. However, leveraging long-term assets on short-term borrowing can be disastrous in a rising interest rate environment. The carry trade could be a critical factor in how the financial markets behave for the rest of 2004. Moreover, instability in the Middle East, high-energy prices and rising inflation have added to the financial markets’ unease. Nevertheless, we continue to find appealing equity and fixed income investments that are benefiting from these conditions.
The investment climate continues to be dominated by low interest rates, a high risk of negative events, high and rising commodity prices and more than $5 trillion of cash in our financial system earning practically no interest. Because interest rates are so low investors are trying to improve their income returns, particularly since 85% of corporate dividend payouts are now free of federal taxes in many cases.
China, with 1.3 billion people, is rapidly industrializing resulting in the most significant increases in energy and industrial commodity prices in memory. Moreover demographic changes in the United States have augmented demand for housing, which is also increasing demand for energy and industrial commodities. Because interest rates are so low home-ownership has become more affordable in spite of rising home prices due to strong demand. Moreover because housing is a home grown product and not an imported one, pricing power exists in the homebuilding industry. In fact where U.S. goods and services do not have to compete with overseas suppliers, prices have been rising much faster than the government’s measure of inflation as represented by the Consumer Price Index. For many consumers and investors to offset higher costs in a low interest rate environment, capital is flowing to higher yielding securities.
The Market’s Focus Will Shift To Upcoming Earnings
As we enter the earnings-reporting season the markets will be focusing more on individual corporate results and less on the big picture as is customary at this time. We believe this upcoming reporting season will be quite positive and likely to be better than projected. When upcoming earnings are robust or likely to be better than anticipated, the markets tend to have a positive bias. It is worth noting that the equity markets refocus on the big picture after companies have reported their results for the quarter.
Employment Comparisons Are Likely To Be Improved Temporarily
We are not surprised at the sub-par employment growth during this economic cycle, and notwithstanding the fact that upcoming employment reports could make for better reading particularly since 65,000 West Coast striking grocery workers returned to their jobs, we expect corporations to continue to maximize efficiencies rather than hire many additional workers. It should be noted that accelerated depreciation allowances enacted last year give corporations an incentive to purchase new equipment which must be operating by year-end to qualify for this special tax benefit. To the degree that this capital investment redirects corporate spending away from hiring, employment growth suffers.
Expect Lower European Interest Rates And A Stronger Yen
The euro-zone economy has not delivered the necessary growth to reduce high levels of unemployment. Moreover the strength of the euro has taken a toll on European exports. We expect the European Central Bank to reduce interest rates by a quarter to a half a point over the coming months. While this could temporarily strengthen the dollar versus the euro, the dollar remains a weak currency in relation to the Japanese yen. And while the Japanese have spent enormous sums ($142 billion during the first quarter) to prevent the yen from rising against the dollar in order to protect their export business, we do not expect this to continue indefinitely, and consequently the dollar should decline against the yen. The extensive currency intervention by the Bank of Japan has resulted in their purchasing significant amounts of U.S. Treasury Securities, thereby tending to keep U.S. interest rates lower than they otherwise would be. While we do not doubt that ending this practice could result in some upward pressure on U.S. rates, we still expect short-term rates to remain at relatively low levels.
Federal Reserve Policy Is Likely To Remain Accommodative
We continue to expect the Federal Reserve to provide a generous amount of monetary stimulus to the U.S. economy. Employment gains are far smaller than past history has led economists to expect during a recovery, and when statistical economic relationships that worked for many decades no longer appear to work, there is a reasonable chance of seeing some fundamental shifts in economic policy. Not surprisingly the outsourcing of manufacturing jobs to Asian countries has become and will continue to be a hot political topic in the 2004 presidential campaign. Unless the United States economy gets materially stronger, we believe the probability is high that our short term rates will stay low for as long as Alan Greenspan remains Chairman of the Federal Reserve Board, which is until January 31, 2006.
In the 1970’s and 1980’s the main issue confronting the Federal Reserve was fighting inflation. Today inflation, as measured by the Consumer Price Index, is at very low levels even as energy and commodity prices have risen substantially. In today’s economy commodity prices have a much smaller influence on the U.S. Consumer Price Index than they have had in the past. This is evident as we have become more of a service-based economy with productivity gains driven by automation and technology, while over time we have outsourced increasing amounts of industrial production to lower cost nations. Consequently, the Federal Reserve Board has been more concerned with deflation than with inflation. Unless employment growth would get so strong as to put real upward pressure on U.S. labor costs, we should expect an accommodative monetary policy to continue.
Today’s Challenges Beget Investment Opportunity
The economy has been improving while corporate profits are rising faster than most analysts had expected. For many companies the bulk of the profit improvement has come from productivity and cost cutting, a characteristic that is difficult to maintain and even less likely to propel a sustainable economic expansion. Below, however, we highlight three areas that are benefiting from revenue growth and pricing power.
Oil and Gas Sector Dynamics Remain Attractive
Overall oil demand will continue to increase in the years ahead, with China accounting for the biggest portion of the rise. In viewing China we note the following; increasing motor vehicle use and the de-emphasis on coal in addition to increasing industrial demand for fuels has resulted in a projection of an increased need of 3 to 5 million barrels per day of additional oil imports over the coming years. According to the Energy Information Administration, in 2001 China vehicle ownership was 13 per 1,000 persons compared to 779 per 1,000 in the United States. As part of its industrialization program, China has embarked on massive highway projects to connect its western provinces which are largely undeveloped.
Last year oil prices in the United States averaged $31 a barrel and this year oil is selling for approximately $36 per barrel. Wall Street analysts for the past two years have expected oil to sell between $18 and $24 per barrel and have recently raised their targets to $28. In so doing they have also raised their estimates of the value of many oil and gas companies.
As clients of our firm know, many of our energy investments have yields of 4% to 9% and not coincidently benefit from negative exogenous forces, a stronger economy, inflation of commodity prices, the need for the United States to import 50% of its needs and increased electric power generation which is often fueled by oil and gas. In 1980 the oil and gas sector represented more than 25% of the S&P 500 and is now 6% to 7% of that index. Oil and natural gas equities look particularly attractive at their current valuations. Looking ahead we believe that earnings and cash flow in this sector will be stronger than expected if oil and natural gas prices persist at relatively high levels.
The Housing Industry Continues Its Secular Up Trend
The recent release of housing data indicated that the homebuilding industry remains very strong. The homebuilders as a group are sharing in a national housing boom fueled by demographics and record low mortgage rates. The companies that we like in this industry continue to report impressive new order growth and profit margins. The strong order growth and an ample backlog of homes under construction should result in excellent revenues, earnings and cash flow in 2004. It can be noted that despite some large fluctuations in interest rates in the 1990’s many of these companies continued to grow revenues and earnings at double-digit rates and yet currently sell from 7 to 9 times this year’s earnings, a low market multiple for growth.
The homebuilders in recent months have rewarded their shareholders with stock buybacks and increased dividend payouts. A number of homebuilders, who in the past have not paid cash dividends, have initiated a quarterly dividend, and they are quite confident that they will be able to sustain and increase their dividend payouts over time.
Gold And Precious Metals Prices Are A Beneficiary Of Dollar Depreciation
Gold bullion continued to enjoy relatively high prices in the first quarter with the average price in the quarter staying above $400 per ounce. At this point, there appears to be almost a perfect correlation between gold prices and the exchange value of the U.S. dollar. The dollar has depreciated against the euro and the yen for almost two years with the likelihood that, with temporary interruptions, this process will continue. The U.S. Federal Reserve’s accommodative monetary policy fundamentally set the stage for the dollar’s decline and the rise in the value of gold. Meanwhile, the Federal Reserve seems perfectly willing to accept the fall in the dollar’s value because of the lack of associated inflation in the U.S. economy. The low investment returns currently available from fixed-income securities, bank certificates of deposit and money market accounts are also supportive of higher gold prices and the companies that mine gold. Industrial metals prices have also soared to their highest levels in many years arising from limited mine production and strong demand from China and India. We expect the leading precious and industrial metals companies to continue to be good investments.
Conclusion
Many investors find the current environment confusing. We would suggest that, among other factors, this is due to the tacit recognition that high budget and trade deficits are unsustainable. However, since our system is highly adaptive and resilient it will readjust as necessary. Logically this leads to industry consolidation and the rationalization of productive resources. Within this overall context we are optimistic about the current and future prospects of many market sectors whose secular trends present unique and exciting investment opportunities. As mentioned in past Outlooks, such secular trends include the economic emergence of China, the growing need for U.S. housing, building of homeland security capabilities, the continuing energy shortfall in the U.S., healthcare innovation, and the need for improved education and job training.
The recovery in the U.S. economy is the result of an inordinate amount of fiscal and monetary stimulus. Forty-five year low interest rates and the easy availability of funds have been stimulating consumer and business spending. Unfortunately job growth during this recovery has been sub par as the forces of globalization have accelerated manufacturing and service sector outsourcing to the Asian economies. GDP growth for the fourth quarter appears to have been at 4%, not sufficient in our view to accelerate employment growth. The price of this recovery is the fiscal imbalance that has been created which is now estimated at more than $500 billion in the latest budget to be submitted by the administration. Federal Reserve Board Chairman Alan Greenspan will be testifying before Congress on February 11th, and we believe that he is greatly concerned about the U.S. federal budget deficit. Last Monday the Congressional Budget Office projected this year’s deficit at $477 billion. President Bush’s new budget, which will be submitted next week, will now project a deficit in excess of $500 billion and could be in the neighborhood of $540 billion. We do not believe that this imbalance is sustainable and will result in some interesting fireworks between the political parties and within the Republican Party this election year.
