Economic Outlook
The Resilient US Economy
Equity markets were notably stable given the challenges the economy faced dur-ing the third quarter of 2005. The Federal Reserve’s (Fed) interest rate hikes, US operations in Iraq, surging commodity prices, and the bankruptcy filings of Northwest Airlines and Delta Airlines had little negative effect on equities. To date, the effect that the catastrophic hurricanes Katrina and Rita will have on the equity and fixed income markets is decidedly vague. The sheer vastness of the destruction, the inability to determine accurate economic data, and the widespread instability these natural disasters have caused in so many sectors has left many companies in many industries unable to ascertain the true effect on their earnings. As we move through the current earning season, we believe the ensuing market volatility from many earnings surprises will provide opportunities for seasoned investors like Oakwood.
Year to date, the S&P 500 Index, a measure for the broad equity market, has returned a mere +2.85% through September 30, 2005, and the Dow Jones Industrial Average ended in negative territory, with a return of -0.14% year-to-date. The fixed income markets, as measured by the Lehman Brothers Intermediate Bond Index, returned +1.06% year-to-date. The yield curve remained rather flat, with shorter-term rates continuing to rise. The 10-year Treasury note stubbornly remains around 4.40%, after beginning the year at 4.25% and beginning the third quarter at approximately 4.00%.
Higher interest rates have helped the dollar to strengthen, reaching its strongest level in more than sixteen months against the Japanese yen and hovering near three-month highs against the Eurodollar, as investors are trading on expectations of still higher US interest rates. International interest rate differentials continue in favor of the US dollar, which is a factor in the dollar’s strengthening. Non-US investors are betting on more rate hikes by the Fed and widening spreads between fixed income securities of the United States and those elsewhere, attracting foreign investment. As stated, the US 10-year Treasury note is yielding around 4.30%, compared with around 3.18% for the Eurobond equivalent and around 1.56% for its Japanese counterpart.
The US real estate market has been a relative pillar of strength, benefiting from below-6% mortgage rates and strong, although slightly decreasing demand, in the midst of a storm of economic risk factors - including oil prices pushing well into the $60-plus a barrel range. The spread between long-term fixed rate mortgages and shorter-term adjustable rate mortgages has been narrowing, suggesting that at some point fixed rates will move to regain a more historically normal spread from their adjustable rate counterparts. We don’t anticipate this to be a rapid move, which means the housing market will continue with favorable conditions through the end of this year, with slowly rising mortgage rates remaining in the “comfort zone” of most homebuyers for the time being. The downside of the hot housing market, of course, has been the reliance of the US consumer on borrowing against the escalating prices of their homes, extracting nearly $600 billion from the values of their properties last year. This equates to a startling 6.9% of after-tax income and has contributed to relatively strong retail sales in the consumer discretionary sector.
While the US economy has maintained moderate economic and job growth in the past year, continued risks such as rising oil prices will likely linger and persist, thereby exacerbating concern about the health of the economy. Oil prices have certainly dominated the headlines, and other energy prices, such as heating oil and natural gas, are beginning to cause concerns as well. Since the beginning of the summer, the price of natural gas has doubled. Those companies with pricing power, such as many of the dominant high quality companies in Oakwood client portfolios, will be able to pass along these increased energy costs to their customers. Those that can’t will be suffering a reduced bottom line. It now appears that for the full year 2005, US energy expenditures are expected to rise to $1.08 trillion, up 24% from last year. That represents 8.7% of US annual gross domestic product (GDP), the biggest percentage share of GDP since 1985.
We believe that the impact of government spending related to the natural disaster recovery could add further inflationary pressures. The government has committed to spend $60 billion by the end of October, with plans in the works to funnel an additional $150 to $200 billion into the region over the next several years. To give you a sense of the stimulative power, this is twice the size of the Bush administration’s 2003 tax cuts. In addition, the supplemental expenditures for US defense-related activities in Iraq, while certainly stimulative to the economy, are adding their own inflationary pressures. The supply shocks from Hurricanes Katrina and Rita to sectors outside of energy add to potential core price pressures. Supply shocks differ from demand shocks. Unless demand slows by as much as the loss of output, shortages and production bottlenecks will push up prices across a broad range of goods and services. A lasting slowdown in demand doesn’t seem likely but we are continuously reviewing data from both the consumer and business sectors.
