"Let Slip the Dogs of War"*
The Economy and Stock Market Investors Watch and Wait

For the first quarter of 2003 common stocks, as measured by the S&P 500, declined -3.2%, continuing their long slide and completing three full years of a bear market. Laden with economically sensitive names and exposed to petroleum stocks the Dow Jones Industrial Average fared somewhat worse, down -3.6%.
Bonds, on the other hand, continued the very favorable performance relative to stocks that have been generated for several years. For the first quarter of 2003 fixed income instruments, measured by the Lehman Brothers Government Corporate Index, were up +1.6%, as bonds continue to respond to a weak U.S. economy.

International stock funds declined –8.3% and equity mutual funds were down –3.3% according to Lipper Inc.

Fourth quarter 2002 real Gross Domestic Product (“GDP”) was revised upward to an increase of +1.4%, double the preliminary number of +0.7% but still reflective of the deceleration in economic activity that was evident throughout that period. A large slowdown in export activity as well as much lower spending on motor vehicles contributed to subpar fourth quarter economic growth. The upward revision, however, brought full year 2002 GDP to +2.4%, an acceptable slow growth number when compared to the recession-impacted +0.3% for all of 2001.

Early economic reports in the first quarter of 2003 showed encouraging signs of reversing the doldrums that pervaded U.S. economic activity last fall. The unemployment rate ticked down and industrial activity increased. By February, however, economic data turned soft again and, exacerbated by looming war rhetoric, March economic results were dismal. At present the economy appears to be held captive to geopolitical uncertainty, as evidenced by delays in inventory rebuilding, delays in starting capital spending projects, continued efforts to reduce the workforce and lowered earnings guidance from those companies that issue guidance.

Nor is all the inactivity confined to the corporate side. Recent reports show consumer sentiment was near ten year lows, auto sales were sputtering and retail sales declined. Even the housing market which, thanks to historically low interest rates, single-handedly propped up the economy last year and kept the recession from becoming much worse, now looks as if it may be turning down.

One important impact of the Iraq War is the substantial negative exerted by the huge increase that has occurred in the price of oil. You will recall that we predicted, in our last two quarterly comments, that the price of oil was likely to reach levels as high as $40 per barrel in a shortage-driven prewar environment and, in mid-March just prior to the start of hostilities, April light sweet crude futures reached $39.99. While we are gratified at the correct conclusion reached by our analysis we dislike being proven right in view of the havoc high oil prices are creating for the economy. With the price of a barrel of oil exactly twice as high as it was fifteen months ago gasoline prices have increased 30 - 50%, driving up inflation, as measured by the Consumer Price Index (CPI), and taking a huge bite out of the consumer’s income. Oil sensitive corporations are reducing their estimates of future earnings. Hence, real income, profits and, more recently, jobs are coming under pressure.

Now that the war is significantly underway, the price of oil has plummeted just as it did in the days immediately following the start of the first Gulf War. The long term effects of the recent spike in oil prices have yet to work their way through the economy. Anecdotally, consumers appear to be paying approximately forty cents per gallon more for gasoline than they did six months ago. Should this situation continue it could remove as much as one percentage point from GDP this year as every sustained penny increase in the price of gasoline takes over $1 billion out of consumer spending. Now that the price of crude has pulled back substantially and it looks as if the war effort will not be as protracted as some had feared, gasoline prices can seek a lower level and the negative impact of higher oil prices on the economy may end up being confined to the first half of the year.

The employment situation continues to deteriorate, however. Nonfarm payrolls in February posted their largest decline since November 2001, down 375,000 jobs. Jobless claims surged by 38,000 people in the March 29th week, a negative surprise providing evidence that the labor market continues to deteriorate. While Reservists entering active duty probably caused part of the decline, as did blizzard conditions throughout a great portion of the United States, it is also likely that higher oil prices contributed to the downturn as well.  Higher oil prices act as a damper on traveling for either business or pleasure and substantially increase the cost of making such products as aluminum, paper and chemicals. It is understandable that these industries would try to hold the line on costs by laying off additional workers where possible.