The Federal Reserve’s Most Recent Message
One of the consequences of our fiscal policy has been the weakening dollar. We suspect that the latest change of language from the Federal Reserve from “to keep rates low for a considerable period” to “the committee believes that it can be patient in removing its policy accommodation” had more to do with trying to stabilize or slow the decline in the foreign exchange value of the dollar by suggesting an end to its easy money policy than any desire to raise interest rates in the short term.
The inflation picture remains very favorable for a continuation of low interest rates. However, several factors are pressuring prices: medical/health costs are rising, local and state governments are increasing taxes, commodity prices are moving up across the board and the U.S. dollar is weak. However we still feel that the Federal Reserve will resist interest rate hikes until at least the third quarter of 2004 and probably into early 2005. Strong economic growth should not result in a rising inflation rate unless that growth is strong enough to generate much higher employment growth and significantly higher industrial utilization. We do not believe that industrial capacity will tighten enough to cause that to happen. The Federal Reserve will be able to remain accommodative for the majority of 2004, in our view, because of technology related productivity gains as well as deflationary manufacturing pressures from Asia.
Sectors That Can Contribute To A Well-Constructed Investment Portfolio
Over the course of the year, portfolio shifts will be determined by security valuations, the dynamics of the U.S. budget and trade deficits and changes in global capital flows. We now turn to some of the sectors that can contribute to a well-constructed investment portfolio as we start 2004.
Precious Metals
We believe strength in precious metals stocks was initially attributed in 2003 to the weakness in the U.S. dollar. With nearly a decade of neglect by the investment community, gold and silver was destined to quickly rise. The Federal Reserve’s accommodative monetary policies, weakness in the U.S. dollar, low interest rates and continuing purchases by the Asian countries should drive precious metals prices higher in 2004. Unless there is an unlikely reversal in these factors, equities in this sector still have considerable room to advance. As unfashionable as gold and silver were just a few years ago they now remain one of the best hedges against a weak currency and large federal budget deficits. The fundamental supply and demand aspect of gold and silver is also favorable and offers support for prices. The under investment in mine projects over the last decade cannot be easily reversed.
Energy
There clearly is a case to overweight energy stocks in portfolios. The companies that comprise this sector have strong balance sheets and attractive free cash flows. The energy sector is also home to some well-managed companies that pay high dividends, and have excellent investment opportunities in their industry. They should benefit from existing supply/demand imbalances in the U.S. and from rising demand from Asia.
The natural gas industry in particular should have another strong year in 2004. The National Petroleum Council recently released a study on natural gas supply and demand that projects that domestic production can only satisfy about 75% of future U.S. domestic requirements. Natural gas prices are likely to remain high and the government could encourage an increase in drilling and new pipeline and processing construction. Companies that supply natural gas to the U.S. market should continue to enjoy high profits and excellent free cash flows for the foreseeable future.
Select Technology
The technology companies have experienced one of their worst down cycles ever over the past couple of years. A weak U.S. and global economy resulted in a sharp drop in technology spending, which caused an unusually severe recession in the industry. While technology companies generally experienced a dramatic improvement in their equity values in 2003, they are still a long way from their all time highs. It now appears that the worst is over, and the spending cycle for these companies has turned positive. Select technology companies’ profits will improve markedly in 2004. However for investors to do well in the coming year in this sector they will need to focus on the companies that will experience much higher revenues and significantly better profit margins. We favor the companies that have reduced expenses and streamlined operations during the down cycle, maintained their technological edge and have strong balance sheets. The introduction of new materials, smaller components, increased memory functions and faster speeds should represent a significant opportunity for a select group of companies in this sector. The caveat, however, is that investors will have to be sensitive to valuation which for some companies are quite extended.
Insurance
Over the last two years the insurance industry has steadily improved its profit margins. Looking ahead we believe that the industry has excellent growth opportunities in both its domestic and international markets. Due to the historically low interest rate environment the industry has been forced to increase its premiums on new business and avoid writing policies that do not make good actuarial sense. While we do not expect the Federal Reserve to raise interest rates significantly in 2004, slightly higher interest rates would benefit the insurance sector’s profit margins. Looking ahead we believe that earnings in this sector could be stronger than expected if current insurance premium levels persist.
Defense Industry
Defense spending is likely to rise over the coming years; there will be a substantial need for new systems and advanced technologies. The federal government’s budget deficits are not likely to lead to any substantial cuts in the funded portion of the defense budget. Even if the conflicts in Iraq and Afghanistan diminish, demand for military hardware likely will be sustained at high levels as our armed forces prepare for new terrorist actions and security threats. The companies that we favor in this sector have broad-based strength as Pentagon suppliers. They are generally well-positioned to maintain or improve their standing as preferred defense department contractors. On land, air, and sea the weaponry they provide has technological distinction and tactical superiority on the battlefield.
Hard Assets Including Real Estate And Industrial Metals
In recent years hard assets, which include the real estate and industrial metals sectors, experienced mixed equity appreciation. Things began to improve in the first half of 2002, but the U.S. economy stumbled, delaying a strong recovery in these sectors. This year, however, revenues and profits have begun to demonstrate sustainable strength, and we are optimistic about the coming quarters. Many of the companies that we follow that fall under this category have been reporting significantly better-than-expected results in 2003. Recently released housing data indicate that the home building industry is on a very solid footing. We have also become progressively more confident about the prospects for many industry commodities. Strong industrial demand and a weakening U.S. dollar against other major currencies have in particular helped copper and nickel prices. We expect companies in the home building and industrial metals sector to increase or initiate new dividend payouts and continue their aggressive share buybacks.
Healthcare
In late November, President Bush signed into law a new Medicare reform bill, whose centerpiece was a $400 billion drug insurance plan. The legislation requires beneficiaries to pay $35 per month and the first $275 in annual costs, then Medicare covers 75% up to $2,200 of these expenses per person. After that no coverage is provided until $3,600, at which time Medicare picks up 90% of the cost. The drug industry posted weak profit numbers in 2003, and the stocks performed poorly, lagging the overall equity market by a significant margin. The passage of the industry-friendly Medicare Drug Benefit Bill should help investors change their perceptions about the industry. We are optimistic that the pharmaceutical companies will have a better year in 2004. In spite of the expanding Federal budget deficits and fiscal constraints on local governments, population, demographic and socio-economic trends favor the profit margins in the healthcare industry. The pharmaceutical equities look particularly attractive at their current equity valuations.
Securities That Have Meaningful Dividends
A security’s market value typically consists of two components: the contribution to value deriving from the profitable growth of earnings and the contribution to value deriving from the current dividend. The dividend contribution is enhanced to the extent that the contribution to equity value deriving from the retention of profits can generate an increase in future dividend payments. Significant capital can be built by purchasing securities that have meaningful dividends and above average yields. A key to success in this area is to identify and invest in companies that have strong finances and a payout ratio that allows for dividend growth. With these characteristics present, one should be able to expect both growing income as well as capital appreciation over time.
Special Situations
We are also always interested in investment opportunities in special situations. What can make for a special situation is an investment that is not highly correlated to its sector due to a combination of a substantial under-valuation and/or an event such as a corporate restructuring, an impending asset sale, or merger that will cause a significant change in its valuation. For illustration, in 2003 we began buying unpopular Sears at $22 a share after the company announced its intention to sell its credit card operations. After valuing the company we determined it was selling for approximately 5 times earnings, 3 times cash flow and had a secure dividend that was yielding over 5% at the time. In addition, during what was a questionable retail environment it was aided by the home appliance business resulting from the housing boom. Some of our last sales of the equity were in the $53 range, and clients received dividend income while the security was held.
Conclusion
In 2004 economic growth in the United States will continue to be dependent on the global economy and government fiscal and monetary stimulus. Employment growth will obviously be determined by the performance of the U.S. economy. A swing to a meaningful, sustainable pickup in the growth of well-paying U.S. jobs could alter the current economic landscape. A significant increase in economic growth would introduce additional consumer and business spending and new profit opportunities for the companies in the sectors that we favor. At this time the probability for such a major pick-up in job growth remains relatively low. Should job growth materialize, we expect the Federal Reserve to raise interest rates sooner than later. However, no matter what the circumstances, the marketplace will always offer opportunities for capital appreciation and income growth.
Portfolio management depends upon security selection and determining what securities are suitable for which clients. The economic and investment outlook is important in so far as capital flows to the highest rate of return. By defining the outlook in terms of who benefits, conclusions can be drawn as to the likely investment beneficiaries.
Today’s economy has benefited from the enormous stimulus that has been put into the system. While classic third and fourth year economic stimulus programs in advance of presidential elections keeps everyone’s focus on near-term improvements, the amount of debt that is being put on the system on all levels appears to be unsustainably large. Recently, Fed Chairman Greenspan observed that Congress keeps increasing spending out of proportion to tax revenues thereby abandoning fiscal prudence. It is under these conditions that portfolio management will face the challenge of compounding rates of return in a low interest rate environment to both meet clients’ objectives and compensate for a declining U.S. dollar that continues to lose value over time.
