MARKET WATCH | 1.2003
by George Gasson, Assistant Vice President/Portfolio Officer, Mellon Private Wealth Management
george@miaminightout.com

Prospects for economic growth

The economic recovery is sustainable, although it has softened in recent months. The recovery has been weaker than average, but the recession was the shallowest and shortest on record. During 2001, the lone policy tool used to counteract the recession was monetary policy, given that the federal budget was in surplus and the dollar was strong. Policy makers previously had not dealt with such a speculative bubble-induced boom and recession. Presently, the total policy arsenal of the government is aimed toward spurring the economy, boding well for sustained growth. For example, the Federal budget deficit has swung from a fiscal year surplus of $127 billion to a deficit of $158 billion. In fiscal year 2002, the change in the Federal deficit as a percent of GDP was a record.

Absent new stimulus, the fiscal spending thrust may fade, but new policy initiatives very likely will be forthcoming. Burned in President Bush's psyche is the memory of the collapse of his father's high post-Gulf War approval rating and election loss because of a weak economy. Replacing his economic team was one of a number of moves to ensure he does not lose the election due to a weak economy.

Even without new governmental policy initiatives, a number of trends signal an improving economy. Commodity prices and bank loans are rising, which is a good sign for continued growth. Interest rate spreads between low and high quality credits have narrowed, implying that investors believe that the risk of an aborted recovery has faded.

The overhang of capital spending from the dot-com bubble has been working down. Lack of pricing power will maintain pressure on companies' profit margins, restricting investment expenditures. Capital spending should cease to be a drag on overall economic growth but, unlike the late 1990s, it will not be a contributor to above average growth.

Consumer spending in 2002 benefited from wage gains, interest rate declines and rising house prices. The recent spurt in mortgage refinancing and cash out of home equity should support consumer spending for the next few months. By then, the economy will have experienced most of the impact from rising home prices and lower interest rates. Consumer spending in 2003 largely will be dependent on wage gains and job growth. Continued high productivity growth implies little job growth. With inflation low, the 94% of employed Americans, which is a very high percentage historically, should continue to experience good increases in real disposable income and purchasing power. Hourly earnings for workers have increased 2.8% over the past year. Consumer spending growth in 2003 will be less than in 2002, but sufficient to sustain the economy's growth.

The 5.6% increase in productivity over the last year, the fastest growth in thirty years, has been stunning. No factor is more important to sustaining US economic out performance over the long term. It has been particularly notable that the productivity increase survived the stock market bubble, a recession, a slow recovery and the collapse in technology spending. Higher productivity growth does mean that higher GDP growth is required to lower unemployment.
This recovery is tracking the one following the recession of 1990-1991, which also was slow and labeled "jobless." The excesses of the late 1990s remain a drag on the economy. Being optimistic on an upside surprise in growth is difficult because of a weak global economy, the potential war in Iraq, high oil prices, and the threat of terrorism.

Profits

For substantial increases in profits a strong economy is required, which implies meaningful job gains. However, given the tough pricing environment for corporations, substantial growth in jobs will not allow significant profit growth. Some easing of price competition, which is not likely in 2003, would seem necessary for above average growth in jobs, GDP and profits.

The worry over the veracity of corporate accounting largely has passed. Most adjustments to more conservative accounting have occurred. The accounting cleanup and concerns over pension and option charges have caused considerable investor confusion. The range of expected earnings on the S&P 500 always has been fairly narrow. Now considerable uncertainty exists as to the level of earnings, even those that already have been reported. The three-year variability in S&P 500 profits is the greatest since the 1940s. Less predictable earnings imply lower stock valuations than otherwise.

Inflation/deflation

A major reason for the surprisingly poor stock market performance in 2002 was a concern that the US and global economies were entering broad-based deflationary conditions. Japan, of course, offers an example of what can happen to an economy when deflation takes hold. In a deflationary environment, corporate earnings decline because costs cannot be reduced sufficiently to offset declining selling prices. Yet corporations' debts and debt service obligations do not decline. Assets must be sold to pay debts, which can result in a vicious spiral of forced selling at lower and lower prices.

The US Federal Reserve is prepared to do whatever it takes to prevent deflation in the US. If deflation were a substantial threat in the US, bank loan defaults would be surging, which is not the case. In fact, bank loan delinquencies are far below levels reported during the previous recession of 1990-1991. Recently, credit spreads between low and high quality corporate bonds have narrowed, indicating that investors believe the deflationary threat has lessened. Commodity prices are rising, which is a favorable sign of improvement in the global economy.

