Economic Outlook
Accentuate the Positive
The 2004 stock market posted a gain of +10.9%, as measured by the S&P 500 Index, which along with 2003’s positive results, gave us the first back-to-back yearly gains since 1999. Most of the index’s return for the year occurred in the fourth quarter, which garnered +9.2%. The Dow Jones Industrial Average, another measure of the US stock market, had a lower annual return of +5.3% and +7.5% for the fourth quarter. The bond market, as measured by the Lehman Brothers Intermediate Bond Index, returned +3.0% for 2004, with a fourth quarter return of +0.4%.
To prepare ourselves for the New Year, let’s do some housecleaning. First, let’s get rid of our “fear of the Fed”. Through the past several decades, when the Federal Reserve has started on one of its interest-rate-raising campaigns, it has been bad news for the markets. In a typical business cycle, the Fed steps in because the economy has become overheated and inflation starts to pick up. The Fed starts to hike rates in an effort to force the economy to slow by boosting borrowing costs. Businesses must pay more for their cost of capital and profits decline. Consumers get hit with higher costs, too, as mortgage rates rise, and people stop buying new homes and cars. The typical result is a declining stock market.
The current cycle of Fed rate moves has not followed the old pattern. The Fed cut rates from 2001 through 2003 to fight deflation and recession, which provided much-needed stimulus in the economy and stock markets. However, because the economy had been so weak, it did not spark an uptick in inflation. In that case, the Fed isn’t fighting inflation; it is moving to normalize interest rates from their abnormally low levels. The Fed is doing its job, by all indications is doing its job well, and the financial markets like the job it is doing. The Greenspan Fed has achieved an unprecedented degree of credibility as an inflation-fighter. The key will be whether the Fed can continue to guide the economy between the obstacles of inflation and recession. The Fed has several more tightenings before it moves the Federal Funds rate back to “neutral,” a level that no longer stimulates growth, which is currently in the neighborhood of 3.0%, given our current low inflation. And with inflation likely to edge only slightly higher, long-term rates, which are crucial to housing demand and corporate finance, probably won’t rise as much as short-term rates and will remain at comfortable levels. We feel that the Fed will continue to hike the Fed Funds rate from its current level of 2.25% to a level of 3.0% by June of this year, and may then pause, depending on the inflationary environment.
Secondly, let’s adjust our perception of the trade deficit. There is an abundance of press and chatter (mostly negative) about the size of the US trade, or current account, deficit, now at 5.6% of Gross Domestic Product (GDP). If Americans buy automobiles from Japan, and have no other transactions with Japan, the Japanese must end up holding dollars, which they may hold in the form of bank deposits in the United States or in some other US investment. The payments from Americans to Japan for automobiles are balanced by the payments of Japanese to US businesses and institutions, including banks, for the acquisition of dollar assets and dollar-denominated raw materials. Said another way, trade or current account deficits are offset by capital account surpluses—that is, the purchase of US assets by foreign businesses and institutions such that net flow of receipts and payments is in balance. By definition, this means the capital account surplus is 5.6% of the GDP as well, not a bad thing.
Whether you are a US or foreign investor, the US is the best destination for capital. That is why the trade deficit, and, in turn, the capital surplus, are so large. The US is the only growth country of all the developed countries, and as such, attracts capital investment. The only way non-US investors can guarantee a dollar cash flow to invest in the US is if they export more goods to the US and import less. Viewed this way, the trade deficit is not a sign of a structural economic flaw, but is instead a sign of a country that has the ability to attract capital because of its potential for growth, its free market, and an economy that regulates the relationship between the government and the market through legal institutions so that economic development is both possible and sustainable.
Third, let’s dispel the notion of a complete free-fall of the dollar. Changes in exchange rates have limits. Without a corresponding rise in domestic dollar prices, US goods and assets become relatively more attractive to both foreigners and Americans when there is a fall in the foreign-exchange value of the dollar. Eventually, the dollar would be so cheap that there would be more buyers than sellers, therefore limiting the dollar’s fall.
As the dollar decreases relative to other currencies, foreign goods become more expensive by the same percentage as the dollar decrease. While in the past a dollar depreciation of the magnitude that we have been experiencing over the past two-plus years would have been a precursor to much higher inflation and interest rates, we are not currently seeing that higher inflation. The reason for that is that the Fed is not accommodating the higher inflation with faster monetary-base growth. The Fed, while monitoring the valuations, believes there is no reason to intervene. When foreign economic policies improve, and the foreign attractiveness of capital increases as a result, the first impact is a lessening of the US terms of trade, followed by a fall in the trade deficit.
Fourth, let’s look beyond the ups and downs in the economic data, oil prices, and the price indexes to understand the bond market. Despite the drop in November housing starts, builders in early December were upbeat, as the National Association of Home Builders’ survey rated market conditions the best in more than a year. Some reasons for builders’ optimism are the current low level of long-term interest rates and the long-term secular demand for housing. At the end of 2004, the yield on 10-year Treasury bonds (a proxy for mortgage rates) was slightly lower than it was a year earlier, despite the backdrop of solid economic growth, an uptick in inflation, and five interest rate hikes totaling 1.25% by the Fed. A unique difference in this expansion is that the Fed has given the bond market an unusually clear road map for future Fed actions and inflation. First, through a new openness of communicating policy, the Fed has put its pattern of interest-rate hikes on a gradual and predictable path. Ever since the Fed began lifting rates in June 2004, the market has come to expect a quarter-point increase in the Federal Funds rate at almost every meeting, an expectation that should remain in place in the first half of 2005. This certainty reduces volatility.
Looking Ahead
We feel that the US economy will continue to improve in 2005, with modest growth, contained inflation and predictable rises in short-term interest rates. This outlook is based, most notably, on the assumption that oil prices will stabilize, after running as high as $55 a barrel in 2004. That should help restrain inflation and strengthen the purchasing power of households that surrendered disposable income to high gasoline and home-heating costs in 2004. Businesses should feel some relief as well. Global economic growth is poised to slow from close to 5.0% in 2004 to below 4.0% in 2005. In addition, although there remains robust demand for raw materials, as the global economy grows moderately in 2005, non-energy commodity prices are likely to moderate as well.