Indicators Suggest The Start Of 2004 Is Looking Strong
The final release of third quarter GDP growth of 8.2%, far better than most observers had expected and the fastest pace in nearly two decades, suggests that an economic rebound is taking hold. The leading economic indicators, industry surveys, recent corporate earning reports, and commodity prices all point to a pickup in global economic activity. Since the equity market has made a significant advance, the question that investors must now face is how strong and sustainable the recovery is likely to be in 2004.
The start of 2004 looks solid, mostly because of low interest rates, tax refunds, and mortgage refinancing activity. In a presidential election year it is typical to expect the Congress, the Treasury Department, and the Federal Reserve to keep the economy moving in a positive direction. Against this backdrop, the Federal Reserve is expected to hold the key short-term interest rate steady at a forty-five year low of 1% at their next meeting on December 9th.
Meaningful Employment Growth Is Critical For A Sustainable Economic Recovery
The Federal Reserve continues to send a low interest rate and an easy monetary stimulus message to investors. We expect the Central Bank to maintain enough economic stimulus to counter the deflationary forces in the global economy. The stronger than expected increase in GDP reflected an increase in investment by business on new equipment and computer software, less severe cuts in inventories and brisk spending on residential construction. In past economic recoveries, inflation concerns forced the Federal Reserve to raise rates when GDP growth recovered. The Federal Reserve feared losing control over stable prices as the economy gathered strength. Investors were also quick to demand higher long-term interest rates at the first sign of strong economic growth. At the moment while employment levels have begun to show some improvement, it has not been significant enough to more than stabilize the labor market. Federal Reserve Chairman Alan Greenspan is more patient about reacting to improving economic growth because, while recent good news on the employment front suggests the job market has turned the corner, payrolls are growing at a rate below that which is needed to match growth in the labor force. In our opinion the Federal Reserve will only consider raising interest rates against a backdrop of strong employment growth. It is unlikely that those conditions would materialize before the latter part of 2004.
The Consumer Confidence Index rose again to 91.7 in November, up from a revised 81.7 in October. The index, the highest since September 2002, was well ahead of the 85.0 projected by analysts. Consumer confidence is now at about its highest level since the recession officially began. Unfortunately global terrorism fears have not gone away and are once again in the headlines after terror attacks in Turkey. We believe that as long as these kinds of attacks are scattered and on foreign soil they probably will have little affect on consumer activity. However, improvements in job creation are a crucial ingredient for a sustained high level of consumer confidence. The vigorous economic growth continues to be accompanied by strong increases in productivity, as corporations under global competitive pressures find ways to reduce costs and expand output without hiring new workers.
Job growth could remain disappointing and consequently monetary policy is likely to remain quite loose throughout 2004 in advance of the presidential election. The corporate profit story, while much improved, is not quite what it appears to be. We note that corporate after-tax profits estimates for the third quarter annual rate of $515.4 billion on a GDP of approximately $11 trillion is virtually unchanged from the $514 billion in 1999 when the GDP was $9.3 trillion. So while the economy looks stronger, profit growth has not kept pace and therefore job creation is likely to remain a challenge unless moves to protectionism accelerate.
Unbalanced Growth Is Contributing To Hard Asset Inflation
The global economy is benefiting mostly from the growth of the Asian economies specifically the growth of China. On balance China’s strength is a plus for world economic activity, although China is being made the scapegoat for U.S. job losses. It should not be forgotten that the stimulus created by the federal budget deficit and the Federal Reserve’s loose monetary policy has resulted in a significant increase in consumer and federal debt. Moreover, the continuing U.S. trade deficit, which puts more and more dollars overseas, has lead to some questioning of the ability to finance the U.S. trade deficit as time passes. Without doubt, it is in everyone’s interest for the dollar to gradually decline rather than suddenly experience a sharp downward readjustment to bring our trade deficit into better balance. However it is easy to make the argument that foreigners will continue to finance our deficit by purchasing treasury paper. But the continuing issuance of paper currency to finance both the federal and trade deficits should continue to put upward pressure on the prices of hard assets such as real estate, precious metals and collectibles.
Failure Of The Euro Stabilization Pact Points To An Increased Probability Of Euro Currency Devaluation Vs. Hard Assets
The particular aspect of the stability and growth pact that has been at issue is the requirement that fiscal deficits not exceed 3% of a nation’s GDP. The suspension of the sanctions mechanism of the stability and growth pact among the European Union member states, which is designed to protect France and Germany from having to take contractionary steps to reduce their federal budget deficits, signals a partial collapse of the stability and growth pact underpinning the euro, Europe’s single currency. There are implications for the ten member states that will come into the euro zone over the next year as well as for the present members who are not nearly as powerful as France and Germany. One of the effects will likely be a devaluation of the Euro versus hard assets over time. As we have pointed out before, currency manipulation designed to prevent a country’s currency from appreciating and thereby injuring that country’s export ability has been a continuing feature of the economic scene, a good example of which is Japan. Now with the euro change, France and Germany will be able to finance its deficits by borrowing money. However if these borrowings drive up interest rates, they will have to monetize some portion of their deficits by just printing additional currency to maintain their present interest rate level. It is important for European interest rates not to rise because they still have very high unemployment and very slow growth.
Mutual Fund Scandals Have Not Impacted Funds Flows
Approximately 90 million people are invested in U.S. stock mutual funds, about one-half of all American households. With the rise of 401(K) retirement plans, they are the principal vehicle for retirement and college savings. While it is unclear how much mutual fund investors actually lost in the recent scandals, investor confidence clearly has been shaken in what was thought to be a trusted investment vehicle. We have often been critical of the mutual fund industry for charging excessive fees and commissions and for failing to disclose vital investor information. Government regulators without a doubt failed to detect extensive abuses by mutual funds and their managers. To curb abuses government regulators must consider requiring mutual funds to provide explicit disclosure to investors on fees, commission and management practices. We have been asked repeatedly if the mutual fund scandals are likely to cause investors to lose interest in investing in mutual funds. The best answer is that during the month of October more than $25 billion flowed into mutual funds despite the negative publicity.
The Outlook Continues To Support Our Investment Positions
On balance we believe economic reports for the remainder of the year will show continued solid U.S. economic improvement. All of this could signal a stronger equity and corporate bond market for the time being. However, the government treasury market may see some weakness in the longer-term maturities due to the projected record budget deficits. Furthermore, our investment themes will continue to take into consideration the continued weakness of the U.S. dollar. Investments in quality companies that have strong balance sheets, top line revenue growth, and improving profit margins that can also increase their dividend payouts should do quite well in the coming new year. The recent reduction in taxes on dividend income encourages these types of companies to increase dividends. We believe the contribution of dividend return to total return will continue to be very important to investors.
We live in a world where the United States consumer is buying more and more goods and services from sources overseas. This has led to a record current account deficit whereby imports far exceed our exports as shown below. This picture strongly suggests why this recovery has not been and will not be the classical one of the past, and we must not ignore or dismiss its economic or investment implications.
U.S. capital sent overseas is essentially financing the industrialization of low wage-based nations enabling these countries to become effective low-cost competitors causing significant manufacturing and service job losses in the United States. Not only are foreign companies able to profit from overseas industrialization in countries like China, but also American corporations are able to profit from building low-cost facilities overseas. This is occurring even while there is excess capacity in the United States. Globalization has become a secular trend that must be a fundamental consideration in the management of dollar assets.
The Fed’s Game Plan Vs. Current Market Forces
The Federal Reserve is playing down signs of a strengthening economy and emphasizing the need to keep interest rates low. Since cutting the target for federal funds rate to a 45-year low of 1% from 1.25% on June 25th, the Federal Reserve has signaled a willingness to hold rates low much longer than is typical in an economic recovery. Despite these reassurances, long-term interest rates have moved higher. Bond investors are demanding higher yields in anticipation of the increased inflation risk associated with accelerating economic growth. Bond market participants have been conditioned to sell on an improving economic picture, however we are not convinced that this rule, as yet, should be applied in the current low inflation environment. A return to economic growth will not result in an automatic return to higher consumer prices, serious inflation risks, and the onset of a Federal Reserve tightening cycle. Nevertheless, low interest rates will be needed to assure continued economic recovery. In essence, the Fed is encouraging asset inflation to give the cash-constrained U.S. consumer and business the ability to spend. Cycles often can last longer and go farther than expected.
Despite Stronger GDP Growth The U.S. Federal Budget Deficit Continues To Expand
The deficit will continue to increase when the economy rebounds because government spending almost certainly will climb faster than tax revenues. The Congressional and the Executive branches face difficult choices over taxes and spending. Even if tax revenues increase in line with overall economic growth, it is now believed that the deficits will continue to grow without tax increases and the revenues generated from the stock market boom.
The most recent Congressional Budget Office (CBO) reports on the outlook for the federal government deficit indicated continuing $500 billion deficits that would persist for an extended period of time. Moreover, as we all know President Bush has requested to congress an additional $87 billion for Iraq, Afghanistan and additional security. These supplemental budgets are no different from corporate pro forma accounting adjustments where, in this case, the government is able to think it can mask the true dimension of the deficit. It should also be noted that the CBO assumed that the economy would be strong when it came up with the $500 billion deficit estimate.
