newsletter

Executive Summary

· Real economic growth slowed in the second quarter due primarily to the spike in oil prices. Despite the slowdown, economic growth remains strong and sustainable. We look for real GDP growth to exceed +4.0% this year.

· Oil prices should decline in the near future based on excess production and growing inventory levels. A decline in oil will have a positive effect on the economy just as the rise in oil prices has restricted growth so far this year.

· Corporate profits are at record levels and continuing to grow rapidly. S&P 500 earnings are expected to increase by +20% in 2004. Earnings momentum should continue into 2005 with earnings up +10%.

· The Fed began raising short-term interest rates in June. Fed Funds rate likely to reach 3.5%-4% over the next 12-15 months.

· 10-year U.S. Treasury rate expected to rise to approximately 5.25% over the next year.

· Stock market P/E ratio is down to 15.4x 2005 earnings estimate, leaving ample 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 second quarter with +3.3% annualized sequential growth and +4.8% year-over-year growth. This was the fourth quarter in a row of above average year-over-year growth. The annualized GDP growth in the first half of the year was a strong +3.9%. However, the annualized rate of growth in the second quarter (+3.3%) was slower than the previous four quarters as higher oil prices reduced real growth in the quarter. Despite the slowdown in the second quarter, economic growth appears to be re-accelerating back towards a +4% or better growth rate in the third quarter as the initial shock of higher oil prices dissipates.

The rise in oil prices appears to be transitory and only a modest constraint on growth. There is no shortage of oil, nor is demand exceeding supply. First, oil inventories in the U.S. have risen by 50 million barrels in the first eight months of the year, the second-largest increase in history. In addition, OECD oil inventories have increased by 83 million barrels in the first seven months of the year. Second, even after taking into account rapid demand growth, oil production is currently exceeding demand by 2.5 million barrels per day. The rise in inventories in the U.S. and the OECD is proof of the excess supply. Third, OPEC and non-OPEC oil production continues to increase. Despite conventional wisdom that only OPEC has excess capacity, non-OPEC production has increased in each of the last six years (see Chart 1). In addition, OPEC has increased its production by 1.7 million barrels this year and Saudi Arabia is planning to boost capacity by another 4-5 million barrels per day over the next three years. Finally, the oil industry continues to be more efficient finding and extracting oil while the domestic economy continues to reduce its dependence on oil. Spending on energy as a percent of total consumer expenditures has fallen from over 9% in the 1980s to under 5% currently. Other than the fear of a significant supply disruption, there is no fundamental reason why oil should be above $30-$35 per barrel. We don’t know when this fear will subside, but when it does, the price should quickly fall.

In the past, a spike in oil prices of this magnitude typically resulted in a recession while the current rise in the price of oil has only been a modest constraint on growth. This is due to a combination of factors: (1) the underlying strength of the economy; (2) the inflation-adjusted price of oil was higher in the 1980s and 1990s at $75 and $60 per barrel, respectively; and (3) energy is a much smaller percentage of consumer spending and as a percent of imports. Energy accounts for less than 5% of consumer spending, down from over 9% in the 1980s and petroleum as a percent of imports has fallen from over 30% in 1980 to approximately 10% in 2004.

Without the impact of higher oil prices we estimate the economy would have grown by at least +4% in the second quarter. With only moderately higher oil prices in the third quarter we believe that strong fundamental factors will lead to economic growth of at least +4%. These fundamentals include the following: (1) consumers are in reasonable financial health with consumer net worth up to a record $45 trillion, personal income growth is up +5% from last year, wages and salaries have increased by +4.6%, and the true savings rate of the consumer is strong at 9%; (2) corporate profits are up by over +20% this year and at record levels resulting in new jobs (1.2 million new jobs this year) and increased capital spending (durable goods orders up +11% versus last year); and (3) an improvement in the trade balance because of the decline in the dollar to more normal levels. Adding to the overall outlook is the fact that the world economy has recovered and is expected to grow by +5% this year, the fastest since 1973. With approximately 30% of S&P 500 profits from international operations, the faster worldwide growth should provide an incremental boost to U.S. growth.

Inflation, as measured by the Consumer Price Index (CPI), is running at +2.7% over the past 12 months, up from +1.9% in 2003. Much of the inflation increase is due to the recent surge in energy costs, as core inflation is up only +1.7%. Inflationary pressures are building but from extremely low levels such that inflation is not a major concern at this point. In fact, it appears that the Fed actually desires some inflation as last year’s deflation scare has altered the Fed’s view such that it now believes a modest amount of inflation is healthy for the economy.

Monetary Policy

The Fed has raised the Fed Funds rate by 75 basis points to 1.75% since June. The Federal Reserve has indicated that it will continue to raise rates at a “measured pace” and that it views current interests rates as additive to economic growth. With the economy growing rapidly, we believe the Fed needs to raise the Fed Funds rate to 3-4% before monetary policy will be considered neutral. This means that the recent 75 basis point increase is only the start of many Fed Funds increases over the next 12-15 months. It also means monetary policy will remain in a stimulative mode throughout 2005 and potentially longer as monetary policy works with about a 9-12 month lag.

Stock Market

The S&P 500 Index finished with a –2.0% return for the quarter while total returns from smaller capitalization stocks (Russell 2000) and foreign equities (EAFE) were –3.1% and –1.6%, respectively. Year-to-date, the returns were +1.6% for the S&P 500, +2.9% for the Russell 2000 and +2.2% for the EAFE. Most of the return this year has been due to the strength in energy stocks, which we believe, is only transitory in nature. Excluding the energy sector, the year-to-date return on the S&P 500 is –0.4%. The increased number of terrorist attacks around the world, the sharp increase in oil prices, the negative political rhetoric, and the risk that President Bush’s tax cuts may not be made permanent have all slowed the stock market advance. Nonetheless, we remain confident the strong earnings growth will propel the stock market higher in the months ahead. Over the last three years, earnings have grown by +71% while the market is up only +2%, meaning the PE on the market has fallen from 25x to 15x next year’s earnings. With strong economic and corporate profit growth expected to continue in 2005 along with longer-term interest rates still relatively low, even after another 100 basis point increase, we expect a strong stock market recovery based on PE expansion and +10% EPS growth.

Longer-term interest rates continued to move higher in a saw-toothed fashion (see Chart 2). Interest rates spiked up on strong economic news and then gradually declined as excess demand from international sources and interest rate arbitrage pushed interest rates lower. With the strong economy, the Fed increasing short-term rates, and inflation lingering around the +3% level, the yield on the 10-year U.S. Treasury Bond should increase to over 5.0% from its current level of 4.0%. We continue to recommend a shorter-than-average duration for bond portfolios in anticipation of this rise. Our fixed income benchmark, the Salomon Broad Investment Grade Bond Index, produced a total return of +3.3% for the quarter and +3.4% for the first nine months of 2004.

Corporate profitability growth continues to accelerate along with the global economy. Corporate profits, as measured by the S&P 500, have increased by over +20% this year are expected to increase by +10% next year. We expect another solid year in 2005 based on healthy domestic economic growth, growing worldwide demand, strong earnings leverage, and a better competitive position versus foreign companies as a result of the decline in the dollar.