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Executive Summary
·
Economic growth was likely reduced by 1% in the third
quarter to approximately +3.0-3.5% due to Hurricane Katrina. We expect
economic growth to rebound to +3.5-4.0% in the fourth quarter and
continue at that rate into the first half of 2006 as increased
government spending stimulates growth.
·
The incredible amount of taxpayer money being spent to
rebuild the area affected by Hurricane Katrina will increase the budget
deficit and inflationary pressures.
·
The Federal Reserve will continue to increase the Federal
Funds rate to 4.25-4.50%, up from 3.75% currently. Although, the end of
the rate hikes has been pushed out a few months, it will still likely be
a very positive catalyst for the stock market.
·
The strong economy and rising corporate profits will
eventually be reflected in the stock market. The market’s P/E ratio is
as low as it was at the bottom of the bear market in 2002 and almost as
low as it was in 1994.
·
Core inflation expected to reach +3% next year.
·
The bond market remains overvalued given the strong
economic growth and rising inflationary pressures. We believe that the
yield on the 10-year Treasury Note will climb to over 5% during the next
few quarters.
Economy
Prior to Hurricane
Katrina, economic growth had settled into an above average rate of
+3.5%-4.0%, corporate profit growth was growing to record levels, the
budget deficit was declining, and new job growth was strong at over 2
million per year with unemployment under 5%. Inflation was rising but
still under control, oil inventories were growing rapidly, consumer net
worth was at a record level, the Federal Reserve was nearing the end of
its rate hikes, and the stock market was, in our opinion, poised to go
higher. In the aftermath of Hurricane Katrina, economic growth is going
to temporarily slow, corporate profit growth may not be as strong, the
budget deficit will be much larger than anticipated, unemployment will
rise moderately, inflationary pressures will increase, and the Fed may
have to increase rates more than we had expected. Regardless, the
economy has weathered far worse economic storms in the past and we
expect the economy to quickly rebound from any slowdown. In fact,
economic growth should be stronger in 2006 as the rebuilding process
stimulates growth.
Fortunately, the economy
was so healthy prior to Katrina that the immediate impact will be a
reduction in the rate of growth, not a reduction in the size of the
economy. We currently expect third quarter GDP growth of +3-0%-3.5%
(down from +4.0%-4.5% prior to Katrina) and approximately +4% growth in
the fourth quarter as the rebuilding efforts incrementally add to
growth.
Chart 1: Economic Growth Was Strong
Prior to Hurricane Katrina and Should Remain Strong After.
While overall economic
growth in the near term will not be significantly affected, Katrina will
have some ripple effect throughout the economy. The most noticeable is
the incredible amount of money the Federal government will spend to
rebuild the damaged areas. With estimates as high as $100 to $150
billion dollars, or approximately $125,000 per person affected by
Katrina, the rebuilding of the damaged areas is going to stimulate
economic growth and raise inflationary pressures. Just the increased
spending without any multiplier effect will add over +1% to economic
growth over the next year.
The increased spending
will also impact the budget deficit. The Federal budget deficit will be
closer to $425 billion than the $300 billion estimate prior to Katrina.
While this is a significant increase in the budget deficit, the deficit
will still be significantly less than the $540 billion budget deficit
originally estimated over a year ago. Once again, the strong economy
has bailed us out of a potential problem. The strong growth in
corporate profits and wages produced the largest increase in federal tax
receipts in 32 years, significantly reducing the budget deficit prior to
Katrina.
Inflation expectations
have also increased post-Katrina. In the 12 months prior to Katrina the
core rate of inflation excluding food and energy was +2.2%. This was up
from +1.8% last year and +1.5% in 2003. We continue to believe that
core inflation will rise to +3% over the next 12 months. Including food
and energy, inflation was +3.6% over the last 12 months. While oil
prices are flat to down since Katrina, gasoline and natural gas prices
have increased substantially. The rebuilding of the damaged areas also
has the potential to be a classic example of too much money (government
aid, insurance proceeds, private donations) chasing a limited supply of
construction equipment, material, and personnel. The end result is
typically higher costs for those items.
A secondary impact of
Katrina will be higher short and long-term interest rates. We have been
targeting a 4.0% Fed Funds rate as the point where the Federal Reserve
would no longer be accommodative. At that point, the Fed would stop
raising rates to assess the impact higher rates are having on the
economy. However, with the inflationary impact of Katrina along with
the excessive government bailout, the neutral level for the Fed Funds
rate may be closer to 4.5% than 4.0%. This may postpone the end of the
rate hikes to early 2006 from late 2005. The key variable to monitor
will be to what extent the economy is negatively impacted by Katrina and
higher energy costs. This is significant because the Fed typically
raises rates too high before stopping, causing a mini-economic crisis of
some type (see Chart 2). Therefore, any indication that the Fed is
close to the end of its rate hikes before there are signs of economic
duress should be viewed positively for the economy and the stock market.
Chart 2: The Fed Tends to Increase Rates Until
Something Breaks 
Potentially the most
significant ripple effect of Hurricane Katrina is the postponement of
legislation that was about to make the capital gains, dividend, income,
and estate tax cuts permanent, or at least extending them until 2010.
Congress had schedule a vote on the tax cuts in the weeks following
Hurricane Katrina and there was a good chance that they would have
passed. In light of the increased spending and budget deficit, the
momentum to make the tax cuts permanent has faded. In our judgment, the
tax cuts were a key ingredient to the strong economy over the last
several years and the failure to extend or make them permanent would
represent a setback for the economy and stock market. It appears that
Congress will try to make the tax cuts permanent later in the year, but
until the votes are in, the potential loss of making the tax cuts
permanent may be Katrina’s most powerful legacy.
Bond Market
Bond investors continue
to ignore the strong economy and rising inflationary pressures, as the
yield on the 10-year U.S. Treasury Note at the end of the quarter was
4.3%. With inflation at 3.6%, the real return is only 0.7% and the
after-tax real return is negative for most taxpayers. Our fixed income
benchmark, the Salomon Broad Investment Grade Bond Index, produced a
total return of –0.7% for the quarter and +1.9% 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 Note
yield to 5.0%-5.5% over the next several quarters.
Stock Market
The large capitalization
S&P 500 Index finished with a +3.6% return for the quarter while total
returns from smaller capitalization stocks (Russell 2000) and foreign
equities (EAFE) were +4.2% and +10.4%, respectively.
Year-to-date, the returns on the S&P 500, Russell 2000, and EAFE are all
positive for the first time this year at +2.8%, +3.4%, and +9.1%,
respectively.
Despite various
short-term distractions, corporate profit growth drives stock prices in
the long run. After increasing by +23% in 2004, corporate profits, as
measured by the S&P 500 operating earnings, are expected to increase by
+14% in 2005 and +10% next year. Due to this healthy earnings growth
and modest gains in the S&P 500 (see chart 3), the stock market at a
multiple of 14.4x 2006 estimated EPS is as low as it was at the bear
market bottom in 2002 and almost as low as in 1994, which marked the
start of five years of outstanding stock market returns. Even if
earnings are temporarily reduced due to Hurricane Katrina, we are
confident the combination of a strong economy, increasing corporate
profits, and reasonable valuations will result in solid equity returns
over the next 12 months.
Chart 3: History of S&P 500 EPS, Price and P/E
Ratio Since 1991
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
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