The U.S. Unemployment Rate Can Remain High
All the upbeat news about sales, profits and employment provide hints of an improving U.S. economy. Unfortunately businesses, which have reduced the rate of layoffs, are expected to continue to wait for stronger signs of economic growth before adding to their payrolls. People who lost jobs are finding it difficult to find new ones, and many who have tried are giving up and claiming self-employment to save face. This understates the reported numbers. The shift of U.S. jobs to low wage-based countries is hampering a U.S. employment recovery, and the real unemployment rate may remain uncomfortably high. Over the past thirty months, 2.8 million jobs have been lost. Most of these losses have been in the manufacturing sector. However, we are beginning to see service sector jobs move overseas as well. Many economists are surprised that job losses have continued in spite of an extraordinary level of monetary and fiscal stimulus. In past cycles when GDP growth exceeded 3.1%, which was the estimate for the second quarter, jobs were created. For the third quarter, growth in excess of 4% is estimated. Forty-year low interest rates, tax cuts, rebates, military spending increases, and record mortgage refinancing have not prevented jobs from disappearing. Current economic strength is due to the stimulus, both fiscal and monetary, that has been injected into the system. What will occur when this stimulus wears off? Will another round of stimulus be required?
An Unusual Economic Cycle Guides Our Selective Investment Focus
As the economy gains strength we expect a somewhat unconventional economic cycle. The recent study by the New York Federal Reserve concluded that employment will be difficult to achieve. This business cycle is characterized by secular changes that have been absent in past cycles. As the economy strengthens inflation could decline further because of strong productivity.
Today effective investment strategies must be able to target positive compound rates of return in an environment that is differing markedly from past periods. Economists have been blindsided too many times by looking at the past to anticipate the future. In an analysis where capital will always flow to the highest rate of return we continue to favor domestic energy and particularly U.S. natural gas companies. Liquefied natural gas (LNG) is now being discussed in earnest as a necessary source of additional energy. We also favor uniquely positioned technology companies at the forefront of productivity and change and that benefit from their leading competitive positions. We also believe that quality, high yielding securities can appreciate in this environment because income continues to be difficult for investors to generate. We have acquired positions in precious metals mining companies for the first time in our 32-years as a firm, as they benefit from powerful macro forces including ongoing excessive monetary stimulus. With respect to precious metals, we believe that the dollar and most other currencies are likely to continue to lose value relative to hard assets. The printing presses in the U.S. and in major countries around the world are creating currency at a very rapid rate. There are weeks where the U.S. alone is creating dollars at an annual rate of $2 trillion. Other attractive investments include companies that have the ability to restructure and enhance their common stock valuations. Finally, another interesting investment opportunity emerging in the United States involves infrastructure. The most recent and public example of under-investment in this area is the electric transmission grid. Many billions of dollars of capital will have to be spent to upgrade, repair, modernize and expand the U.S. infrastructure.
Investing In Gold Has Merits
The Federal Reserve’s accommodative monetary policies, coupled with the reality of record federal budget and trade deficits and a weakening dollar are among the important factors to consider in relation to higher gold prices. The Federal Reserve has indicated that it will do whatever it takes to keep the U.S. economy moving forward, including an aggressive push on the money supply. Even though the dollar has strengthened in recent weeks, an aggressive U.S. monetary policy will likely weaken support for the dollar over time and cause foreign investors who continue to accumulate dollars to sell or hedge their dollar denominated holdings. The outcome should be continued support for higher gold prices since gold is quoted in U.S. dollars.
Before the end of this year the SEC is likely to permit the creation of an ETF (Exchange Traded Fund) on the New York Stock Exchange, which will be backed by gold. This will enable institutions to have a direct participation in the gold market without purchasing bullion. The fundamental gold supply and demand factors also indicate considerable support for the price of gold. Over the longer term one can argue that the physical demand for gold should outstrip gold mining production by a wide margin. The deregulation of the gold market in China as a precursor to their joining the world of major industrial nations should also provide strong support for gold over the longer term. Under these circumstances ownership in quality gold mining companies can contribute meaningfully to the total return of an equity portfolio. It is especially interesting to note how unpopular a notion it is to invest in gold related investments perhaps suggesting a strong contra indicator. It appears that to be upbeat on gold one is still viewed as a killjoy and a pessimist regardless of the facts that backup such a position.
The Technology Industry Is Beginning To Reflect An Upturn
For the past four years the technology sector has been waiting for business to improve in the second half of each year. While the consumer and business technology-spending environment has indeed been a difficult one, we are now seeing some early signs of improvement in this area. Technology spending should be helped by the growing obsolescence of productive capacity, low interest rates and the recently enacted U.S. tax cuts that have put more money in consumer pockets. Consumers have both the desire and the wherewithal to buy new computers, flat screen TVs, digital cameras and a host of other new electronic devices. Continued economic growth should also lead to higher business spending on long-delayed technology projects. While most technology companies continue to exhibit weak revenues and earnings, their equity prices have advanced because of the emergence of these positive factors.
Conclusion
In our last Outlook we noted that we are in a strong market environment, but underlying fundamental difficulties in the U.S. and global economies persist. Favorable expectations for the economy and corporate profits must become a reality in the second half of 2003 for the equity market to maintain and continue its advance. While we do not participate in market timing and prefer to avoid active trading, we are mindful of capital flows and sector rotations. We have a fundamental belief in value and growth at reasonable prices and are willing to purchase equities in sectors that are temporarily out of favor. Equities in market sectors must often be purchased when the market has less interest in a sector. The reverse of this principle is also true, and positions in sectors often must be trimmed when the market aggressively bids up equity prices. Overall, in this environment our equity and fixed income positions as noted should continue to provide an excellent total return.
The many points we made in our prior outlooks – dollar devaluation, persistently high energy prices particularly for natural gas, the expectation of further interest rate declines and the increasing emphasis on yield by investors – was far from consensus thinking. While these views have proven to be correct, the question now is, what is the outlook over the next six to twelve months.
With War Over, Investors’ Attention Turn To Economic Fundamentals
With the war in Iraq “declared” over, it is time to once again note some of the key elements that support the U.S. economy and our financial markets.
Consumer demand and business spending At the present time, growth in consumer and business spending is likely to remain slow, but a positive trend has been all that is needed to result in better financial markets. However, it is important to note that the U.S. economy is being supported by the strength in housing and the ability of consumers to refinance their mortgages without which growth would be virtually nonexistent.
Interest rates We expect current inflation rates to decline further and the Federal Reserve to maintain short-term interest rates at historically low levels for the foreseeable future. Furthermore, recent statements by Fed Chairman Greenspan indicate a likely further reduction in short-term interest rates.
Availability of credit, the difficult employment outlook, and prospects for a lower U.S. dollar are also important variables to consider in assessing the health of the U.S. economy and the financial markets.
The Current Structure Of The Equity Market
While stock prices are already reflecting a mild economic recovery in the second half of 2003, the structure of the markets suggests that further appreciation is likely to occur. The factors leading to this conclusion are as follows:
More than $6 trillion of liquid assets barely earns any interest.
Dividend-paying common stocks are attracting significant capital flows as a result of the need for yield.
The new tax reduction act will provide some economic stimulus as well as lower the cost of capital as both the capital gains tax and the tax on dividends have been reduced.
The depreciation of the dollar will result in better business for exporters and can bring about higher reported earnings for U.S. multinational corporations.
Hedge funds still carry near-record short positions on both the New York Stock Exchange and the Over-The-Counter market, and as they cover their short positions by buying in shares and also initiate new long positions, they can be a powerful force in pushing equity prices higher.
If markets continue to rise, cash on the sidelines will be forced into being invested. The market is professionally dominated at the present time and investors are not willing to miss a rising market. In fact the latest mutual fund flows indicate that $16 billion flowed into equity funds reversing many prior months of outflows.
The history of the stock market provides numerous examples of powerful, tradable rallies that are independent of whether a new long-term bull market has been established. These rallies reflect oversold conditions that can combine with temporary let-ups of negative pressures that attract both bargain hunters and momentum players. Such tradable bear market rallies can occur several times during the grip of an overall bear market.
The Housing Market Is Supporting The US Economy
While the growth in consumer spending is unlikely to reach the levels the U.S. economy had grown accustomed to in recent years, it is also unlikely to collapse. Home equity loans continue to fuel consumer purchasing power. Increases in property values and low interest rate home equity loans have left many middle-income consumers in good spirits. Access to additional credit is readily available and is being fueled by the Federal Reserve. However, it is vitally important that interest rates do not rise since consumers are being encouraged to take on considerably more debt. We believe this condition is fundamental to the Federal Reserve’s concern, however remote, of the prospects of deflation.
The Outlook For A Sustainable Corporate Profits Recovery Is Muted
Over the remainder of the year, we do not believe that GDP and corporate earnings are likely to grow rapidly enough to justify many common stock valuations. Moreover, the most recent testimony of Chairman Greenspan, for the first time we can recall, focused attention on the high cost of natural gas and its likelihood of remaining expensive. Many companies will be burdened by high-energy costs that will mute their profit growth. (Interestingly, natural gas related share prices immediately strengthened after his statement and in some cases went on to make new highs.)
A cyclical recovery in the second half of 2003 has already been factored into equity valuations. We think that the case for a new broad-based bull market is difficult to make. Nonetheless, companies with operating and/or financial leverage can do reasonably well in this environment. Many of the equities that we follow will not need a strong consumer or business-spending environment to deliver an excellent total rate of return.
