Economic Outlook
As Usual, the US Economy Adapts

After suffering broad losses during the first quarter of 2005, US stocks rebounded in the second quarter of this year, as widespread fears about inflation were somewhat abated. Meanwhile the economy continued to show signs of moderate but healthy growth. These and other factors led stocks to almost recoup their first-quarter losses, although they did give up some of these gains near the very end of the quarter. Bonds also enjoyed a surprising rally, due to a proactive Federal Reserve (Fed) and mild inflation news. The following table provides a summary of the returns of the Lehman Brothers Intermediate Bond Index (L/B - Int.), a proxy for the overall bond market, and the S&P 500 Index (S&P 500), a proxy for the broad US stock market. We have also included the narrower Dow Jones Industrial Average (DJIA), an index comprised of 30 large, mainly industrial “blue chip” stocks and the NASDAQ Index, whose composition includes mostly technology stocks.

The growth in both the economy and the labor market over the past months has been moderate enough that inflation has been milder than expected, especially considering the current volatility of energy costs. The Fed announced its widely-anticipated ninth consecutive quarter-point increase in its short-term interest rate target, to 3.25%, when its meeting ended on June 30th. The Fed said that pressures on inflation “have stayed elevated” but repeated a comment it has made in past statements that “longer-term inflation expectations remain well contained”. Historically, as the economy has been in an expansionary phase and the Fed has been tightening its short-term Federal Funds rate, the long end of the yield curve has usually risen as well, creating a parallel shift in the yield curve. Currently, during this round of nine consecutive interest rate hikes, the long end of the yield curve has not shifted upward in a parallel fashion. In fact, the long end of the yield curve has actually come down, creating a flattening of the yield curve, and narrowing the interest rate spread between short- and long-term rates.

Investors, although encouraged by the decent growth in the economy, moderate job growth, and low inflation trends, have been confronted by the headwinds of skyrocketing energy costs. In the current US economic expansion, the markets have shown that they can tolerate a price of $50-plus per barrel of oil. Despite these record oil prices, gross domestic product (GDP) grew 3.9% over the course of 2004, and the latest revision to GDP shows the economy grew at a 3.8% annual rate in the first quarter of 2005, when oil prices began their latest climb. With crude prices breaching $61 a barrel in the first full week of July, it remains to be seen what effect these sustained record prices will have on the economic expansion rate.

Crude oil prices have increased more than 50% in the last year and have accounted for 85% of the rise in retail gas prices. The average price for regular grade gas in the week of July 4th was at $2.26 a gallon. These higher prices have historically acted as a quasi-tax on the consumer, inhibiting economic growth. However, as shown in the healthy GDP numbers, the oil price spike and its corresponding filtering down to gas prices has not resulted in a significant slowing of the economy. One possible explanation when talking about the lower impact of rising energy costs on our economy is that energy consumption per dollar of GDP has fallen. For example, energy consumption per dollar of GDP today, is only half of what it was in 1950. Oakwood will continue to be vigilant in watching the effect of oil prices on the overall economy and the holdings in your portfolio.

This most recent round of oil price increases comes as the economy faces challenges such as a rising dollar and the likelihood of a less accommodative monetary policy. So far this year, the dollar has risen about 3.5% on a trade-weighted basis. The effect of the cheaper dollar is disappearing, dampening the export growth US manufacturers expected in the second half of 2005. As we correctly observed in the 2004 year-end edition of the Oakwood Outlook, changes in exchange rates relative to the dollar have limits. As the dollar decreases relative to other currencies, foreign goods become more expensive by the same percentage as the dollar decrease. 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 becomes so cheap that there are more buyers than sellers, thereby reversing the dollar’s fall, which describes the current strengthening trend of the dollar and the corresponding reduction in the balance of payments.

On the global front, we see Japanese corporations recording record profits, but not engaging in much capital spending. Chinese companies are pushing to invest wherever they can, but the country is getting so much money from exports that it has billions to spare, including $18.5 billion that China National Offshore Corporation (CNOOC) bid for Unocal. The surging oil prices are giving oil producing countries such as Russia and Saudi Arabia far more money that they had anticipated. The International Monetary Fund (IMF) predicts that in 2005 the worldwide savings rate should hit its highest level in at least two decades. The following chart shows the expected level of savings for many countries that are big savers, in relation to the US, which is expected to remain an enormous borrower.

If global savings are channeled in the right ways, they can be a great catalyst to the world economy, enabling investments and risk-taking that fuel growth. However, instead of going into productive investment, cheap money may be overheating spending and sending asset prices soaring too high. Globally, investors are used to watching economic news and events in the US for use as economic signposts – for example, actions of the Fed and the levels of federal budget deficits – but in a global economy awash in savings, investors must increase their assessment of events outside the US and the implications for the companies owned in their portfolios. Oakwood’s global approach to research allows us to uncover those multinational companies that capture the advantages of such global economic trends.