May 2004
Despite a war in Iraq that seems to have no end in sight and continual threats of terrorism against us, the U.S. economy has been growing with increasing momentum over the past year. A year ago the economy was having difficulty achieving 3.0% real growth and the unemployment rate was rising. Today, economic growth is cruising along at a 20-year high rate of about 5.0%, interest rates are still historically low, and the job market is improving. Corporate revenues and earnings growth have, for the most part, been better than expected over the past six months and many companies have been increasing their sales and earnings targets for the rest of 2004. According to various surveys, optimism is on the rise for both consumers and businesses. So what is wrong with the stock market?
One would think that with all of these good things happening, the stock market would be hitting new highs. Instead stocks have been selling off on really good earnings and economic news. Investors seem to be implying by their eagerness to realize profits in the face of rising expectations that maybe it cannot get better than this. Maybe this is as good as it gets. We think that may be the case.
The Wind At Their Back - likely a thing of the past.
Up until now the financial markets have had the economic winds at their backs and the prices of bonds and stocks reflect it. In an effort to prevent the possibility of deflation, the Federal Reserve has been pumping out money into the economy to keep interest rates low and encourage consumer spending and business investment. The money supply has been growing much faster than the economy so the excess dollars that were not needed to fund economic activity flowed into the financial markets and raised bond and stock prices. Our leaders in Washington DC provided tax cuts to also stimulate spending and investment and the first quarter corporate earnings reports have been a testament to the success of that strategy. With about 60% of the S&P 500 companies having reported their first quarter results, revenues are up an average of about 12% and profits increased about 26%. For the first time in a long time many companies were able to increase prices of their goods and services to help cover the higher costs for energy and employee medical benefits.
Easy monetary and fiscal policies are not the only reasons for the accelerating growth in our economy. The strong growth in Asia, especially China, has also contributed. U.S. exports to China have been steadily increasing as the Chinese have been consuming a large portion of the global supply of materials like oil, copper, steel, cement, and lumber in what seems to be an insatiable appetite. Many technology companies are finding new markets for their products in China and other Asian and European countries. The weaker U.S. dollar (and stronger foreign currencies) has made U.S. products more affordable for consumers and businesses in other countries.
From Tailwinds to Headwinds
We think these economic tailwinds are becoming headwinds for the economy and the financial markets and are forcing investors to reassess their future expectations. The most forceful headwind for the markets in our opinion is the recent and expected future rise in interest rates. The Federal Reserve has clearly communicated to the markets that the next move in short-term interest rates is up. It is only a matter of when, not if.
The Fed has been waiting for clear signs that the job market is improving before taking any action that might slow the economy down and they got some good news of strong job growth in March. I expect that the good news will continue into May as both of my kids and many of their friends will be graduating from college and entering the "real world" of the gainfully employed!
The Federal Reserve will also be inclined to raise interest rates because of various indications that inflation is heating up. Industrial commodity prices like copper, steel, oil and natural gas have been rising for over a year but there have recently been signs that these higher costs are now starting to be passed on to consumers. Many companies are now able to increase prices, which have recently been reflected in about a 3% jump in consumer prices, excluding food and energy, during the first quarter of 2004. That was up from near 1% for the first quarter of 2003.
Another headwind will be the slowdown in the growth rate of sales and earnings for the rest of 2004 and beyond. Profit margins have already expanded close to historical highs thanks to years of cutting costs so future profit growth will be very dependent on sales growth and we think that is going to slow. Much of the pent-up demand for homes and cars has been satisfied and people can only purchase so many electronic gadgets. In addition, most of the benefits from the 2003 tax cuts have been spent and rising mortgage rates will slow refinancing activity that provides cash for other purchases or to payoff other debts. Sales from exports may also moderate as China attempts to slow their economy to a more sustainable rate.
An Aging Economy - a longer term reality
Like Japan and Europe, the United States is considered to be a mature economy because of the demographics of its population. We as a society are getting older whether some of us want to admit it or not! About 35% of people living in the U.S. are now over the age of 45 and that percentage is expected to grow to 43% over the next 50 years. That percentage could prove to be a little low if the medical community and healthier life styles continue to improve and extend the aging process. People over 50 tend to save more and spend less of their income in preparation for retirement so as this proportion of the population increases it puts a restraint on the aggregate demand for goods and services. I know that baby-boomers like me are realizing that it is now time to save for retirement...right after we purchase that Harley-Davidson motorcycle and pay for the plastic surgery to make us look young again.
The aging population is obviously a longer-term issue that will dampen domestic economic growth in the coming decades. With that, Americans will have to seriously confront the huge cost of providing social security and medical benefits to all the aging boomers who failed to save enough to care for themselves. There is no doubt that the government will have to be taking a larger chunk of taxpayers' income to fund such massive social programs. Budget deficits will also be rising, which will put upward pressure on interest rates and inflation. While these long-term demand and budgetary issues are concerns, we do not want to overstate the risks - we have a history of adjusting to the new realities and finding new ways to profit from it.
We think the stock market has been selling off because investors' expectations for future earnings growth got a little ahead of reality. It is very unlikely that the economic fundamentals will be as good 6-12 months from now as they are today and that is what investors are beginning to focus on. With interest rates rising, the prices of stocks in relation to those expected earnings (price/earnings ratios) are being reduced. From my experience, it is much more difficult to make money in stocks when interest rates are rising and earnings growth rates are declining - and so, the stock market tends to be caught in a trading range. It is not a good environment for just a buy-and-hold strategy. We see this environment as a good fit for our equity investment style of being patient and waiting for good buying opportunities - along with knowing when to sell and lock-in profits. Our bond strategy of preserving principal by investing in higher quality, shorter-maturity bonds should allow us duck the blow of rising rates on bond prices and then increase income for our clients' portfolios as interest rates head up in the months to come.
John W. Gudritz, CFA
john@frontstreet.com