Why Tangible Assets Continue To Be Major Beneficiaries
The long cycle of disinflation and slowing growth has now taken us to the point where the continuation of such a trend could possibly tip us toward deflation. Under present conditions, central banks are turning up the dial with respect to pumping liquidity into the system to stave off such an outcome. A natural consequence of this concerted effort to reflate is a competition involving currency devaluations and a readjustment in the value of these fiat currencies against hard assets. This cycle is reinforced by the decline in the dollar that places additional pressure on European growth while the renminbi’s peg to the dollar makes China even more competitive as they export their goods at ever-lower prices. Recently the increase in uncertainty associated with financial assets has lead to an increase in interest in tangible assets such as real estate, natural resources and gold. On an historic basis the purchasing power of gold has notably deteriorated and this trend is likely to reverse due to the current dynamics of the world economy.
Interest Rates Are Low And Will Likely Head Lower
The Federal Reserve is not in any hurry to raise interest rates. On the contrary Mr. Greenspan, in his latest testimony, raised the possibility, however remote, of a deflation scenario. Under these circumstances, short and long-term interest rates would likely remain at historically low levels for an extended period of time.
To give you a sense of how easy it would be for the Federal Reserve to lower long-term interest rates, we list below the national debt in the public hands beginning with the year 2016. Notice how few long-term bonds are outstanding.
Year
Billions
2016
$39.0
2017
$21.7
2018
$11.6
2019
$26.9
2020
$28.5
2021
$51.0
2022
$14.4
2023
$34.0
2024
$8.0
2025
$17.0
2026
$28.0
2027
$34.0
2028
$35.0
2029
$38.0
2030
$15.0
2031
$15.0
2032
$4.9
As can be seen in the following graphic, the total national debt in the public hands from the year 2021 to 2032 is an astonishingly small $294 billion out of the total national debt of $6.5 trillion. With so few bonds comprising the long end of the market it would not take many dollars to influence rates. As of the end of 2002, the average maturity of the national debt was only sixty-six months. Since there is so little long-term Treasury debt outstanding that one can purchase to lock in a reasonable return, with total liquid assets in excess of $6 trillion earning almost no interest, demand for yield has had a significant impact on raising Treasury prices.
Federal Tax Relief Is A Short Term Positive For The Financial Markets
Most U.S. taxpayers and businesses will get some tax relief from the new $350 billion tax relief package. However, investors appear to have the biggest benefit since the tax bill reduces the tax rate to 15% on stock dividends and long-term capital gains. Another feature of the tax relief legislation accelerates the write-off for new business investment allowing companies to depreciate 50% of the cost of new capital purchases in the purchase year. Given the depressed level of capital spending due to lingering overcapacity this will likely represent a mild positive at best. Additional positives come from both a downward adjustment in tax brackets for couples filing joint returns (eliminating some of the marriage penalty) and an increase in the child tax credit to $1,000 from $600. While the financial markets reacted to the legislation in a positive way, it is questionable as to how much it will actually help the economy. The tax bill has been controversial from the start and the economic stimulus it provides will be partially offset by state and local governments as they raise taxes and cut spending to close their rising deficits.
The Challenge Of Predicting The Future
Who ever would have ever imagined two years ago, that U.S. interest rates would decline to 1% while at the same time the vast majority of US workers would remain employed? Clearly, something is occurring during this cycle that has not occurred in prior cycles. The primary difference that is driving this divergence is that we have been exporting high wage base jobs to low wage base nations at an accelerating pace. The global trading system is now more open than in any time in history while capital is more fluid as deregulation and price controls have given way to free market mechanisms. This must be considered with great care when comparing to past cycles and extrapolating those cycles in to future outcomes. Finally, given the growing importance of the global trade of goods and services, economic activity and the flow of capital will be highly influenced by exchange rates.
Conclusion
While noting the significant technical positives in the market, the underlying fundamental difficulties in the U.S. and global economy are still with us. World growth depends too heavily on the American consumer, Western Europe’s labor structure needs reform and the dollar’s depreciation is further weakening Europe’s economies making them less able to purchase U.S. goods. As a consequence the U.S. trade deficit will remain unsustainably large. For significant improvement to occur in the world economy, the Euro Zone and Japan will have to do more to stimulate their domestic consumption and not depend on just the American consumer.
As of this writing we expect the European Central Bank to lower interest rates and the dollar to continue to depreciate over time. It is important to recognize that overseas’ economies which are running trade surpluses with the United States can purchase U.S. Treasury bonds to prevent their currencies from appreciating too rapidly and damaging their export industries. This process tends to lower U.S. interest rates. At the present time, the two-year Treasury is yielding 1.22% or less than the federal fund’s rate of 1.25% suggesting another decline in the federal fund’s rate is in the offing. We believe we are currently in a powerful bear market rally where the opportunity to capture substantial capital gains can occur. Many investments that we continue to favor are beneficiaries of the current rally but are also in secular up trends – an important distinction as it is impossible to know with certainty when the rally will exhaust itself.
Wall Street’s economists are being asked, “Will the economy recover when the Iraqi war is behind us?” The answer we hear is “I don’t know.” The reason given is that negative economic forces have been at work long before geopolitical issues over Iraq began burdening the economic outlook. We have often indicated that despite a possible powerful, tradable market rally after Saddam Hussein’s regime falls, fundamental U.S. economic issues will still have to be resolved, and it is these issues that are likely to prevent a strong market from being anything but temporary. Traditional investors are not driving current market activity. The stock market’s gyrations have been the result of some 6,000 hedge funds attempting to take advantage of war-related short-term opportunities while investment funds for the most part have been sitting on the sidelines. The most recently published short-interest positions on the New York Stock Exchange showed an increase of over 4% amid speculation on higher oil, gold, and treasury prices as a result of the war. As the war comes to conclusion hedge funds are unwinding positions by buying back shares they sold short and selling bonds, gold, and oil to participate in what they believe will be a stronger overall market. We should also expect a temporarily stronger market environment as cash sitting on the sidelines gets invested and the war-risk is diminished. It is worthwhile noting that the week the war began, the Dow Jones average surged 1,000 points as hedge funds reversed their positions as described above.
Energy Prices Remain Strong
We continue to hold a minority view with respect to the outlook for energy pricing, particularly oil. Most analysts believe that the price of oil will decline to the low 20’s and possibly into the high teens as occurred after the first Gulf War. However, today’s conditions are different from the first Gulf War experience in the early 90s. Since our last Outlook oil supplies in storage in the United States have declined even further and are at twenty-seven year lows; and Nigeria, a two-million barrel a day exporter of high quality oil, has been experiencing civil unrest. Major oil producers, Shell and Chevron/Texaco, had declared force majeure on 40% of their Nigerian production, further tightening the oil market. In the Middle East we do not know how long Iraqi oil will be off the market, but formidable production difficulties keep cropping up. The challenge for United States producers will be to rebuild gasoline supplies for the summer driving season and at the same time rebuild inventories for next winter’s heating season. As for natural gas, it is in tight supply and is likely to remain so for a considerable period of time.
Pressures Brought On By Growing Budget Deficits
The Administration’s supplemental budget request of $75 billion for the war effort will add to the fiscal deficit bringing the total close to $400 billion or approximately 4% of GDP. Moreover, it is likely that another budget request will be submitted raising the deficit even further. In spite of a significant increase in the total budget deficit over last year, some important programs are still being under-funded putting in question the size of future deficits. As an example, the government’s costs associated with providing health, education and other human services are growing more rapidly than tax revenues and the potential long-term growth of the U.S. economy. The effect of federal government under-funding in combination with higher Medicare costs has resulted in a 12.4% premium increase for medical benefits in the private sector. These higher costs will be passed on to consumers and businesses putting a further burden on them. This is in addition to the economic and tax squeeze on consumers and businesses brought on by the need to eliminate state and local budget deficits.
Interest Rates Could Head Lower
We would expect the economy to do better eventually to the degree that it has been held back by the war. However, once it becomes clear that the U.S. economy is still operating considerably below its ideal rate of growth, the probabilities for further Fed easing are high. Moreover, as we wrote in our December Outlook, the Central Bank is prepared to use unconventional methods to reduce long-term interest rates. The prospect of a no-growth economy is not a comfortable scenario for the Federal Reserve. Since the amount of outstanding Treasury debt in the public hands which matures in twenty years or longer totals only about $235 billion, it would not be difficult to bring down interest rates should the Federal Reserve decide to intervene in the long-term Treasury market. In a speech supporting this possible course of action, Fed Governor Bernanke referred to Fed’s capping long-term treasury yields at 2.5% in the 1940s. In the private sector, companies are fast retiring high cost debt, which denies portfolios the opportunity of receiving the higher interest income. This is making high dividend-paying securities increasingly difficult to find. Consequently, there is a strong demand in the face of shrinking supply for high-yielding securities that is lifting their prices thereby increasing the total returns to their present owners. Growing Pension Fund Liabilities Pressure Earnings It is important to emphasize that, as we mentioned in prior issues of The Outlook, the pension fund liabilities of corporations are likely to be a significant depressant on corporate earnings for the following reasons:
The SEC is concerned about many companies’ pension rate-of-return assumptions. Rate-of-return assumptions range from 8-10% in many cases. If, or more likely when these assumptions are lowered, companies will have to contribute significantly more to their plans from their earnings.
