September 2003
Optimism continues to build on Wall Street with the recent news of faster economic growth and the increases in analysts' earnings expectations. Most popular stock market indexes have hit 12-month highs after spending much of the summer stuck in neutral. The bond market, on the other hand, is still weak as bond yields have continued to move higher (and, therefore, bond values continue to fall) after the unprecedented jump they took in July. While we don't expect this to happen every time, Front Street's defensive bond strategy, which we detailed in early July, has certainly turned out to be more timely than we anticipated. True to form on Wall Street, since stock prices, in general, are looking a bit stretched, analysts are now beginning to use 2004 and even 2005 earnings estimates to help justify even higher prices. This looks especially true for the most economically sensitive stocks. Our portfolios have performed very well, but we are certainly not going to get caught up in the jubilation. As always, we worry about what lies ahead for the market. A strong case can be made that this economic momentum will peak in late 2003 or in early 2004 and end up disappointing investors next year. So, we think it is far too early to celebrate this recovery.
Numbers don't lie. Usually, that is.
There is little doubt in our minds that the economy is picking up steam. The recent numbers prove it. Second quarter GDP growth was recently calculated to be 3.1%, which was higher than the 2.6% average annual rate for the prior four quarters. Third quarter GDP growth is now expected to come in as high as 5.0% as the government's tax cuts help to keep consumers buying homes, cars and new clothes. Corporate profits have bounced back and are near an all-time high despite the fact that economic growth has been somewhat sluggish. There are signs that these higher corporate profits and new tax incentives are finally loosening the purse strings of corporations. Companies are even beginning to invest in new equipment after a three-year hiatus. Inventories fell to such a low level in the second quarter that manufacturers are now seeing higher orders in the third quarter just to build them back up in anticipation of this future growth in demand. Globally, the European and Japanese economies seem to have at least stopped declining, which should give some additional hope to U.S. companies that export to those countries. And, finally, the Federal Reserve is doing their part to boost the economy by stating that they are committed to keeping interest rates low for as long as it takes. In a nutshell, that is the case for the optimists out there. All of these indicators are good news but the most important question for future equity gains is, where does the economy go from here? Our worry is that the economy is not yet out of the woods.
Unlike most endeavors, what got us here, may not keep us here.
When we look out into 2004 we are having trouble seeing what the big driving forces will be for the economy. The Federal Reserve has provided a massive amount of liquidity for the economy over the last three years by keeping interest rates low, which has encouraged consumers to keep shopping, especially for homes and cars. Home and auto sales have remained near record highs since late 2001. It is obvious that the consumer has kept the ship afloat. But, going forward, we don't see there being much left in the consumer's tank as a primary engine of the economy. Interest rates have been increasing since mid-June despite the Federal Reserve's serious efforts to talk them down.
It is now pretty clear that the bond market is currently ignoring the Fed's policy of easy money and our reading of things leads us to believe interest rates are heading upward, not downward over the coming year. The worry is that rising interest rates could significantly crimp the economy by ending the steady flow of easy cash-out refinancing activity that has put so much money into consumer's checkbooks and raise the financing costs for corporations. We don't think government is likely to send any more tax cuts or rebates our way in the face of such huge budget shortfalls. In other words, there isn't a lot of wind at the back of the consumer that got us here. What, then, will to keep it going?
The fiscal stimulus from the tax cuts and rebates have certainly given the economy a positive jolt. Studies have shown that consumers are spending up to 75% of the income tax rebate checks they got this summer. Additionally, the lower withholding for taxes in their paychecks is also boosting demand. But the more important driver of a long-term recovery will be when corporations begin to invest in new equipment. The problem is that there is not a lot of pent up demand for new equipment beyond what is needed for maintenance or replacement. Investing for expansion purposes is not necessary in an environment of excess capacity. With elections coming up in a year, we are concerned that our elected officials will continue to try to boost economic growth (and their re-election chances) with new spending programs. However, with the estimated budget deficits for 2004 already reaching nearly $500 billion, the politicians are limited in the amount of generosity they can extend to the American people. We obviously don't hold out much hope for the consumer to continue to bail the economy out.
The 90's bubble/boom is providing a negative echo effect. Only time will heal this wound.
There is simply no quick fix to an economy that has come through such a large capital-spending boom like the one in the late 1990's. The fact is that our economy has more plant and equipment than it needs right now. No matter how low interest rates or how big tax incentives are, these techniques will not provide the level of stimulus they have in past economic recoveries. Companies made huge investments in the late 90's in new technologies that have helped workers become much more productive. The natural downside of this productivity boom is that it significantly lessens demand for additional labor in a recovery. Thus, we've seen a "jobless" recovery. While we have a lot of confidence that U.S. businesses will continue to compete, discover and innovate, it will probably not be enough to keep our real economic growth rate much above 3.0% or 3.5% on a sustained basis for the foreseeable future. This is not good news for those expecting a significant decline in the unemployment rate over the next year or two.
In an election year, we feel that the Federal Reserve will have to wait for a lower unemployment rate before it considers raising short-term interest rates. Yet, despite the evidence of the risks looming on the horizon that could derail this young economic recovery, we do feel that the concerted effort around the world to "reflate" things leads us to continue our defensive bond strategy of limiting our clients' interest rate risk. We intend to hold this position as long as monetary and fiscal policies are so simulative in nature.
Portfolio Management is about risk analysis and humility.
Although we are questioning the consensus expectations for the economy and the stock and bond markets in 2004 (we might add that it is our job to question the consensus, not reflexively disagree with it) we are always mindful of the possibility that we could be wrong. That explains why we would not take an extreme position of selling all of our clients' stocks when we are nervous about the general market. For example, when we turned negative on the bond market in June, we did not simply sell all of our clients' bonds and hold cash instead. We reinvested the sale proceeds into bonds with shorter maturities that we feel will better protect our clients' capital. Why not just hold cash? In the event we are wrong on the direction of interest rates, these bonds will allow for higher returns than the paltry yields that money market funds currently offer. We are not market timers. We are risk-averse value seekers. Our approach is to sell assets when we determine they are expensive, look for attractively priced investments to fill the void and build diversified portfolios to achieve our clients' long-term investment goals.
John W. Gudritz, CFA
john@frontstreet.com