Economic Outlook
Texas Tea and Hedonics - A Bitter Brew to Swallow

As with investment results, it is important to look beyond the numbers to get at the real economic story. A review of the stock and bond markets shows the Lehman Brothers Intermediate Bond Index, an accurate proxy for the bond market, returning a +2.71% for the quarter, with a year-to-date return of +2.59%. The Standard & Poor’s 500 Index, which is a broad measure of the US stock market, had a negative return of -1.87% for the quarter, with a return of +1.51% year-to-date. The oldest continuing US market index, the Dow Jones Industrial Average, is comprised of 30 of the largest and most widely-held US public companies. This index showed a loss of -2.90% for the quarter, and a loss of -2.09% year-to-date. A look at the dynamics of the economy sheds light on what is driving these returns. Economic indicators give economists, research analysts, and investors help in grasping economic trends. However, even these tried-and-true indicators may at first glance tell one story, but upon closer examination tell another.

For example, the core Consumer Price Index (CPI), the widely used measure of inflation, is running at just under 2%. Since seasonal and other factors can cause extreme price fluctuations in energy and food, our focus is on the “core” CPI, which excludes these two volatile sectors. The CPI has come under attack for its use of hedonics, a descriptor for the governmental practice of deflating prices on certain goods if the “quality” of the product is judged improved over the past twelve months, even if the actual price goes up. An example would be prices on desktop and notebook computers which have declined approximately 8% during the past decade, but due to the improvement in computer power and memory, their hedonically adjusted prices have dropped by 25% a year since 1997. While there are certainly some benefits from quality improvements in the cost of goods and services, the extent of the hedonic adjustments is astounding, with no less than 46% of the weight of the US CPI subject to hedonic adjustments. These adjustments are adding 1% to 1.5% of real Gross Domestic Product (or GDP) growth by cleverly lowering inflation by the same amount.

Despite the somewhat benign core CPI number, we do see inflation of the cost-push variety in the economy. Commodity prices as measured by the Commodities Research Bureau Index (composed of raw materials used by manufacturers) increased 17% over the past twelve months, and were accompanied by skyrocketing energy prices. These costs have yet to be pushed through to the end user. Instead, the benefit from tremendous productivity gains is offsetting the squeeze that these costs are putting on corporate margins. This offset will be difficult to sustain and eventually will have to be passed on to the end user.

Global economic growth is driving the increase in commodity prices. The International Monetary Fund estimates that global GDP will grow by 5% in 2004, moderating to a still robust 4% to 4.5% rate in 2005. In the US, we are seeing estimates of 3rd quarter 2004 GDP growth in excess of 4.0%. Despite this, the US government’s balance of trade and investment flows are rapidly deteriorating, heading towards an unprecedented 6.0% of GDP, a 25% increase from last year. The US now owes $3 trillion abroad, up 100% since the year 2000. Currently, non-US creditors are the source of two-thirds of America’s net domestic investment. If these investors lose confidence in the US economy (i.e., if they see inflation rising or GDP declining), they could quickly sell billions of dollars worth of Treasury instruments, sending the dollar plummeting and sparking a global currency crisis, and the havoc that ensues, including a possible recession. The US must develop a mandate to reverse the fiscal deficits that absorb our domestic saving and force us to borrow so heavily. We must boost sales of US products abroad by developing a workforce that can clearly dominate high-skill, high-wage global industries. Government and business officials must press Asian and European nations to deregulate their own economies to open them to more imports and stimulate GDP.

On the oil front, the effect of spiraling prices has neutralized much of the real positive news about the economy. Oil prices have jumped over the past year, hovering at over $50 a barrel. Higher demand is an important factor in rising prices, but doesn’t totally explain the surge. Supply issues are a significant force behind the price rise, with no significant capital expenditures or increase in productivity being seen from current producers. Political factors, such as the problems between Lukos Oil and the Russian government and in the Middle East, combined with the higher demand of the upcoming winter season, all add to the tightness in supply. China’s demand for oil has continued to surge, on top of supply worries exacerbated by terrorist fears and the Iraq situation. The role of speculators is a factor in the oil markets, with some analysts estimating an additional $5 to $10 a barrel due to speculator involvement.

Consumer spending accounts for two-thirds of US GDP. Consumer assessment of the economy has been slipping, due in part to rising gasoline prices, but based mainly on worries about the labor market. September’s report shows that companies added 96,000 jobs to their payrolls during the month, well under economists’ forecasts. This data comes at a critical time for the economy. Federal Reserve officials remain confident that the economy is back on track from the unexpected slowdown that struck in late spring and through much of the early summer. But many private-sector economists and the bond market are taking a less optimistic view of current and future conditions, and are increasingly questioning the need for future Fed interest-rate increases.

What do we think about the upcoming presidential election? What history shows us is there is always a bit of short-term relief after a contentious election, regardless of the outcome, with a resulting rally. Oakwood’s long-term perspective and its proven investment discipline holds steadfast in and through any political or economic environment. We note anecdotally that Vietti Foods of Nashville is marketing two canned bean recipes, one for Bush and one for Kerry. The Bush label is called “Conservative Republican Texas Chili Beans” and claims “Dubya would love ‘em.” The Kerry beans are called “Liberal Democrat Boston Baked Beans” and are described this way: “Liberally-spiced Boston beans married to a rich ketchup-based sauce.” Sales at last count were about equal. An executive of Vietti Foods says: “It’s not scientific,” but “it could be a barometer of public opinion.” Look for the validity in that.