Companies are using discount rates in establishing their liabilities that bear no relationship to the rates of return currently prevailing in the financial markets. When more realistic discount rates are acknowledged, pension fund liabilities will increase.
The government’s Pension Benefit Guarantee Corporation, charged with insuring companies’ pension liabilities, is currently under-funded by $3.5 billion. However, last year, it had a surplus of more than $7.5 billion. The airline industries’ pension plans are currently under-funded by $18 billion and overall U.S. defined benefit plans according to the PBGC’s calculations are now actually under-funded by some $300 billion. We expect that companies will have to pay higher fees to the PBGC. In addition, if the Financial Accounting Standards Board changes the rules for pension fund accounting by requiring companies to reflect their pension funds’ true liabilities on their financial statements, then earnings’ predictability will be greatly diminished.
Weakness In Many Sectors Of The U.S. Economy
The unemployment situation deteriorated in February and March, and we believe that the labor market is still slowing. Moreover, it appears that the loss of jobs is part of a secular trend where manufacturing and service sector jobs are moving overseas. Accordingly, weather, Iraq, and seasonal adjustments may be only part of the real underlying reasons for the economy’s weakness. We cannot help noticing a pattern of weakness across many sectors of the U.S. economy. With consumer demand slowing, high-energy costs, and pricing power confined to only a select few industries, jobs are being cut to shore up margins. Finally, sudden acute respiratory syndrome is something to be watched closely since the recent outbreak of the SARS virus has geoeconomic ramifications. A great deal of manufacturing outsourcing is based in Asia, which also has been the fastest growing economic region. At the present time, growth rates are being lowered as travel has begun to be seriously impacted by the spread of SARS and manufacturing efficiencies are being reduced.
Our Portfolio Focus
Mutual funds that have broadly diversified portfolios will likely find the current outlook particularly difficult. Hedge funds account for a significant percentage of the overall market’s trading activity and exacerbate volatility. In this environment our portfolio focus continues to be on high-yielding securities with growth prospects and clear under-valuation. Notwithstanding attractive exceptions to this, the ability to compound rates of return will be more dependent on the income flows that a portfolio generates than it has over the past several years. In spite of a difficult economic environment, this continues to be a stock pickers’ market where capital-building opportunities can be found. For example, we recently purchased an equity position in a multi-billion dollar retailer after they announced their intent to restructure by selling a major part of their business to unlock value. The shares have begun to appreciate sharply while still yielding nearly 3.5%, and we estimate a reevaluation well in excess of the current price. These are the kinds of investments that should be included in portfolios where suitable.
In confronting today’s investment outlook, geopolitical issues play some part in establishing the direction of the markets in the short term, but by no means are these issues the determining factors. We cannot point to any convincing reasons to believe that a new bull market cycle can begin from these levels when the S&P 500 yields 1.9% and sells at twenty-seven times 2002 operating earnings. On the contrary, the economy’s anemic growth (last quarter’s real GDP growth was estimated to have slowed to a .7% annual rate) is insufficient to withstand the strong headwinds that will likely hit as state and local budget deficits swell. Municipalities must use a combination of borrowing and raising taxes and cutting services and employment to close their budget deficits. Economic weakness in Europe and Japan and high and rising energy costs are making matters even worse by undermining consumer confidence and corporate profits. The longer global economic and geopolitical risks linger, the longer the financial markets are likely to be under pressure. Geopolitical forces including the loss of Venezuela’s oil production, however limited in duration, have pushed up oil prices. We understand that significant reservoir and well damage has occurred in Venezuela. Venezuela’s oil fields probably will require nearly $6 billion of investment to restore production to former levels. Oil prices have risen 75% over the past year and natural gas prices have risen over 70% since this past December. We do not need to be reminded of the impact of energy shocks on the US economy, but this time the shocks will hit the system at a particularly weak point of the economic cycle when only consumer spending is keeping the economy growing. The question is how long will consumers continue to spend and take on more debt before they will have to cut back.
Anemic Business Spending and Investment
The outlook for business spending and investment remains weak. Businesses want to see a clear path to higher revenues and improved earnings before committing to increasing capital outlays. Companies also need to pay down debt and improve free cash flow in order to satisfy the rating agencies. They risk credit downgrades and increases in their cost of capital if they fail to improve their capital structures and deliver satisfactory results in this regard. The outlook for business spending contrasts somewhat with the outlook for consumer spending. Cash flow generated by home-mortgage refinancing has effectively been able to keep consumer spending in positive territory. Consumers have used some of the interest-rate mortgage relief provided by refinancing to restructure their debts. This could indicate a long overdue start to the recovery in household saving rates. The above actions should provide a better foundation for consumer spending over time.
Pressures on Pension Plans
In recent years corporate America became accustomed to adding pension plan surpluses to their earnings or making only minor cash contributions to their pension plans. Investment managers have been reaching the actuarially assumed rates of return for their pension plans with oversized profits from equity investments. This has now come to an end. The problem now weighing heavily on many companies, both domestic and European, and carrying over to the broad equity market is that companies must take significant cash charges against 2003 earnings in order to fund their benefit plans’ bare minimum asset requirements. In addition, the rating agencies are reviewing corporate balance sheets for possible credit downgrades if their pension and benefit shortfalls meaningfully impact their debt/equity ratios. Public companies that had assumed rates of return on their pension and benefit plans of 9 – 11% have begun lowering their expectations and have had to inject cash and/or stock into their plans to meet their objectives. Some companies have lowered their expected rates of return to 9%, but we believe that these return assumptions are largely unachievable for large funds given the present low-level of interest rates and stock market over-valuation. If this year proves to be difficult then we should expect a further lowering of expected rates of return next year and more corporate injections of cash and equity which will come out of profits. These contributions will depress 2003 reported earnings and also are likely to result in further reductions of stock price multiples, particularly if further contributions will impact next year’s earnings as well.
Possible Mutual Fund Redemptions
After constantly adding money to mutual funds throughout the ‘90s investors redeemed a small portion of their equity mutual funds last year after experiencing almost three years of losses. Last July $51 billion exited equity funds. If this year’s equity returns continue to be negative, we would not be surprised to see a surge in mutual fund redemptions resulting in a significant market decline. Should this occur, we will have a major buying opportunity. For many years, the notion of relative performance and relative returns held sway. Institutions that beat their benchmark indices were considered by their sponsors and consultants to be adding value. At the present time, fiduciaries can no longer be satisfied with good relative returns that nevertheless produce losses. Foundations, endowments, retirement funds, pension and profit sharing funds as well as individuals must confront their spending plans in the context of losses and forty-year record low interest rates. Strains are being experienced by many organizations and even individuals’ plans for retirement have been postponed. As a result, many are remaining in their jobs longer making it more difficult for new entrants into the labor market to find employment.
Federal, State and Local Government Deficits
Another issue that must be addressed for 2003 which requires careful consideration with regard to its potential to destabilize the financial markets is the fiscal condition of government at all levels. The federal, state and local governments are now running substantial deficits because of the following: a weak economy has caused tax revenues to decline, state and local government pension assets have underperformed and employee health benefit costs keep rising. President Bush sent Congress a $2.23 trillion fiscal 2004 budget that seeks a major spending increase for the military and slashes billions of dollars in taxes. It does not count the costs of a possible war with Iraq. The federal budget projects a deficit of $307 billion in 2004, up from the expected $304 billion in the fiscal year now under way. The White House estimates the deficit will be 2.8% of GDP in the current year, which ends in September 2003, and 2.7% in 2004. The U.S. combined federal, state and local budget deficits are in excess of $400 billion and our current account trade deficit is approaching $600 billion this year. For state and local governments to bring their costs in line with revenues they will have to reduce the number of employees that currently total approximately 18 million people. The U.S. economy has never run combined deficits of $1 trillion or 10% of GDP in one year. More so than in the past, the administration’s attempt to stimulate the economy will increase the trade deficit since increasing consumer spending will go to purchase foreign-made products particularly from China. We should expect the presence of such a high and growing trade deficit to result in a further depreciation of the dollar. We believe the U.S. and global economy must adjust to these large and unsustainable imbalances. The only question is how and when.
A Positive Outlook for Energy
Investment opportunities always exist no matter the outlook. The important question to ask is where will capital flow and how can one achieve positive returns in order to compound capital. Current inventories of U.S. crude oil supplies are at twenty-seven year lows and must be rebuilt to prevent possible supply dislocations, and as we said earlier the loss of Venezuelan oil production exacerbates supply shortfalls. In addition, increased natural gas demand and declines in drilling activity over the past two years have resulted in U.S. natural gas inventories now below the five-year average. Increased natural gas demand has been augmented by the cold weather. Our views are that higher energy prices are most probably going to exist for a longer period than many expect. At the same time equity valuations are discounting significantly lower oil and gas prices. Accordingly, we believe that investment in North American oil and gas producers at current depressed prices represent investment opportunity. Some of these companies are selling for as little as three times cash flow from operations and yielding over 4%.
