·
Strong economic growth is locked in for the second
half of 2004. We look for real GDP growth to approach +5% this
year, the strongest annual expansion since 1984.
·
Strong economic growth appears sustainable as
businesses are finally beginning to hire new employees. Over
1.3 million jobs have been produced this year through June.
·
Corporate profits are at record levels and
continuing to grow rapidly. S&P 500 earnings are expected to
increase by nearly +20% in 2004. Earnings momentum should
continue into 2005 with earnings up over +10%.
·
The rise in interest rates has had some negative
impact on equity valuations, but strong economic growth, record
earnings, and reasonable P/E ratios should more than offset
this.
·
Rising inflationary fears and stronger economic
growth indicate higher interest rates ahead.
·
Fed began raising
short-term interest rates in June. Fed Funds rate likely to
reach 4% over the next 12-15 months.
·
10-year U.S. Treasury
rate expected to rise to approximately 5.50% over the next year.
·
Stock market P/E ratio
is down to 15.7x 2005 earnings estimate, leaving room for
multiple expansion even assuming moderately higher long-term
interest rates.
·
We remain positive on
equities but cautious on bonds.
Economy
Strong economic
expansion continued in the first quarter with +3.9% annualized
growth and +4.8% year-over-year (YOY) growth. This was the
fifth consecutive quarter of accelerating YOY growth. The key
development this year was the sudden increase in new job
creation. After three years of job losses, the economy is
finally creating jobs (see Chart I). Through June, the
economy has produced 1.3 million jobs and in the last four
months the economy has created over 1 million jobs. Even
manufacturing jobs have been created in four out of the last
five months. The unemployment rate has also improved from a
June 2003 peak of 6.3% to 5.6% currently.
The strong new
job creation solidifies our belief that above-average economic
growth appears locked in for the second half of 2004 and
sustainable into 2005. The strong new job creation is the final
confirmation that the virtuous cycle of capitalism is working
once again. This cycle consists of rising corporate profits
creating the financial wherewithal and confidence to invest in
new endeavors, hire workers, take risks, and spend on new plant
and equipment. This incremental spending grows the economy,
creates new jobs, improves our competitive position in the
world, and increases corporate profitability further, which in
turn creates more jobs, etc.
Chart
I: After Three Years of Job Losses, the Economy is Finally
Producing New Jobs
Inflation
A negative
result of stronger economic growth is that inflationary
pressures will increase from the extremely low levels
experienced in 2002 and 2003. Inflation, as measured by the
Consumer Price Index (CPI), is running at +3.0% over the past 12
months, almost double the +1.6% average rate of inflation in
2002 and up from +2.3% in 2003. Much of the inflation increase
is due to the recent surge in food and energy costs, as core
inflation is up only +1.8%. Nonetheless, inflationary pressures
are building, as only six months ago core inflation was only
+1.1%. With oil prices falling from their peak, inflation will
likely decline to the +2.0-2.5% in the near term before heading
back to the +3% level later in the year.
Despite the
strong global economic growth and still easy monetary policy for
the next year, we expect only a moderate amount of inflation
(+3%-3.5%) in the next couple of years, as global competitive
pressures remain a deflationary force limiting price increases.
The other factor limiting inflation is the current stability of
the dollar. The weakness of the dollar over the last year has
created a one-time step up in inflation that will run its course
over the next year. The decline in the dollar made foreign
goods more expensive and gave U.S. firms competing with imports
some pricing flexibility. As long as the dollar remains stable,
the dollar induced inflationary pressures will recede.
Chart II: Core CPI Moving
Higher But Still Well Contained.
Monetary Policy
In the past few years, the
Fed’s tendency has been to “err on the side of growth”. This
explains why the Fed raised the Fed Funds rate by only 25 basis
points in June from 1.0% to 1.25%, despite accelerating economic
growth over the last two years. A Fed Funds rate that is
1.5-2.0 percentage points higher than the rate of inflation is
considered neutral (not additive or restrictive) to economic
growth. With core inflation of +1.8% and Fed Funds at 1.25%,
the real Fed Funds rate is negative or highly additive to
economic growth. The real Fed Funds rate has rarely been
negative, especially when economic activity was as strong as it
is currently (see Chart III).
With the economy growing
rapidly, we believe the Fed needs to raise the Fed Funds rate to
4% before monetary policy will be considered neutral. This
means that the recent 25 basis point increase is only the first
of many Fed Funds increases over the next 12-15 months. It also
means that despite future increases in the Fed Funds rate, the
Fed will continue stimulating economic growth for at least the
next year and potentially longer as monetary policy works with
about a 9-12 month lag.
Chart
III: Monetary Policy will Remain Additive to Economic Growth
for the Next Year due to the Unprecedented Level of Easing from
2001-2003
Corporate Earnings
Corporate
profitability growth continues to accelerate along with the
global economy. Corporate profits, as measured by the S&P 500,
are expected to increase by +20% this year after +18.5% and
+19.5% increases in earnings in 2002 and 2003, respectively.
Unlike in past years, where most of the gains in corporate
earnings were the result of cost reductions, strong revenue
growth and operating leverage are driving profit growth. We
expect another strong year in 2005 with +10% growth, based on
price increases, growing worldwide demand, strong earnings
leverage, and a better competition position versus foreign
competition.
Stock Market
The S&P 500 Index finished
with a +1.8% return for the quarter while total returns from
smaller capitalization stocks (Russell 2000) and foreign
equities (EAFE) were at +0.2% and +0.4%, respectively. For the
year, the returns are +3.6% for the S&P 500, +6.2% for the
Russell 200 and +3.9% for the EAFE. The increased number of
terrorist attacks around the world, sharp increase in oil
prices, the negative political rhetoric, higher interest rates,
and the risk that President Bush’s tax cuts may not be made
permanent have all slowed the stock market advance.
Nonetheless, we still find the case for owning stocks to be
strong considering that earnings have rebounded sharply, the
global economy is growing rapidly, P/E ratios are reasonable at
15.7 times next years estimates, longer-term interest rates will
still be relatively low even after another 75-100 basis point
increase, and cash reserves remain high.
Bond Market
The yield on the 10-year
U.S. Treasury Bond increased to 4.59% from 3.84% in the second
quarter of 2004. Our fixed income benchmark, the Salomon Broad
Investment Grade Bond Index, produced a total return of –2.4%
for the quarter and +0.2% for the first half of 2004. 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 5.50% over the next year, resulting from
strong economic growth and higher inflation.
Management Meetings
During the first half of 2004, in addition to having conference
calls with various corporate executives, members of our
investment team have traveled to New York, New Jersey, West
Virginia, Illinois, Michigan, and California to meet with
management from Intel, National Semiconductor, Synopsys, Varian
Medical, Sun Microsystems, IXYS, Northern Empire Bancshares,
Adobe Systems, Oxford Bank, First Health, Zebra Technology,
Citizens Bank, Comerica, Perceptron, Valassis, North Fork
Bancorp, Henry Schein, Thor Industries, CompuDyne, City Holding,
Marsh & McLennan, India Fund, Asia Tigers Fund, Cendant, and
City National.
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.
