By Joseph A. Harrison, CFA, Partner

The new year began with a continuation of the positive investment returns we enjoyed in 2003. Late in January the press release following a meeting of the Federal Open Market Committee presented a slight change in language describing its attitude toward a future rate change. The word “patience” was substituted for “a considerable period.” Investors retreated to Webster and Roget for clues to any prospective change in interest rates. Federal Reserve Board Chairman Alan Greenspan offered public reassurance that a change in interest rates was unlikely. Current thinking is that August is the earliest likely time for a change. The economy continued to post impressive readings:

• A continuing recovery appeared to be transforming into an expansion;
• Housing and automobile sales remained strong as consumers were encouraged by continued low interest rates, rising disposable income, and the start of the tax refund season.
• Consumer prices remained stable. Low interest rates made the assumption of more debt an affordable luxury.

Corporate profits

Corporations also benefited from these same stimulants. Profits and cash flow, the mirror of personal disposable income, are very strong. Loans for capital and inventory investment remained very inexpensive, and more-attractive depreciation schedules enhanced cash flow. Furthermore, strong research and development expenditures—as well as the growing number of patent applications—suggest a positive longerterm outlook for the economy. Other measures of economic health, such as initial claims for unemployment, regional and national reports from the Institute for Supply Management (ISM), store sales, and housing starts, all point to a broad economic expansion that is gaining momentum.

Lethargic job growth

Longer-term issues are subject to much debate. The most immediate issue is employment growth that has only recently shown modest improvement. Technology-based productivity improvements require fewer new jobs. We are in the midst of a significant change: today our population is much better educated than prior generations and much better equipped to adapt to a new environment. For example, the level of persons over 25 with a high school education is 84%, twice the 41% in 1960. Those with college degrees at 27% are triple the 8% level of 1960. Further, with 70 million youngsters under the age of 15, advanced educational opportunities speak to a highly skilled work force in years to come.

Some concerns

A second long-term issue is the specter of higher rates of inflation and the prospects for much higher interest rates in response. Consumer inflation rates, whether measured by the familiar Consumer Price Index or the Price Index of Personal Consumption Expenditures, remains quite low. But commodity prices which directly affect the consumer are a concern. Energy and agricultural commodities are subject to natural global demand and the additional demand occasioned by a lower dollar. Thus, everything from grain to paper products, building materials, metals, and chemicals are all increasing in price. Eventually these prices will find their way to the consumer. How federal policy makers and the economy respond is not known, and that suggests caution. Another cautionary issue is that of the domestic federal deficit. While the dollars are high, the amount relative to the size of the economy is not a concern. However, the trend of the deficit cannot be ignored. At the moment, cyclical factors are working to reduce the deficit. Corporate tax receipts and individual tax withholding are increasing as unemployment benefits decline. The pace of overall government spending, magnified by election year budget appropriations, remains a concern.

Looking ahead

On balance the current economic climate is favorable. Low interest rates, growing incomes and expanding corporate investment are all favorable to us both as citizens and investors. With the past year’s improvement in equity prices, valuations are not as favorable, but do remain attractive given the broad momentum in the economy.

Joe Harrison’s keen understanding of economic trends has helped him generate outstanding returns for client portfolios. To learn more about the benefits a managed account relationship offers, you are invited to contact him at (216) 830-1131 or e-mail: jah@mimllc.com.