A Positive Outlook for Precious Metals
A sector that has been neglected for more than twenty years until recently has been gold. The price of gold has appreciated against all major currencies since the start of the year as a result of the interaction between forces that relate to gold both as a commodity and investment vehicle. Renewed tension between the U.S. and the Middle East, weakness in the equity markets and the decline of the U.S. dollar have brought renewed interest in gold assets. In addition, investment buying of gold is being driven by prolonged increases in the United States Federal and current account deficits and the continuation of a generally turbulent global economic and political climate. Uncertainty in the global banking sector and strong consumer demand in Asia have also been noteworthy factors affecting the price of gold. Finally troubled situations in Venezuela and other important economies in South America support the buying of gold as a safe haven. Asian central banks have large and growing currency reserves. They hold almost $1 trillion in official reserves, and Japan has nearly $500 billion in central bank reserves. The United States is running large trade deficits with these countries so their central banks are continuing to accumulate additional dollars. Their gold holdings are a minor percentage of their total reserve assets as seen below and are likely to increase over time. Moreover, Malaysia has been discussing the creation of a gold-backed dinar – an Islamic currency for trade purposes. China opened its first gold exchange in Shanghai last October. As the European Central Bank, the Japanese Central Bank and the Federal Reserve attempt to re-inflate their respective economies, we expect the interest in hard assets – precious metals and many commodities – to continue to increase.
World Official Gold Holdings According to the World Gold Council
Gold’s percentage share of foreign central bank reserves: China 2.0% Hong Kong less than 0.1% Japan 1.7% Korea 0.1% Kuwait 7.4% Malaysia 1.1% Russia 8.0% Saudi Arabia 7.3% Taiwan 3.3%
False Parallels Between the 1990 – 91 Gulf War and the Present
The great majority of strategists and market commentators appear focused on the parallels between the 1990 – 91 Gulf War and the present. They believe that once the Iraq situation is behind us a stronger market environment reflecting gradually improving economic fundamentals will result in a rebound of the equity market. Bearing in mind that deteriorating market conditions have been going on well before Iraq was an issue, our view is that there is more to the story than just geopolitical events in the Middle East. Notwithstanding the fact that the fear of war has been hurting the global equity markets and that the absence or disappearance of these fears will result in equity-market rallies, there are significant differences between the world economy of the early 1990s and today’s global economy. While it is always unwise to attempt to forecast the stock market, it is nevertheless apparent that the economic fundamentals for the U.S. and most global equity markets are weak at best. There is a reason why United States interest rates are at a four-decade low and money funds barely pay interest. As the Bush Administration targets the market with a proposal to eliminate the taxation of dividends, which may or may not pass, the investment trends emerging involve a greater emphasis on absolute returns rather than relative returns. Dividend-yielding common stocks and high-yielding equity securities will be increasingly important as the reliance on capital gains alone may prove insufficient in compounding returns under present conditions.
Conclusion The underlying fundamentals point to a slow economic recovery at best. They favor a modest pick-up in business and consumer spending in the second half of 2003. The greatest immediate risk to this view is the potential danger associated with the pending showdown with Iraq. We think 2003 will be a difficult year for the U.S. economy and expect investors to favor stocks that pay substantial dividends, have strong balance sheets, predictable cash flows and have conservative business plans. Should a market decline occur driven by investor capitulation that has not been present throughout this down-cycle, great values will appear. In the meantime it is important to be in a position to produce positive returns in a difficult environment by concentrating on investing in the following: asset-rich securities, high-yielding securities, and companies that can grow their revenues in a deflation-prone global economy. Maintaining good cash reserves should prove advantageous under present circumstances.
The most significant changes from our last Outlook, aside from an eight week recovery of the market after six straight monthly declines, have been the Federal Reserve Board’s reduction of interest rates by 50 basis points which we indicated would likely occur if the economic data came in weaker than expected, and the Bush administration’s strong interest in an economic stimulus package that includes the elimination of the double taxation of corporate dividends. It is a move that the White House hopes will boost both the U.S. economy and the stock market. Economists have long argued that dividends are taxed twice. Companies pay dividends from the earnings left after paying corporate taxes, and then shareholders pay income taxes on the dividends they receive. However, corporate interest payments are deducted from income before taxes. This unequal treatment has encouraged companies to take on debt, which has tended to weaken their balance sheets. Individual holders of common stocks, especially those in higher tax brackets, have generally preferred capital gains to cash dividends. Investors can keep a larger portion of their profits from realized capital gains after taxes than they are allowed to keep from interest and dividend income. Because of the unequal tax treatment of interest and dividends, growth stocks have tended to be popular and generally overpriced relative to high-yielding dividend paying stocks. Over the years, corporations have focused less on dividend payouts and more on boosting earnings per share. The pressure to show regular double-digit earnings growth to drive stock prices higher contributed to the recent corporate accounting scandals. For quite some time business groups and common stock shareholders have been pushing for a change in federal tax policy towards dividends. To end the double taxation of dividends, the administration could eliminate either the corporate or the individual tax. We believe that the President prefers eliminating the tax at the individual level. The individual tax option is cheaper since about one-half of dividend recipients are taxed-exempt entities, such as foundations, pension funds, and IRA accounts. A new tax break would not be beneficial to taxed-exempt entities and for that reason it would not lead to as great a reduction in federal tax-revenues. Reducing the individual federal tax on dividends would make dividend-paying stocks more attractive to taxable individual investors. Corporate dividend-tax reductions to companies would increase business investment and improve balance sheets by encouraging companies to issue equity rather than debt. According to a White House study, either change should foster enough economic activity for the federal government to recoup about one-half of the tax-revenue loss.
Monetary Policy
The Federal Reserve Board’s recent decision to lower interest rates 50 basis points brings the federal funds rate down to 1.25 percent, a forty-one year low. In spite of the stimulus the Fed has provided through twelve rate reductions, the economy is not growing fast enough to prevent unemployment from rising. As can be seen in Appendix A, the Federal Reserve has been aggressively expanding the money supply to stave off the strong deflationary headwinds facing the U.S. economy. For those concerned that the central bank has little ammunition left to lower rates further should the need arise, a November 21st speech by Federal Reserve Board Governor Ben Bernanke to the National Economic Club in Washington D.C. is noteworthy and remarkable. We quote some of his speech as follows: “With inflation rates now quite low in the United States, however, some have expressed concern that we may soon face a new problem–the danger of deflation, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation–a decline in consumer prices of about 1 percent per year–has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors. While it is difficult to sort out cause from effect, the consensus view is that deflation has been an important negative factor in the Japanese slump.” And he goes on to say,
“So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself. Over the years, the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow. Flexible and efficient markets for labor and capital, an entrepreneurial tradition, and a general willingness to tolerate and even embrace technological and economic change all contribute to this resiliency. A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape. Also helpful is that inflation has recently been not only low but quite stable, with one result being that inflation expectations seem well anchored. For example, according to the University of Michigan survey that underlies the index of consumer sentiment, the median expected rate of inflation during the next five to ten years among those interviewed was 2.9 percent in October 2002, as compared with 2.7 percent a year earlier and 3.0 percent two years earlier–a stable record indeed. The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself. The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief. Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association). Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade. Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill. The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills. Interestingly, though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding. For example, the Fed held 7.0 percent of outstanding Treasury securities in 1945 and 9.2 percent in 1951 (the year of the Accord), almost entirely in the form of 90-day bills. For comparison, in 2001 the Fed held 9.7 percent of the stock of outstanding Treasury debt.”
Governor Bernanke continues,
“To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities. The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.”
U.S. Economy
The flexibility and resilience of the U.S. economy is encouraging for the future. The Conference Board said its consumer confidence index rose to 84.1 in November from 79.6 in October. Sales of new homes continue to run at strong levels with a seasonally adjusted annual sales rate hovering around 1.7 million units. The Commerce Department reported that third-quarter inflation-adjusted gross domestic product rose at a surprisingly robust annual rate of 4.0 percent. The government also reported that the GDP, the value of the nation’s output, grew faster than initially estimated in the July-September period. These are significant pieces of evidence that the U.S. economy has stabilized and may even be on an expansion track. However the U.S. unemployment rate jumped to an eight-year high in November. The manufacturing sector lost 45,000 jobs; it was the sector’s 28th consecutive monthly decline. Despite the poor performance in the manufacturing sector there are signs that the U.S. economy is firming. Stocks and corporate bond markets have rallied and the service-sector economy strengthened in
November.
Worker productivity grew faster in the third-quarter than originally thought. Its growth over the past 12 months was the fastest pace since 1966. This is a positive signal for the country’s standard of living. Productivity is the ultimate determinant of how well Americans live. Gains in productivity enable companies to pay workers more without raising prices and the economy to grow faster without inflation. For most U.S. companies top line revenue growth has been extremely difficult to achieve. Weak revenue growth has forced companies to make the most of advanced technology in order to become more efficient and sustain their profitability. If companies remain committed to improving worker productivity, profits will improve once demand for their products and services picks up. Regrettably improving productivity for now has largely been a defensive effort to stay ahead by keeping costs down. A subdued global economic recovery may not be far off. The European Central Bank’s (ECB) 50 basis point interest rate reduction is an attempt to strengthen one of the world’s weakest regional economies. Europe’s lack of flexibility with labor has meant that even when demand falters their companies are not able to respond by cutting wages and reducing staff. This has kept the ECB from cutting interest rates anywhere nearly as aggressively as the U.S. Federal Reserve. Asia minus Japan is on track for nearly 6 percent growth this year. Japan, the world’s second biggest economy, is still mired in a decade-long recession. While it began to crawl out of recession early this year, it slipped again in the past few months amid skepticism over the health of their banking system. China has emerged as the real engine of growth for Asia. The challenge which faces the administration in promoting a more aggressive fiscal stimulus program in conjunction with a loose monetary policy is made more difficult by the need for state and local governments to eliminate their deficits which could total in excess of $80 billion and which will subtract from any federal government stimulus ultimately approved by Congress. The economic risk in the United States is that consumer spending weakens before business spending accelerates resulting in slower growth for the U.S. economy. Since the United States consumer is the principal engine of growth for the world economy, any stimulus will tend to increase the United States’ trade deficit, which could easily put downward pressure on the dollar and raise the perception if not the reality of increasing inflation. As can be seen in Appendix B, the current account balance is approaching $500 billion, and one could argue that this cannot go on indefinitely without resulting in a devaluation of the dollar.
