·
We expect relatively strong real GDP growth of
+4.0% in 2005, the 4th consecutive year of economic
expansion.
·
An accommodative monetary policy will transition
to one of neutrality in 2005, as the Federal Reserve increases
short-term interest rates from 2.25% currently to 4.0-4.5%.
·
Inflation should decline from +4.0% in 2004 to
+2.5-3.0% this year.
·
The value of the U.S. dollar should stabilize and
even strengthen later in the year due to slower monetary growth
and higher U.S. interest rates. We expect the trade deficit to
shrink in 2005 based on strong export growth.
·
Although rising interest rates could eventually
act as a restraint on equity valuations, this should be more
than offset by strong economic growth, record earnings, and
reasonable P/E ratios.
·
The 10-year U.S. Treasury Bond yield should
increase to 5.0-5.5% from 4.22% currently. A rising interest
rate environment will make 2005 a difficult year for bond
investments, especially longer-term issues.
Economy
Critics of the
economy have once again been confounded by the above-average
+4.0% growth rate of real GDP over the 12-month period ending in
September 2004. This strong level of economic activity appears
to be sustainable as expectations are for +4% annual growth in
the fourth quarter of 2004 and throughout 2005. If our fourth
quarter 2004 GDP forecast is correct, the economy will have
grown at an annual rate of +4.2% over the past two years, well
above the +3.1% average of the past 30 years.
Strong real GDP
growth of +4.0% is expected for 2005 as a result of the
stimulative effects of extremely low interest rates over the
last 3 years (monetary policy), 3 years of government budget
deficits (fiscal policy), 3 years of dollar weakness (currency
policy), a revitalized corporate sector due to record corporate
profits, an improving employment environment, and continued
consumer spending as personal income is up +4.9% from a year ago
with consumer net worth at record levels.
We expect 2005
to be the year that the trade deficit begins to shrink and
business confidence, capital spending, and hiring return. After
three years of dollar weakness, businesses are finally starting
to benefit from increased export growth and incrementally weaker
import competition. In addition, after falling in 2000 and
2001, corporate profits, as measured by the S&P 500, have
increased by +18%, +19%, and +22% (est.) in 2002, 2003, and
2004, respectively. The rise in profits gives corporations the
confidence and the capital to begin spending for expansion, not
just maintaining their businesses. Corporate managements are
starting to believe in the economy and are increasingly
investing for future growth. Evidence of this can be seen by
the +10% growth in durable goods orders in 2004, an all-time
high in small business optimism, and the return of employment
growth. The increased spending and hiring bodes well for a
longer, more sustainable period of economic growth.
CHART 1: Corporate Profits At Record
Levels and Still Growing!
Federal Reserve
Federal Reserve
monetary policy has been highly stimulative to economic growth
for the last three years and continues to induce expansion (see
Chart 2) despite the recent hikes in short-term interest rates
from 1.0% in June 2004 to 2.25% at present. Easy monetary
policy results in faster economic growth, higher inflation, and
a weaker dollar.
CHART
2: The Fed Funds Rate Still Highly Stimulative!
With strong
growth, rising inflationary pressures, and a weak dollar, we
expect the Fed to continue raising interest rates until the real
Fed Funds rate (nominal rate less inflation) is at a neutral
range of 1.5%-2.0%, which indicates a nominal Fed Funds rate of
4.0-4.5% by the end of 2005. As the Fed increases short-term
interest rates and slows monetary growth, the value of the
dollar should stabilize and even strengthen later in the year.
Because of the
deflation scare in 2002, the Fed has stated that it will err on
the side of growth, which leads us to believe the Fed will pause
when the real Fed Funds rate reaches 1.5-2.0%. The key factor
will be the inflation trend. If the current increase in
inflation proves to be mostly transitory in nature due to the
rise in oil prices and the inflationary effects of the decline
in the dollar, the Fed may be able to stop raising rates sooner
than we anticipate. Since monetary policy works with a 12-18
month lag, it should continue to have a positive effect on
economic growth through 2005 and even into 2006.
