Economic Outlook
Legs at Last
Last year at this time, caution was the watchword among economists and investors alike. Businesses held back on new hiring and investing, waiting to see what would unfold in Iraq. Twelve months later, the pundits are virtually unanimous in declaring that the US economy has reached a turning point and should experience above-average growth into 2004.
A look back at the US market results for 2003 brings to mind Market Rule #1: the market always anticipates and overreacts to news - both good and bad. The stellar performance of the S&P 500 Index, with a fourth quarter return of 12.1% and 28.6% for the year, gives evidence to that rule, that the good news of a strengthening economy was anticipated and built into the return for the past year. With some tumultuous months behind it, the bond market ended the quarter with a 0.06% return as measured by the Lehman Brothers Intermediate Government/Corporate Index, and a yearly return of 4.3%.
For the first time in four years, the economy is making its way into a new year with a solid, broadly based foundation that can generate a sustained upturn. The US economy, as measured by Gross Domestic Product (GDP), roared ahead at an 8.2% annual rate in the third quarter of 2003, the best showing in nearly 20 years. This anomalous third quarter rate was the result of a magnification in consumer spending which was helped by the summer tax cut, the lagged impact of lower interest rates on housing demand, and an improvement in net exports during the quarter.
As these economic factors languish, a mixed bag of data has been emptied onto the table that we need to sort through. The most recent durable goods order, for example, is in contradiction to the majority of generally positive economic news recently released. The durable goods order for November plunged 3.1% from October, which included a sharp decline in orders for capital goods. This drop seems discouraging, given that businesses are expected to share with consumers more of the burden of generating demand in 2004. However, the three-month moving average, which is a better indication of the trend, continued to rise, as it did for most of 2003. Nondefense capital goods orders excluding aircraft, which is a key capital spending barometer, grew at a 23.6% annual rate over the past six months, strengthening the case for sustainability. In addition, both shipments for capital goods and the trend for unfilled orders are also rising, which has contributed to reported fourth-quarter economic growth, and on into 2004.
The expectations for demand gains, both domestically and abroad, are increasingly bright. The weaker dollar, plus economic growth in Southeast Asia and Europe, are contributing to the gain in US exports. Our expectations for GDP growth in 2004 are at an annual 4.5% rate, fueled by strong gains in business investment spending and in exports. The projected increase in business investment spending this year is expected to flow from an approximate 15.0% increase in corporate profits during 2004.
An ongoing upswing in profits and margins is a crucial ingredient for sustainable growth. Despite high energy prices that will put a squeeze on corporate profit margins, there is top-line improvement in the form of increased sales that has covered fixed costs, giving way to a healthier bottom line. The combination of three years of depreciation with minimal capital spending has led to a pent-up demand for capital goods, with tax benefits from more favorable depreciation allowances aiding the demand. The increase in earnings provides both an incentive and the wherewithal to sustain a capital expenditure recovery.
At the same time, the need to rebuild inventories is acute. The Institute for Supply Management’s (ISM) inventories component of their December index fell to 47.3 from 50.0 in November, continuing the lean trend and further highlighting to companies the need to boost their outlays on both equipment and inventories or risk losing sales. The ISM’s overall manufacturing index indicates that companies are indeed realizing this need, as the index rose to 66.2 in December from 62.8 a month earlier. This is the fastest pace in 20 years.
Business sector spending and the push to rebuild inventories seem to be leading to employment growth, another crucial element in the longevity of this recovery. The unemployment rate for December 2003 is another element in our mixed bag of data. The rate fell to 5.7% from its previous 5.9% reading. On the surface, this appears to be an improvement, however, much of this can be attributed to the fact that there was shrinkage in the overall labor market. Fundamental factors continue to suggest that there is job growth in the months ahead. The ISM’s employment index, which in November ended a three-year slide, stood at a four-year high of 55.5 in December, compared with November’s 51.0 and October’s 47.7. The group noted that readings above 47.8 are “generally consistent” with increases in manufacturing hiring.