Conclusion
Judging from the daily trading volumes of the exchanges, the markets seem to be dominated by institutions including a vast number of hedge funds. Their time horizons for investments tend to be short to say the least, and consequently we believe that market volatility will remain high. Companies can have wide trading ranges offering significant rates of return when purchased during periods of pronounced market weakness. There will be occasions for us to take advantage of opportunities that will be created under these circumstances. With respect to any changes in the double taxation of dividends, at this time 30 percent of the S&P 500 companies do not pay dividends, and the yield of the S&P 500 is currently 1.7 percent. Should these tax changes occur in favor of greater dividend payouts, we would expect to see many corporations favor greater current returns to shareholders which we believe will have a positive impact on their valuations. In our view portfolio strategy must encompass multiple scenarios since specific outcomes are a question of probabilities. Some of the areas which we believe must be part of a well-constructed portfolio include high-dividend paying securities, bonds, energy companies, defense companies, select technology companies, natural resource companies, and convertible securities. This would enable a portfolio to benefit from any of several outcomes which are not predictable. To reach the goal of compounding rates of return in order to build capital over time, good equity selection will be critical. The overall valuation of the equity market remains expensive, but at the same time there exist some outstanding investment opportunities. The short interest on the New York Stock Exchange and the Nasdaq still remain at high levels, notwithstanding the markets’ rise since the low of October 9th. The period from November to April is seasonally the strongest period of the year for equities, and next year is the presidential cycle year which invariably is a positive year for stock market returns. We should not assume that this coming year will be true to form. However, we believe the administration will make every effort to produce a better ‘03 than ’02 to ensure the reelection of President Bush. We wish our readers a Healthy, Happy and Peaceful New Year!
The relentless bear market of six straight down months has eliminated more than $8 trillion of market value since the decline began two-and-a-half years ago. The market is now at one of its most oversold levels ever. Investor’s Business Daily publishes a daily mutual fund index of 26 leading growth equity funds. As of yesterday, it is down 26.5% for the year and the Dow Jones Average has declined 17.4% this year. To believe that this is not likely to affect U.S. economic activity is unrealistic considering that the $8 trillion decline is almost 80% of one year’s gross domestic product.
Global Economic Weakness
Global economic growth is more dependent on the United States than at anytime during the past decade. Each economic region has lost its growth driver. Brazil, the engine of growth for Latin America, has faltered. Japan, the world’s second largest economy, continues in its deflationary mode, still unable to effectively handle its banking problems. This leaves China as the growth driver of Asia and the leading source of worldwide deflation. Moreover, Europe is no longer able to depend on Germany and France to enhance global growth prospects. On the contrary, Germany may be on the verge of a significant policy mistake as it shows signs of slipping into recession while the government considers tax increases and spending cuts to reduce its budget deficit in order to conform to the agreed fiscal discipline required by the stability and growth pact of the European Union. At the same time, European Central Bank President William Duisenberg again indicated that Euro zone interest rates should remain unchanged. On the other hand, France, to honor its election tax cutting pledges refuses to meet its obligations under this same pact. Mr. Duisenberg made clear that each government has to spur recovery by pursuing tax and labor market reforms. The European Central Bank is quite concerned that the stability and growth pact is at risk. This is occurring while German unemployment is rising, putting more pressure on the financial system. The financial systems of all the major economies are coming under increasing stress. Credit downgrades are rising, delinquency rates are moving higher and global equity markets have been hitting new lows. To make matters worse U.S. investors have lost confidence in corporate behavior and are facing continued downward revisions of earnings for the third quarter and an uncertain outlook for the fourth quarter. Some of the issues presently weighing on the markets are:
A war against Iraq…
Declining consumer confidence…
Reduced business spending…
Pension fund rate of return assumptions that are too high ranging from 8% to 10% per annum and must be reduced. Corporations will have to take money out of profits to add to their funds, thus reducing reported earnings.
State and local governments’ budgets moving into deficit…
Rising mortgage delinquencies…
Proforma earnings results being reported versus actual earnings results, which tend to put a better face on earnings reports…
Energy prices that are too high with oil near $30 a barrel and natural gas over $4 per mcf.
Under these conditions, estimating next year’s earnings is particularly challenging. Many investors now feel that equity securities must sell at extremely attractive prices in order to cause them to be enthusiastic about buying.
The Equity Market is Oversold
The S&P 500 has declined approximately 25% for this year and almost 50% from its peak. During July, $51 billion were pulled out of mutual funds, a record amount of cash, as investors could no longer put up with such dramatic declines. Is it possible that this long, painful bear market is almost over? The technology bubble has still not fully deflated as evidenced by the heavy and costly debt burdens which continue to plague the telecom sector. In the attempt to reduce costs, telecom and related companies have been laying off employees to bring costs in line with revenues. With October being the end of the year for most mutual funds, tax selling could put additional pressure on overall market valuations. However, the equity market was so oversold, and the short-interest was so large that a significant market reversal is occurring at the present time.
Fixed Income-Credit Risk
Barrons’ confidence index, which is the ratio of the yield of the highest-grade bonds to the yield on medium grade bonds, has declined to the lowest level in many decades. Rising individual and business credit risks have affected bank and insurance equity valuations. If the corporate-bond market continues to lead the stock market down, then equity prices could come under further pressure. However the lead-time has been about two to four months which would mean that by early next year, if the corporate-bond market stabilizes, we could see the end of this phase of the stock market decline. With investor confidence badly damaged by Wall Street’s conflicts of interest and corporate scandals, many investment strategists view the market as significantly undervalued, particularly so when based on their estimates of next year’s earnings. From our perspective we do not accept the view that next year’s earnings will be materially better than this year’s. Corporate profits continue to be at risk. Since the market will reflect bad news before it occurs, this bear phase will be over while the outlook could still appear to be difficult. At that time great values will have been created for long-term investors. Portfolio structure should encompass the following areas – energy companies, defense companies, insurance companies, high dividend-yielding quality equities, and select technology companies. Should deflationary forces persist as we expect, U.S. Treasuries Bonds should benefit as interest rates continue to decline. Investment flows into China are expected to continue as China continues to build a manufacturing powerhouse creating continuing deflationary pressures on the global economic system.
Consumer Spending
The stock market continues to take a toll on Americans’ household net worth. Economists now worry that a sustained decline in household net worth could cause consumers to sharply cut back on spending. Household net worth is a measure of total assets such as homes and retirement funds, minus liabilities such as mortgages and credit card debt. Current consumer spending, while healthy considering the soft economy, still is growing at only about half the rate it did during the late 1990’s. The negative wealth effect from the stock market has slowed consumer spending and hurt the economic recovery.
Expectations for Future Economic Growth
Expectations for future economic growth are highly uncertain as the recovery remains in question from quarter to quarter. Business demand is uneven and erratic, export demand is weak, and state and local governments are struggling financially. The Federal Reserve’s latest survey of business conditions has found significant economic weakness. The report known as the “beige book” was not weak enough to push the Federal Reserve to lower interest rates at their September 24th meeting. The Federal Reserve is hoping that once concerns over a weak stock and corporate-bond market subside, low interest rates will propel the economy back to a reasonably healthy growth pace by the end of the year. The “beige book” found residential real-estate markets and automobile sales both strong, but conditions elsewhere generally were sluggish or declining. With the job market still weak and consumer spending power being eroded by high energy prices, near-term growth in consumption depends more and more on home equity refinancing and modest growth in real income for those who are working. The latter story is mainly one of increasing productivity, which allows for higher real wages without inflation. Home equity refinancing depends on low interest rates and rising home prices.
The Federal Reserve
The consumer sector accounts for more than two thirds of the nation’s gross domestic product. September retail sales were weak; it was the third consecutive month that consumers held back on spending amid doubts about the economy and fears of a war against Iraq. These concerns do not bode well for the important holiday shopping season just ahead. We expect consumer spending to slow during the fourth quarter. Should the economic data begin to show even weaker performance, the chances would improve for the Federal Reserve to cut interest rates further. The Federal Reserve Board’s recent decision to leave interest rates unchanged reaffirms the belief that borrowing costs are low enough to keep the U.S. from falling back into recession. However the Federal Reserve is leaving the door open to a possible interest rate cut later on this year if the economy continues to show weakness.
Conclusion
The leading stock market averages have fallen to lows not seen in over five years. The markets are focused on uncertainties regarding the state of both the domestic and the international economy. The two-and-a-half year bear market has brought many equities down to price levels that should be rewarding when the economy begins to recover. The globalization of markets and low-cost foreign competition make it more important than ever to direct investment dollars to the companies with strong balance sheets, dominant market position and superb
