October 2004
Before we go too far into a discussion about the state of the US economy and how it is affecting both stocks and bonds, we'd like to point out that our economic views serve only as a backdrop to our main job as investment managers. That is, finding a few dozen investment opportunities that we see as too cheap to pass up. To be fair, the economy does influence the volume of investments we find attractive enough to consider, but since John and I are searching for a relatively small number of bargains, it doesn't completely preoccupy our minds. Nonetheless, the US economy has been a truly fascinating thing to watch this year and we want you to understand how it is affecting our investment strategy.
Interest rates have jumped and settled back down again. Job creation has disappointed, then picked up and then settled back down again. And oil prices have unexpectedly spiked to over $50 a barrel and…well, we don't yet know its ultimate trajectory. These issues have substantially affected investment returns in 2004. Since the start of the year, the bond market has given investors decent returns to those who've braved the potential of a rising interest rate environment. The stock market is looking nothing like last year even as the economy is poised to grow at a solid 4% rate. It seems investors are in a bit of a tug-of-war about the state of the economy and while making good investments one-at-a-time is what matters the most, the outcome of this tug-of-war does have an influence on our actions.
The "Steroids" Economy
The US economy is currently facing headwinds that are proving tough to fight through. Namely, we operate in a highly competitive global economy that is shifting the balance of power to Asian economies - especially in the important manufacturing sector. Over the past few years, the US has developed a huge trade deficit with the rest of the world. We are importing goods, like electronics, apparel and cars from China, Japan and other Asian countries at a truly rapid clip. With this come lower prices and the latest gadgets, but it might also be denying our recovery high quality jobs with benefits.
Following the bursting of the bubble in 2000 and the terrorist attacks in 2001, the US government, the Federal Reserve and Asian central banks all embarked on a full out effort to save the US consumer from a very deep recession. The Federal Reserve cut short-term interest rates to a low of 1% and with it came rock bottom mortgage rates and cash-out refinancing became all the rage. The federal government cut taxes multiple times and sent rebate checks to households for three straight years. As a result, the US consumer has kept spending and housing prices have surged. All said, we think it was a brilliantly successful attempt to limit the damage, but it is having some lasting effects on this recovery.
The worry is that the US consumer has been artificially propped up though these tax cuts and their inflated home values and it only delayed the day of reckoning that is yet to come. Along with the federal government, consumers are deeply indebted and in order to unwind the effects of these "financial steroids", the Federal Reserve has very little room for error. One of the Federal Reserve's main jobs is to keep inflation in check and they know their easy monetary policy - if held too long - could possibly spark inflation. Its other job is to encourage steady economic growth and they know that a normal tightening of their interest rate policy - if done too quickly - might choke off the consumer and the end the recovery.
They have raised rates three times in as many months and short-term interest rates now stand at 1.75%. It is commonly believed that they are on their way to 3.5% to 4.5% before they will stop. But when they reach the level of 2.0% to 2.5% it may start to get a little touchy - unless the economy shows some sustained strength. It hasn't yet and the worrying has begun in earnest. This explains why bonds have done surprisingly well this year.
Oil prices have risen by about 50% this year alone and this surge has thrown cold water on the economic recovery. As this flows through to higher gas prices it has acted as a tax on consumers. The recent jobs data has shown that we may be in the middle of a muted, if not a jobless recovery. These tepid jobs numbers beg a legitimate question of whether productivity gains have an ugly consequence - too few jobs to build consumer confidence. Consumer confidence is needed to get the business sector to take the next step in the recovery, capital investment and job creation. This is the classic "chicken or the egg" conundrum.
As the consumer's insecurities and debts grow, can it be expected that they will continue driving the economic recovery? This is a particularly good question in a time when Greenspan and our federal government, out of sheer necessity, have ended their monetary generosity. In a time of constant underlying terrorist threats, surprisingly high oil prices, tough competition from lower cost producers overseas and a over-leveraged consumer to boot, what will persuade executives to loosen their grip on their growing cash piles? What will drive them to put it to better and more productive uses? These questions help explain the sluggish and worried stock market and they shed some light on a bond market that doesn't seem to believe we are out of the woods economically speaking.
The "Time Heals All Wounds" Economy
On the bright side, our economy is in relatively good shape. This year growth will come in around 4%, the unemployment rate is at 5.4%, inflation looks under control and household wealth is sitting at record levels. Yes, the US consumer is an indebted creature. Yes, as interest rates rise they will feel some pain trying to make higher interest payments. This worry is not really new as economists have fretted over the US consumer's debt levels for 25 years. Yes, the federal government, too, is indebted and is running huge deficits again. But remember Ross Perot's flip charts back in 1992 right before the 90's boom created budget surpluses. And, yes, it is true that Asian central banks are huge buyers of our bonds and without them, interest rates could substantially rise, leaving the dollar severely damaged as capital flees to safer havens. While a legitimate worry, we believe the US is a critically important market for Asia companies and their interests are clearly aligned with the health of our economy.
It looks to us that a bet against the US and a global economic expansion is generally a bad bet. Japan, China, Europe and a host of others important economies are showing tangible signs of recovery. The US recovery isn't like past recoveries and it does have some challenges - yet with time - the US will likely retain its place as a great place to do business in the world. Time is in fact one of the key ingredients that allows economic imbalances to correct themselves. Since the 1970s, 1980s and 1990s, many of the same popular worries we have today have been soothed by time. The 70's showed the repercussions of our dependence on foreign oil. Thirty years later, our economy is far less dependent on oil. The 1980s was a decade of deficit spending, worries of war and talk of our growing reliance on foreign investors to fund our trade deficits. But we should not forget that economic growth like we saw in 1990s can bring into balance things that are clearly out of balance.
John and I see value in thinking through negative scenarios. Today's economic recovery has certainly not been a classic one. We see the US continuing on a path to a moderate economic recovery - although robust 90's-like growth is unlikely in our view. At today's prices and considering our tempered outlook, we don't see the general stock market as overwhelmingly cheap. It is important to stress that this doesn't mean we won't take advantage of buying inexpensive stocks when they're getting hit as we did July and August. On the other hand, with our expectation of a healthy recovery and with it rising interest rates, we still view the bond market with caution. Our shorter maturity bond strategy will hold until yields entice us to think otherwise. Our overall conservative stance is heavy on flexibility and as the current tug-of-war shakes out, our goal is to use it to your advantage.
Jason P. Tank, CFA
jason@frontstreet.com