Inflation
The rate of
inflation has been increasing over the last two years from +1.6%
in 2002 to +2.3% in 2003 and an estimated +4.0% in 2004. Most
of the increase has been due to the rise in oil as the core CPI
(excludes food and energy) has been fairly stable since 2002.
Core inflation was +2.3% in 2002, fell to +1.5% in 2003 and
increased to an estimated +2.6% in 2004. Despite the increase,
core inflation is still well contained (see Chart 3).
CHART 3: Core CPI Rising But
Still Well Contained
Within the core
CPI, the goods deflation experienced in 2002 and 2003 has ended
with some inflation in 2004, while the services inflation has
actually declined from +4.0% to +3.0%. With oil prices falling,
we expect the overall rate of inflation and the core CPI to
converge at +2.5-3.0% for 2005.
Fiscal Policy
President Bush
is pursuing a strong pro-growth agenda in his second term, which
includes Social Security reform, tort reform, budget restraint,
a new energy policy, and tax reform. Instead of promising
additional giveaways, the President is trying to remove a number
of restraints on our economy and encourage ownership and
capitalism. If he is able to push through much of this agenda,
it will be positive for the economy and our competitive position
in the world. The last pro-growth agenda of this magnitude
dates back to the Reagan Administration. What followed was one
of the longest U.S. economic expansions and one of the strongest
bull markets in history.
Stock Market
The large
capitalization S&P 500 Index finished with a +9.2% return for
the quarter while total returns from smaller capitalization
stocks (Russell 2000) and foreign equities (EAFE) were even
higher at +14.1% and +15.3%, respectively. For the year, the
S&P 500 increased by +10.9%, the Russell 2000 by +18.3%, and the
EAFE by +20.2%. Strong corporate profit growth, the end of the
Presidential election uncertainties, the increased likelihood of
the dividend and capital gains tax cuts being made permanent,
and the relatively robust economic growth fueled the rally. The
weak U.S. dollar contributed to the above-average foreign equity
performance.
Despite the
rebound in stock prices, we still find the case for owning
stocks to be strong. Corporate earnings are continuing to grow,
P/E ratios are reasonable at 16.2 times 2005 S&P 500 EPS
estimate of $74, and longer-term interest rates will still be
relatively low even after a 100-125 basis point increase.
Although concerned about investor reaction to rising interest
rates, we believe that a healthy economy, increasing corporate
profits, and reasonable valuations will be more than enough to
generate solid equity returns in 2005.
Bond Market
The yield on the
10-year U.S. Treasury Bond increased to 4.22% from 4.12% in the
fourth quarter. Our fixed income benchmark, the Salomon Broad
Investment Grade Bond Index, produced a total return of +1.0% in
the quarter and +4.5% for the year. We continue to recommend a
shorter-than-average duration for bond portfolios in
anticipation of a rise in the 10-year U.S. Treasury Bond yield
to +5.0%-5.5% over the next year, resulting from strong economic
growth and higher core inflation. The current 10-year U.S.
Treasury Bond yield is just marginally higher than the rate of
inflation. Bond investors have typically required a +2-3% real
return over the rate of inflation, which is why we remain
relatively cautious on bonds.
Management Meetings
During the
second half of 2004, in addition to having teleconferences with
various corporate executives, members of our investment team
have traveled to Illinois, Maryland, Michigan, New York, Oregon,
Pennsylvania, and Virginia to meet with managements from Midwest
Bank Holdings, Career Education, American International Group,
Cendant, Henry Schein, North Fork Bancorp, Pfizer, Thor
Industries, Illinois Tool Works, Hospira, Compudyne, Fiserv,
Citizens Banking, Comerica, Oxford Bank, Hershey Foods, Dearborn
Bancorp, Virginia Financial, Center Financial, Columbia
Sportswear, Radisys, and La Crosse Footwear.
In accordance with SEC Rule
204-3(b), our Form ADV Part II is available upon request.
Please call or write to Susan C. Beaver, North Star Asset
Management, Inc., P.O. Box 8012, Menasha, WI 54952-8012.