We expect between one half of one percent and one percent to be removed from GDP this year, depending on the impact of oil prices. We are lowering our current forecast of GDP growth for 2003 from +2.7% to +2.4%, giving some effect to the negative impact on the economy occasioned by high oil prices. We are also increasing our estimate of inflation for the same reason and estimate that the CPI will end 2003 up +2.4%.  Previously, our estimate for 2003 inflation was around +2.0%.

High oil prices, a nearly-stalled economy and a country at war can’t help but raise the specter of another recession. After all, an industrial downturn was already underway when the September 11th disaster occurred in 2001. The resulting stoppage of economic activity generated negative growth in GDP. In 1990, oil prices also spiked prior to the Gulf War and the economy went into recession. Why wouldn’t the same thing happen again?

The answer is: it may. But we don’t think so. While there is no doubt that the risk of recession has been elevated along with the price of oil, we think several important things militate against such a downturn.

First of all, the price of oil alone did not cause the 1990 - 1991 recession. Economic conditions were very different then. The yield curve was inverted, interest rates were comparatively high and monetary policy was very tight as the Federal Reserve Board (“Fed”) was oriented toward fighting inflation. Today, the yield curve slopes upward, interest rates are low, credit is plentiful and monetary policy is easy.

Second, the very fact that inventories remain low is positive economic news. In previous periods of high oil prices, spending was curtailed by an increase in the price of oil, leaving corporations sitting with unsold inventory. Companies had no choice but to cut production. Today, inventories are already lean so a slowdown in spending occasioned by a period of high oil prices does not result in production cuts. In fact, the need to rebuild inventories at the first sign of a spike in demand is a very positive sign for future economic activity. The same is true for capital spending, which has slowed, not stopped.

Third, it looks as if the Iraq War will not result in a confidence-sapping catastrophic event. In 1990 - 1991 rumors were rife about Iraq’s huge cache of biological and chemical agents, its crack Republican Guard, the suicidal commitment of its troops and the fact that they had a secret stash of sophisticated weapons. Yet the allied troops who fought the Gulf War had, in the aggregate, a fairly easy time of it. While it is premature to call the end of this War at this stage it does appear to be going well for the Allied forces.

Fourth, the Fed is keeping the economy awash in liquidity. The year-over-year growth rate in the money supply is at 7%. In fact, in a purchasing power context, the fed funds rate is now negative, meaning that, if a borrower could borrow at the fed funds rate, money is being given away after adjusting for inflation, that is, the lender is effectively paying the borrower to borrow. This has not occurred since the period immediately after the Gulf War in 1991. However, in the absence of growth in the economy, too much liquidity has the potential to be inflationary. We remain alert for signs that plentiful liquidity will have a negative effect on inflation. Continued lack of stimulative effect and a sustained move upward in traditional inflation harbingers, such as commodities, are two indicators we watch.

Finally, we must factor in the economic effect of fiscal policy. The year 2004 is an election year and the outcome of the tax bill is still uncertain. But, if the magnitude of tax cuts in the second half of 2003 is $50 billion LARGER than investors are currently assuming, as has been suggested, the impetus to spending and the economy could be enormous.

It is important to understand, however, that the war is covering up a lot of negative economic news. Unemployment is hovering very close to 6% and the fledgling and anemic recovery is continuing, virtually without job growth. Capacity utilization remains in the low 70’s, where it has been stuck for months, around 73%. With slack in the labor market and low capacity utilization, there is likely to be downward pressure on wages before the economy can “get its legs under it” and resume an upturn. If the war became protracted, if occupation of Iraq became a reality requiring the presence of tens of thousands of American troops for an extended period of time, or if another terrorist event or other external shock occurred, the U.S. economy just does not appear to have a lot of resilience left in it.

However, on balance and for all the reasons cited earlier, we expect that a double-dip recession will be avoided. In fact, once past the horror and uncertainty of the Iraq War, we should be facing lower oil prices, an inventory rebuilding and capital spending cycle, however modest, and continuing and substantial fiscal and monetary stimulus. It should be remembered that the U.S. economy has been expanding for approximately a year. While it slowed in the fourth quarter of last year, it moved into an acceleration mode during the first quarter of this year, only to have momentum curtailed by the Iraq War. A resumption of sustainable growth, accompanied by the environment outlined above, would go a long way toward restoring consumer, business and investor confidence.

*From Julius Caesar, by William Shakespeare