No Harm, No Foul? An Even Quarter for Stocks and Bonds
Is the Economy Taking Off?

Increasing evidence of a broad economic recovery convincingly reversed the market’s January and February slide resulting in a slightly positive total return in the Standard and Poors 500 (“S&P 500”) of +0.3% for the first quarter of 2002. The NASDAQ, mired in technology earnings disappointments, lost a full 5% in the first quarter. Bonds, on the other hand, experienced performance nearly the exact opposite of equities, appreciating substantially during the first two months of the quarter and declining on rate increase worries during March. Thus, the total return for the quarter on the Lehman Brothers Government/Corporate Index was in negative territory, down -0.5%. With the S&P 500 up around a quarter of a percent and bonds down a half a percent, it appeared that not much changed with the major indices once the quarter had concluded.

Mutual fund performance was lackluster as well during the first quarter. The average diversified mutual fund was up just 0.4% while large capitalization growth funds lost 2.9%, according to Lipper Inc. The average international fund was up just 1.2%.

The U.S. economy appears to have begun an improving trend. Real Gross Domestic Product (“GDP”) rose at a 1.7% annual rate for the fourth quarter of 2001 after declining -1.3% for the third quarter of last year and is expected to increase as much as 5% when first quarter 2002 numbers are finally in. Consumer spending increased at an annual rate of 6.1% in the fourth quarter of 2001 and, while moderating, may still be up at a 3% annual rate in the first quarter of this year, led by continued strength at chain stores and automobile dealerships. Durable goods orders were up 1.5% in February after a 1.3% increase in January 2002. The Institute for Supply Management (the old Purchasing Managers) Index showed its strongest reading in two years in March. On the employment front, nonfarm business payrolls in March rose for the first time in eight months.

Moreover, there is evidence that improvement is occurring in the economies of our major trading partners. Among the best news of the past quarter is the forecast by the Bank of Japan that a gradual economic recovery, led in part by increasing production, will be underway in that country by mid-year. Non-Japanese Asia has represented strong demand, especially for U.S. industrial and technology goods, throughout much of the economic downturn, suggesting that economic stability is settling into that part of the world. Things are also turning upward in Europe. Healthy economies abroad exert demand for U.S. goods, lessening the drag on domestic GDP that occurs from the negative balance of trade.

By far, the surprise economic event of this downturn, however, has been the phenomenal continued strength in productivity growth. While the 5.2% rate of increase in fourth quarter productivity was no less than amazing, occurring as it did amid an economic decline, it will apparently be followed by another 5% productivity gain in the first quarter. The significance of these incredible back-to-back productivity numbers is that they allow for large declines in unit labor costs, holding down inflation and, most significantly, contribute to a widening in corporate profit margins.

While signs abound that an upturn in the economy may be upon us, it is important to temper these positive reports with realism. The strong consumer spending number has been aided substantially by its durables segment which was up 39.4% in last year’s fourth quarter and which was attributable almost entirely to strength in the auto sector. The strength in autos occurred because of impetus from zero interest rate promotions and other one-time incentives not likely to be repeated. While durable goods orders were up 1.5% in February, defense capital goods were up 78.6%, representing all the gain. On a year over year basis, durable goods were actually down 4.9%. Unemployment was at 5.7% in March, up from 5.5% in February. The 58,000 increase in March payrolls masked a 38,000 decline in the manufacturing portion of payrolls, extending a pervasive and disquieting decline that has lasted for sixteen months. In fact, the payroll increase was entirely due to the service sector, which experiences large seasonal adjustments.

The point is that early signs of an economic recovery do not mean that the U.S. economy is out of the woods. Depending upon which data are emphasized the economy could be either in the early stages of a recovery or in a directionless transition period characterized by mixed economic data and modest prosperity.

One economic worry centers around conditions in the corporate sector. Last year’s decline in business inventories was the largest on record. This colossal inventory liquidation was the direct cause of the large drop in industrial production, which in turn caused 2001’s massive corporate earnings decline, triggering the recession. While most economists agree that an inventory rebuilding cycle has probably begun it is more difficult to gain visibility on how continued high levels of economic growth can be sustained without additions to capacity, that is, increased business spending. Such business outlays would only be undertaken to make deliberate additions to capacity, which are difficult to justify with capacity utilization at 75% and technology utilization at levels substantially lower than that. This implies that the recent upturn in capital spending is cyclical, meaning likely to exist for the duration of a single cycle, instead of generational, that is, representing such a substantial and compelling enhancement to technology or life style that it transcends business cycles. This could limit the duration of the recovery. We believe this concern has plausibility but would note that more rapid technological obsolescence of plant and equipment, given their much higher component of information technology these days, mitigates this concern substantially.

Another concern continues to be the periodic appearance of pockets of commodity inflation, especially oil. When OPEC agreed last January to continue its production cuts through June, the market breathed a momentary sigh of relief. Assuming the normal amount of cheating (or, put more positively, compliance) OPEC production cuts would reverse last year’s petroleum inventory buildup and stabilize oil prices in the $20 per barrel range. However, oil prices are substantially above that, approximately $25 - 26 per barrel, reflecting, we believe, a $5 premium for the potential of a protracted conflict in the Middle East or a U.S. offensive to remove Saddam Hussein. Because OPEC can choose to bring back any portion of its previous production cuts at any time, any move in the direction of $30 oil is likely to be met with additional supply, driving prices back down. Our own estimate is that, by year end 2002, oil will be closer to $20 than $30 and that oil price inflation will not become a significant worry for the economy.

Still another issue appears to be that the nascent economic recovery could be choked off by early moves on the part of the Federal Reserve Board (“Fed”) to raise interest rates. Higher interest rates, it is believed, would soak up a lot of discretionary consumer dollars, putting consumer spending growth at risk. It is interesting to note, however, that interest rates are currently well below GDP potential. Consequently, the Fed has room to tighten rates by nearly two percentage points before they become truly restrictive. Furthermore, an interest rate increase on the part of the Fed would send a signal to the financial markets that the potential for further ease is gone. Since further Fed ease would be deemed too stimulative, a rate increase could instill confidence in the monetary system and create a more stable environment for the capital markets.

Despite our ongoing concerns, we expect at least a 4% growth rate for Q1 2002. As inventory rebuilding gets underway, it will add between 1 and 2 percentage points to GDP growth this year. The consumer spending portion of GDP could continue to moderate as the year progresses, once the effect of interest-rate-driven big ticket purchases moderates. On balance, however, we find that we must increase our estimate for full year GDP in view of stronger-than-expected economic data. For 2002, therefore, we expect that GDP will increase 3.5%, up from our previous 2% estimate. Preliminarily, we look for a 4% GDP number in 2003.

Inflation always declines during the first year of a domestic recovery and this year will be no exception. The huge gains in productivity, low levels of capacity utilization, strong dollar and low interest rates argue for a low level of inflation in the economy, absent a protracted war effort in the Middle East or other commodity shock. We continue to maintain that inflation will spend most of this year at a run rate well under 2%.