Executive Summary
·
Anxiety over growing inflationary pressures, rising
interest rates, higher energy prices, a widening trade deficit, and
a weak dollar dampened investor enthusiasm during the first quarter
of 2005.
·
The stock market is as cheap as it was at the bottom
of the bear market in 2002 as a result of strong earnings growth and
only moderate market appreciation over the past year. Eventually,
investors will refocus on the strong economy and growth in corporate
profits.
·
Financial markets should also get a boost from
improving trends in both the trade and budget deficits later this
year.
·
Above-average economic growth of approximately +4.0%
should continue into 2006.
·
The Federal Reserve will continue to increase the Fed
Funds rate until the rate reaches 4-4.5%, up from 2.75% currently.
·
The bond market is starting to reflect the strong
economy and rising inflationary pressures. We believe that the
yield on the 10-year Treasury bond will climb to over 5% before the
end of the year.
Economy
Investor anxiety
continues to overhang the stock market while bond investors are just
starting to realize that interest rates are too low given the strong
economy and rising inflation. The laundry list of concerns that
have impacted the markets include the trade deficit, budget deficit,
weak dollar, rising inflationary pressures, increasing interest
rates, and higher energy prices. We believe that all of these
issues are overblown, unfounded, or quite manageable, considering
the strength of the current economic expansion. In this update, we
will attempt to defuse these concerns.
First, it is
important to remember that despite being in the fourth year of
economic recovery, the economy is still benefiting from the
stimulative effects of fiscal policy (budget deficits), monetary
policy (rising but still relatively low interest rates), tax policy
(tax cuts), and currency policy (weak dollar). Four years into a
recovery, most if not all of the policies should be in a neutral
mode, not stimulating the economy. Since most of these policies
work with a 1-2 year lag, the economy should grow faster than
average for the next 2 years despite higher interest rates, high oil
prices, and a growing trade deficit.
The evidence of the
stimulus can be seen in the strong economic growth of the past two
years. After growing by real rates of +4.4% in 2003 and +3.9% in
2004, real GDP growth of +4.0% is expected for 2005, well above the
30-year average growth of +3.1%. Given the size of the U.S.
economy, the incremental +1% growth is similar to adding the entire
economy of Hong Kong, Israel, or Malaysia on top of normal growth.
Economic growth will eventually slow to a 2.75%-3.25% rate as many
of the stimulative policies are removed, but for the near future, we
continue to believe the economy is more likely to surprise on the
upside rather than the downside.
Federal Reserve/Interest Rates
Despite the recent
hikes in short-term interest rates from 1.0% in June 2004 to 2.75%
currently, monetary policy continues to be stimulative to economic
growth (see Chart 1). To put the lower rates in perspective, the
Federal Funds rate was never lower than 3% from 1970 – 2000, despite
going through five recessions. We believe the Fed will continue
increasing short-term rates in a measured fashion until rates reach
a neutral level of 4.0-4.5% by the end of 2005. The Fed must raise
rates because too much stimulus from low interest rates results in a
weaker dollar and higher inflation.
CHART 1:
Short Term Interest Rates are Increasing but Still Too Low!
Trade Deficit/Dollar
We are not overly
concerned with the large trade deficit at this time, as we believe
free trade is a net benefit to our country. The trade deficit is
primarily the result of the increase in the value of the dollar from
1997-2002 and the relatively fast U.S. economic growth compared to
the rest of the world from 1997-2002. Because of the stronger
dollar, our exports became 50% more expensive to foreigners and
imports became 33% less expensive to U.S. consumers. As a result,
exports slowed while imports rose significantly. The reduction in
the value of the dollar to the current level has removed this
competitive disadvantage for U.S. businesses (see Chart 2). We are
also starting to see stronger growth worldwide. According to The
Economist, global growth is the strongest in about three
decades. Stronger worldwide growth along with a fairly valued
dollar should result in healthier export growth and a declining
trade deficit.
CHART 2: Dollar Should Stabilize or Increased From Current
Levels
We do not expect
additional weakness in the value of the dollar as the Fed is raising
interest rates and has slowed the growth of money supply to better
match demand growth. The dollar increased in value from 1997 to
2001 primarily because the Fed wasn’t growing the supply of dollars
fast enough to meet world demand growth. From 2001 until 2004, the
Fed was extremely easy with monetary policy and grew the supply of
dollars much faster than demand, so the value of the dollar fell.
As the Fed continues to tighten monetary policy, we expect the
dollar to stabilize and, potentially, increase in value.
Energy Prices
High energy prices
are once again threatening economic growth, raising inflationary
fears, and holding back the stock market. The recent rise in energy
prices will have a negative effect on economic growth but to a
lesser extent than in the past. Fortunately, our economy is much
less reliant on energy than 25 years ago when a doubling of energy
prices would have led to a recession. Last year higher oil prices
contributed to a “slowdown” in economic growth in the second
quarter. Growth was still above average at +3.3%, but slower than
the +4% plus growth in the prior four quarters. High energy prices
could slow growth by +0.5% in the second quarter and beyond if they
persist. Nonetheless, economic growth would still be strong, just
not as strong as we currently anticipate.
Inflation
The rate of
inflation has been increasing over the last two years from +1.9% in
2003 to +3.4% in 2004. Much of the increase was due to the rise in
oil as the core CPI (excludes food and energy) was only +1.1% in
2003 and +2.2% in 2004. However, there are enough signs of
inflationary pressures that bond investors are starting to get
worried. We continue to believe that core inflation will rise to
+3% this year. The Fed has been too easy for too long which has
caused the dollar to decline and inflation to rise. As the Fed
transitions to a more neutral stance, the dollar should stabilize
and help reduce inflation rates. The excess money supply will be
removed from the system, thereby eliminating the root cause of most
of the current inflationary pressure.
Fiscal Policy
After four years of increases, the federal budget
deficit is beginning to shrink. These deficits helped end the
recession but now with the economy back on track, Congress needs to
start reining in spending growth. This is a lot to ask of
politicians but, fortunately, the economy and resulting government
tax receipts are growing faster than Congress can increase
spending. In addition, President’s Bush’s attempt to reform the
Social Security system is long overdue and will be a significant
positive if the appropriate legislation can be passed.
Bond Market
Bond investors are
finally starting to acknowledge that interest rates are too low
given the strong economy and rising inflation. The yield on the
10-year U.S. Treasury Bond increased to 4.65% from 4.22% in the
first quarter. Our fixed income benchmark, the Salomon Broad
Investment Grade Bond Index, produced a total return of –0.5% for
the quarter. 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.
Bond investors have typically required a +2-3% real return over the
rate of inflation (+3% inflation expected in 2005), which is why we
remain relatively cautious on bonds.
Stock Market
The large
capitalization S&P 500 Index finished with a -2.1% return for the
quarter while total returns from smaller capitalization stocks
(Russell 2000) and foreign equities (EAFE) were also negative at
-5.3% and -0.2%, respectively.
Despite investor
concerns about oil prices, rising interest rates, and deficits, we
still find the case for owning stocks to be strong. Due to the
healthy earnings growth and only moderate price growth, the stock
market at a multiple of 16.0x 2005 estimated EPS is as cheap as it
was at the bear market bottom in 2002. Corporate earnings are
continuing to grow and longer-term interest rates will still be
relatively low even after a 100 basis point increase. We continue
to believe that a strong economy, increasing corporate profits, and
reasonable valuations will produce solid equity returns in 2005.
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