The substantial government policy response to the deflation threat and a soft economy could lead eventually to an inflation problem, but that is well down the road. In fact, a little inflation in goods prices would be favorable for stocks because it would mean that corporations were able to regain some degree of pricing power. Credit spreads would narrow further, profits would improve and job growth would resume. For the foreseeable future, inflation will remain very low. Service prices will continue to increase, while prices for goods will remain soft. China will continue to offer a tremendous competitive challenge for goods' pricing. Factory payrolls in the US have declined for 28 consecutive months, reflecting the very competitive global economy.

Fixed income investments

High quality fixed income investments have benefited from a soft economy, frightened stock investors, the threat of deflation, corporate governance issues and geopolitical risks. As some of these concerns fade and conditions improve, interest rates likely will move somewhat higher. Political efforts over the next two years will be directed toward improving economic growth and the stock market. Later in 2003, the Fed will begin taking back some of its deflation protection cuts in short-term interest rates. With increased confidence that deflation is not taking hold in the US and that the economic expansion is sustainable, interest rate spreads between low and high quality credits will narrow. While interest rates on Treasury securities are expected to rise in 2003, high yield and lower quality bond rates should reflect a lessening of investor concern over default risks.

Tax-exempt bonds were issued in record amounts in 2002. Budget gaps in state and municipal finances suggest that the supply of new issues will remain relatively high in 2003. Tax exempt bonds have benefited from many of the same factors that have driven interest rates on Treasuries lower, namely the soft economy, frightened stock investors and geopolitical risks. We expect investors to be less risk averse in 2003. Thus, interest rates on tax exempts likely will rise somewhat.

The stock market

Corporate misdeeds, profit adjustments, the threat of deflation and a continued unwinding of the speculative market of the late 1990s resulted in the surprisingly poor stock market performance of 2002. After the substantial two and one-half year decline, stocks cannot be expected to immediately embark on a new bull market. It is as if the market went through major surgery and now an extended period of convalescence is required before normal activity can resume. A speculative bubble, like the one at the end of the 1990s, will take several years to fully unwind. The market lows of September 2001 and this past July and October were attempts by the market to complete a foundation and form a major bottom. Investors' fright and selling pressures at the October low were characteristic of major market bottoms. No one can know whether early 2003 will see a test of previous low points or even a new low, but we believe that the period of major market risk has passed.

Asset allocation

Unlike the 1980s and 1990s when a concentration on large capitalization US stocks and bonds was very rewarding, we continue to believe that for the next several years broad asset class diversification will produce the best combination of return and risk.

• Large cap US stocks should remain the core of a portfolio. Stock valuations seem reasonable. Uncharacteristically, stocks fell over the past couple of years as interest rates on treasury bonds declined. We do not expect any rise in treasury interest rates in 2003, reflecting a diminishing deflation threat, to impede stocks moving higher. Valuations on small and mid-cap US stocks remain attractive and these stocks deserve a meaningful portfolio allocation.
• Abroad, Japan continues to frustrate investors because of its ineffective policy response to very serious economic problems. We remain interested because of the potentially explosive upside should Japan ever take the steps to resume a consistent growth pattern. Europe, aside from the UK, has nowhere near the economic attractiveness of the US; however, stock valuations reflect this reality. We do believe that the dollar is overvalued given the US's major trade deficit and, as we expected, the dollar declined relative to the euro in 2002. Investors tend to hold currencies with solid economic growth and the US remains the best place to invest. Thus, we expect the dollar to give ground very slowly relative to other currencies. The opportunity to protect against a possible decline in the value of the dollar and potential in Japan are reasons to have a representation in developed international markets.
• Emerging markets were good relative performers in 2002. The world's best prospects for growth and most dynamic economies are in Asia. In a world of low returns, the emerging markets offer potential for higher, although volatile, returns.
• During the substantial market decline of the last two and one-half years, equity long-short hedge funds probably have seen their greatest performance advantage relative to long-only managers. However, the stock market's volatility likely will continue. Significant moves in the market, both up and down, which are sustained for a number of months, are tailor-made for the trading orientation of hedge funds.
• Since we expect credit spreads between low and high quality credits to narrow as investors' risk aversion declines, high yield corporate bonds should provide returns competitive with stocks.
• Major risks include the geopolitical situation, a soft world economy and a tinge of inflation in the air. Fixed income investments continue to offer a hedge against the volatility of stocks in such an environment.

 

Article courtesy of George Gasson, Assistant Vice President/Portfolio Officer,
Mellon Private Wealth Management
george@miaminightout.com