Economic Outlook
Measured Change
The Federal Reserve has raised the Federal Funds rate for the first time in over four years, as the economy is coming off an extended period of massive monetary and fiscal stimulus that has allowed easy and inexpensive credit to support consumer and business spending. Recently, the economic pendulum has been kept in motion by the deflation-inflation dialogue. Currently, economic momentum and its longevity have replaced deflation as a conversation partner. Opinions are divided as to the effect that the timing, size, and appropriateness of the recent rate hike and those that may follow will have on our current recovery process.
The current unemployment rate suggests that there is still slack in the labor market. Although the US economy has added approximately 1.2 million jobs since January of this year, employment growth slowed in June, as the government reported 112,000 new jobs in the US economy last month, well short of many Wall Street forecasts. The gain was about half of May’s revised gain of 235,000 jobs, and after three straight months of strong reports, marked the weakest jobs report since February. The lackluster growth in June may set the tone for the second half of 2004, as many companies, particularly small ones, may be hesitant to hire in what they consider to be a fragile economy. Persistent violence overseas and uneasiness ahead of the November presidential election have created a tense environment in which inaction is becoming the watchword among hiring managers. Looking beyond the June payroll report and continual monthly statistical “noise” however, the trend in job growth has been positive, as are rising income levels. According to the Commerce Department, wages and salaries are now rising at an annual rate of 5.00%.
We see productivity as a key variable in determining how fast the economy will grow and whether that growth is sustainable. New technology and improved business practices helped squeeze more output from fewer workers, and pushed the current productivity rate well above the historic fifty-year average. With average productivity growth of 4.5% since the beginning of 2001, uncertainty looms over just what rate of productivity growth is sustainable, or, indeed, how far it might drop. This is worrisome because, should these productivity gains decelerate, companies will have to boost prices in order to maintain their profit margins.
As we enter the season of corporate earnings announcements, the focus will again be on a primary determinant of equity prices: future earnings. The past few years have been especially kind to US companies. Profits are rising at a double-digit pace while tax-law changes have created generous depreciation allowances. Companies as a whole have seen their cash flow surge by 24.2%, and have spent over half of that on capital expenditures and have reduced debt as well. Businesses will most likely keep up the pace of capital goods spending through the remainder of the year, as the tax credits for this business investment activity expire at the end of 2004.
Certainly, rising short-term interest rates can impact profit growth. At this point, however, short-term rates are artificially low, both from an historical standpoint and relative to inflation. Assuming by late 2005 that short-term rates rise to a level closer to their long run average (between 3.00% and 4.00%), very few projects that are currently viable would be cancelled because the cost of borrowed funds becomes too high. The economic and stock market boom of the 1990’s saw yields on the 10-year Treasury ranging between 5.00% and 6.00%. The 4.50% current yield on the 10-year Treasury, or even an increase in the yield to as high as 5.50%, would have only a modest effect on capital expenditures.
For consumers, who hold the bulk of the nation’s wealth and represent two-thirds of its spending, high debt coupled with rising interest rates is not a palatable combination. In addition, the effect of last year’s tax cuts is waning. However, while some consumers will face higher interest rate costs on floating-rate debt, many have locked in low cost, fixed rate mortgage financing. The rise in housing prices will likely decelerate over the next 18 to 24 months as interest rates rise, crimping consumer wealth, but not deflating it.
Oil prices have jumped 30 percent this year due in part to supply-and-demand problems. China, now the world’s second largest oil market, has been a huge driver of oil demand, with import growth up about 40 percent so far this year. The weaker US dollar is another factor in the rise in oil prices. A 10 percent drop in the dollar against currencies of other oil-consuming countries means a 7.5 percent rise in the dollar price of oil. Although oil — and natural-gas — prices have risen sharply, they will likely have only mild effects on overall economic activity, making the Gross Domestic Product (GDP) only about 0.9 percent lower than it would otherwise be. Businesses also have more experience with energy price shocks; they understand how to manage the shocks that affect them and how other segments of the economy will respond.
The scale of the current US budget deficit, projected to be $477 billion in 2004, can cause a fundamental shift in market expectations and a related loss of confidence both at home and abroad. The era of large and lasting deficits can lead to decisions by international investors to shift out of dollar-based assets, thereby sparking a fall in the dollar and a more ratcheted rise in interest rates.
Does the latest Fed move signify a major change in our economy? The recent less-than-expected job number suggests that the economy is still growing, just with less momentum. Despite the slack in the labor market, we are seeing increasing pressures for inflation, with the Commerce Department’s most recent report stating that the Personal Consumption Expenditures Index had its largest increase in 14 years. In the June Chicago Purchasing Managers report, the inflationary expectations were confirmed as the Index of Prices Paid rose to 84.5, from 80 in May. This is a huge month-over-month increase of 5.6%. However, neither the Fed nor others can be sure if the recent surge in inflation is an isolated event or a return to the era of rising prices. Fed Chairman Greenspan is expected to be cautious in increasing rates too quickly in order to avoid one of the rare blunders of the Greenspan years – a string of increases in 1994, which followed a long period of low rates, that caught the financial markets by surprise. The subsequent financial chaos contributed to the Mexican peso crisis and the bankruptcy of Orange County, California.
The downwardly-revised final release of the first quarter GDP indicates economic growth increased by 3.9%, a solid pace but lacking the verve we experienced entering 2004. The downward revision reflects the drag created by the yawning trade deficit and moderated consumer spending. The advance estimate of second quarter GDP will be released this month which we predict to be in the 4.0% range, modest but not meek. Notwithstanding any shocks on the geopolitical front or dramatic moves on the pricing front, the Fed has room to raise rates in digestible increments. While financial conditions will likely tighten more, we feel that the gradual pace, and the continuance of the economy’s momentum, will mean a measured change on the consumer and corporate front, not a fundamental change. With this likely to be Greenspan’s last term, many feel he wants to leave on a high note to secure his legacy, and to do this, he can’t lead the Fed in an overly aggressive way.