A bittersweet impediment to a solid employment rebound is the long-run trend in higher productivity growth. Even as demand waned over the past three years of recession and weak recovery, corporations were making significant productivity gains, which in 2003, averaged 5.0%. The bitter is that the productivity gains mean fewer workers are needed to perform the same work. Another bitter element in the employment situation is the increase in outsourcing of jobs that continues to occur. The sweet is that every addition to revenue will create even more profits. If productivity slows to a more normal 2.0% to 3.0% in 2004, an economy growing at 4.0% to 4.5% would be able to generate job growth of 1% to 2%.
Yet another component of the mixed bag, inflation, closed out 2003 at an annual rate of 1.8%, as measured by the Consumer Price Index (CPI). This figure almost certainly overstates the weakness in pricing, since broad reflationary forces are gradually building momentum. First, monetary policy is actually encouraging inflation. For example, when the dollar was rising from late 2000 until early 2002, US prices of imports, excluding oil, fell, and US goods producers had to cut their prices to compete. But since the dollar’s peak in 2002, import prices have crept up. This gives US manufacturers some room to lift their own prices. Secondly, the economy is slowly beginning to absorb some of its slack in the form of improving labor markets and shrinkage of manufacturing capacity. There is inflation in the economy - in housing prices, stock prices and many commodities, for example. Commodity prices as measured by the Commodity Research Bureau (CRB) Index were up 8.9% in 2003. It just isn’t showing up in the classic inflation gauges, partly because companies are facing intense competitive pressures on the pricing of many goods, mostly from China and other Southeast Asian countries.
However, even with subdued inflation, a better economy means stronger credit demands and potential rising interest rates. If the economy continues to outperform expectations and inflation ticks up, the Fed will tighten. This act would not be unprecedented, as the Fed Funds rate has risen in 5 out of the past 11 election years. A popular assumption is that the stock market would flounder in the face of higher interest rates or inflation, but this is not necessarily true. Companies’ earnings growth and the relative appeal of other investment alternatives weigh in heavily as factors to consider, along with rates and inflation. The late 1970s, a period of soaring inflation, was an excellent time to own energy and other stocks in commodity businesses, for example.
The weaker dollar is its own mixed bag. The US dollar’s value has been declining for two years. The US dollar sold off in 2003, as evidenced by the -14.7% decline in the US dollar Index, an index of the dollar against the currencies of seventeen nations that represent the bulk of international trade with the United States. The current administration is believed to support the idea of a weaker dollar because it should help to fix the current trade-deficit problem over time by making US exports less expensive for foreign buyers. The downside to this is the long-term appeal for foreign investment in the US may decline because of the huge US budget and trade deficits. But most agree that the dollar is not near a crisis point. Measured against key currencies, including the Swiss franc, the dollar hasn’t given back the gains that it made in the late 1990’s.
China, on the other hand, has become a magnet for foreign capital, emerging as the world’s largest recipient of foreign direct investment. The Chinese economy accounts for about 4% of the world GDP. However, its outwardly-focused push for growth has become so powerful that it now accounts for 15-25% of the world’s overall growth in GDP, trade, industrial production, and capital formation. Its attractiveness to foreign investors means the US may have to compete for capital, another impetus for a nudge in interest rates. Oakwood clients are benefiting from the “China factor” and other non-US growth opportunities from their ownership in multinational stocks held in client portfolios.
As we finish sifting and sorting through the contents of our mixed bag, we feel there are strong positive elements to sustain economic expansion. The capture of a bedraggled Saddam Hussein has bolstered confidence but has by no means ended the war on terrorism. Anti-terror and combat operations continue in Iraq to this day. Military operations aimed at containing remnants of the Taliban and the hunt for Osama bin Laden continue in Afghanistan, and the dictatorial regimes in Iran and North Korea are nuclear threats. Relations with certain US allies are strained and the threat of a terrorist attack on the US remains at high levels.
The US current-account deficit remains immense. Should non-US investors see our country’s situation as being too leveraged, the US will have to raise interest rates to maintain foreign investment. A plunge in the dollar could bring a retreat in foreign capital that is crucial to US growth, along with higher inflation.
The Conference Board’s Consumer Confidence Index took a dip in December, mostly a reflection of current anxiety about labor market conditions. However, the Board’s December Expectations Index rose, signaling consumers’ belief that these conditions will improve in the months ahead. For the coming year, the elixir of rising demand, heftier profits, and job growth will provide the basis for sound economic growth.
