Economic Outlook
Blinking Yellow Light -- Proceed with Caution
We look beyond the short-term “noise” in the equity and fixed income markets, and believe the economy will continue to motor ahead, despite a few potholes. The economic recovery that began in late 2002 is in its third year. A review of the stock and bond markets shows the Lehman Brothers Intermediate Bond Index, a proxy for the bond market, returned a negative -0.9% for the first quarter of 2005. The Standard & Poor’s 500 Index, which is a broad measure of the US stock market, had a negative return of -2.2% for the quarter.
The US housing market remains relatively strong. New home and existing home sales remain historically high, although both have likely peaked and will continue to moderate this year. One factor that may precipitate the moderation is that mortgage rates have begun to creep up in response to additional rate increases by the Federal Reserve (Fed). As the Fed began its rate-hiking campaign in June 2004, mortgage rates actually fell more than half a point, from 6.3% to about 5.6% in early February 2005. Now, with the most recent rate increase occurring at the March 2005 meeting leaving the Federal Funds rate at 2.75%, most economists are predicting that longer-term rates will eventually move higher.
For the past year, markets have been reassured by both the Fed’s own rhetoric that inflation was under control, and by the price indices. However, at its most recent meeting, the Fed continued to voice concern about future inflation, and shortly thereafter, the Labor Department announced that consumer prices rose 0.4% in February, compared with only 0.1% in January. Oil and food prices provided the biggest push, but even without those two volatile elements, prices increased by 0.3%. If inflation gets a foothold, the Fed could end its policy of “moderate” interest rate increases and pick up the pace in an effort to make borrowing more expensive and slow the economy.
Traditional forward-looking inflation indicators, such as gold and other commodity prices, have been flashing red for some time. While they fell for a time last year as the Fed started to raise rates, these prices have rebounded again. Part of the reason for the commodity price rally of the past year or so has been attributed to the US dollar’s decline, which makes the dollar-denominated assets more affordable in other currencies.
US oil prices have surged by more than 30 percent this year, recently hitting record levels. Demand is surging worldwide, particularly in India and China. In his most recent pronouncement, Fed Chairman Greenspan said that oil inventories could expand enough this summer to “damp the current price frenzy.” He also called the lack of spare refining capacity “worrisome.” Greenspan, who was addressing a conference of petroleum refiners and processors, didn’t promise that prices would fall substantially, nor did he venture any estimates of how much the recent price increases might affect the economy.
Overall, the US economy seems to be healthy, and may be transitioning to a slower, more sustainable growth rate that allows interest rates to stay tame and allows stock prices to move gradually higher. With more moderate growth in the US economy, investors will feel an increased need to determine which companies will rise to the top in this new environment. Increased opportunities may be found for high quality US-based multinational companies that can increase their exposure to other faster-growing economies, such as those in China and India. The main threat to this current expansion isn’t the savings rate, the trade or budget deficit, or any of the other media fads. The real danger is a renewal of inflation that forces interest rates higher than they would otherwise have to be, and a continuation of oil prices staying at higher levels. While the future of oil is hard to control and forecast, we are confident that the Federal Reserve will not give up its fight on inflation.
