Executive Summary
·
Strong third and fourth quarter GDP growth should
continue into 2004. Robust corporate earnings growth will accompany
this expansion.
·
The missing pieces of a sustainable economic recovery
are emerging as capital spending and new job formation are returning
and inventory re-building is expected to start soon.
·
Accommodative monetary policy will begin to be
reversed in 2004 as the Fed starts to raise interest rates by
mid-year.
·
Although rising interest rates will eventually have
some negative impact on equity valuations, this should be more than
offset by strong economic growth, record earnings, and reasonable
P/E ratios.
·
A rising interest rate environment will make 2004 a
difficult year for longer-term bond performance. It is suggested
that bond durations be kept relatively short.
Economy
Critics of the
economy have been silenced by its exceptionally strong +8.2% annual
growth rate in the third quarter. The above-average momentum
appears to be sustainable as fourth quarter GDP is expected to grow
by nearly +5% sequentially followed by +4.5% growth for all of
2004. Assuming +4.5% growth in the fourth quarter, the economy
will have grown at an annual rate of +5.3% over the last three
quarters, well above the +3.1% 30-year average. More importantly,
the year-over-year (YOY) growth has accelerated throughout the year
as illustrated in Chart 1.
CHART 1:
The Economy is Growing at an Above-Average Rate.
Strong real GDP
growth of +4.5% for 2004 is a result of the stimulative effects of
rising government spending and tax cuts (fiscal policy), extremely
low interest rates (monetary policy), and two years of dollar
weakness (currency policy). These growth-oriented policies have
encouraged consumer and government spending and will soon shift
business spending into high gear.
Increasing business
confidence and capital spending growth are required to sustain this
economic growth cycle for the next several years. Fortunately, we
have seen clear signs of this in recent months as capital spending
and job growth have turned up and look to be carrying growth
momentum into 2004. In addition, inventory levels are so low that a
restocking trend is almost inevitable this year.
The best leading
indicator of business confidence is corporate profits. After
falling in 2000 and 2001, corporate profits have increased by +18%
in each of the last two years and have surpassed prior peak levels,
giving businesses the confidence and the capital to begin spending
for the future. Capital spending and new job formation are already
on the rise, but inventories continue to fall. Businesses are
currently meeting demand by reducing inventories rather than
increasing production. Even with better inventory management
techniques, at some point in the near future, production must be
increased to meet demand and to rebuild inventories.
CHART 2:
Employment Surveys Indicating Job Growth is Returning
The best signal that
business confidence (and sustainable economic growth) has returned
is new job growth. After two years of job losses, the stronger
economy is finally producing new jobs. In the last four months,
more than 300,000 jobs have been added according to the
establishment survey and more than 1.1 million jobs according to the
household survey (see Chart 2). We expect even faster job creation
in 2004 as new jobs tend to come after corporate profits and capital
spending have rebounded and tend to be more tightly correlated to
rising inventories and production levels.
Federal Reserve
Although the economy
has clearly picked up steam, the Federal Reserve is maintaining the
Federal Funds rate at 1.0%, the lowest level in 45 years. With core
inflation around +1.3%, the real Fed Funds rate has been in negative
territory for 1˝ years and, thus, highly stimulative to economic
growth. As Chart 3 indicates, the decline in inflation has been
primarily a result of actual deflation in the price of goods. The
service sector inflation rate has fallen only slightly to about
+3%. We believe the deflationary policies of the Fed, the strong
dollar and the intense price competition from China caused most of
the decline in goods prices. With economic growth strengthening,
the dollar falling back to 1997 levels, and the return of inflation
in China, we expect goods deflation to be replaced by goods
inflation in 2004. With service sector inflation at +3% and even
modest goods inflation, the overall rate of inflation could rise to
+2.5% or higher by the end of 2004.
CHART 3: Goods Deflation is Ending;
Higher Inflation is on its Way.
For the Fed to move
to a neutral stance, we estimate that the Fed Funds rate will need
to increase to approximately 4.0%, a significant increase from the
current level of 1.0%. It is expected that the Fed will raise
short-term interest rates by at least 200 basis points to 3.0% by
the end of 2004 with more tightening to follow in 2005. Although
strong economic and corporate profit growth is almost “locked in”
for the next year or two as a result of the stimulative policies
previously discussed, the eventual shifting of Fed policy gears
requiring higher interest rates (probably by mid-year) will likely
cause some temporary anxieties among investors, gyrations in stock
valuations, and downward pressure on bond prices.
Stock Market
The large
capitalization S&P 500 Index finished with a +12.1% return for the
quarter while total returns from smaller capitalization stocks
(Russell 2000) and foreign equities (EAFE) were even stronger at
+14.2% and +15.6%, respectively. For the year, the S&P 500
increased by +28.6%, the Russell 2000 by +45.4%, and the EAFE by
+35.5%. Strong corporate profit growth, tax cuts, the capture of
Saddam Hussein, and the very robust economic growth fueled the
rally. The weak dollar also contributed to the strong foreign
equity performance.
Corporate profit
growth drives stock prices in the long run. After increasing by
+18% in 2002, corporate profits, as measured by the S&P 500
operating earnings, are expected to increase by +18% in 2003 and
+14% next year. We believe earnings growth will continue to
surprise investors and support higher stock prices, especially
considering that economic growth appears sustainable, the rest of
the world is recovering along with the US, and foreign operations
(which account for 25% of U.S. corporate pre-tax profits) are
receiving a huge boost from the weak dollar.
Despite the rebound
in stock prices, we still find the case for owning stocks to be
strong considering that earnings are rebounding sharply, P/E ratios
are reasonable at 17.8 times 2004 S&P 500 EPS estimate of $62.00,
longer-term interest rates will still be relatively low even after a
100-125 basis point increase, and cash reserves remain high. We are
concerned about the markets reaction to higher interest rates but
believe the strong economy, rising corporate profits, and reasonable
valuations will more than offset the negative impact of higher
rates.
Bond Market
The yield on the
10-year U.S. Treasury Bond increased to 4.3% from 3.9% in the
quarter. Our fixed income benchmark, the Salomon Broad Investment
Grade Bond Index, produced a total return of +0.4% in the fourth
quarter and +4.2% 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
inflation.
Management
Meetings
During the second
half of 2003, in addition to having teleconferences with various
corporate executives, members of our investment team have traveled
to New Jersey, Illinois, Indiana, New York, Maryland, Missouri, and
Florida to meet with management from Altria, Emerson Electric, AG
Edwards, Anheuser-Busch, Express Scripts, Sigma Aldrich, Stifel
Financial, North Fork Bancorp, Compudyne, Columbia Bancorp, St. Joe
Company, Biomet, Illinois Tool Works, Telephone & Data Systems, and
Molex.
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
