2nd Quarter Economic Review
Improving economic results offer bright outlook for equity markets

By Joseph A. Harrison, CFA, Partner

The security markets faced a mixture of very positive economic news, some very worrisome incipient economic trends, and a number of disturbing events in the Middle East during the second quarter.

The equity market was marked by some wide swings and the net result for the quarter was essentially unchanged. Fixed income markets, on the other hand, suffered a significant setback as the yield on 10-year U.S. Treasury Notes increased nearly a full percentage point.

Almost all economic data was positive. We saw strength across all sectors of the economy—from manufacturing to housing to consumer goods. Any lingering doubts about the strength of the recovery should have been removed. The brightest news related to strong gains in employment—a total 1.2 million jobs in the first five months of the year (see chart).

Factories hiring

The employment increase was broad-based across 75% of all industries, with the largest gains in the higher paying sectors. Factory hiring was up for the fourth consecutive month after 42 months of losses. Average hourly earnings are increasing at a 3.1% annual rate. The average factory workweek rose to 41.1 hours, the highest since October 2000, and average overtime rose to 4.7 hours, the highest rate since July 2000.

The implications of this data is very important. Wage income constitutes over 70% of national income. The large number of new jobs at higher pay and overtime for hourly workers will produce far more than sufficient income to cover higher gasoline prices and interest rates. In addition, the overtime and workweek figures suggest additional new jobs will be created in the months ahead. Strong consumer demand should be sustained for many months to come. Rising personal income is a powerful ingredient to a healthy economic expansion. A further benefit is a lower federal budget deficit than had been forecast.

Capital spending

Two other forces for a healthy economy are inventory and capital spending. To a great extent, the lag in inventory spending is testimony to the productive effects of technology investment. Thus, it is not surprising that capital spending, especially on technology, is showing larger gains than spending on inventories.

While additional good news is likely, some worrisome signs have emerged on the horizon that must temper any inclination to “irrational exuberance.” With a weaker dollar and strong economic growth, wholesale and consumer prices have started to accelerate from the very moderate pace of the past few years. The price of oil is the most visible culprit, due to terrorism in Saudi Arabia and tight refining capacity in the U.S. The recent decision by OPEC to increase production should provide some relief in coming months, but many other materials and goods will still provide upward pricing pressure. Metal prices have also risen sharply. Imported consumer goods, lodging, healthcare and homeowners equivalent rent have all shown strong increases in recent months.

Federal Reserve

Although increased productivity should have a moderating influence on inflationary pressures, increasing employment costs (wages and healthcare) will dampen recent strong gains in productivity. Recent action by the Federal Reserve Bank to increase interest rates should also help. With rates so very low, however, this rate increase is only a small step to return short-term rates to a more normal 3% level (see chart below). Even several 1/4% or 1/2% increases should not be cause for concern if the recent upward move in the rate of inflation can be moderated.

On a longer term basis, higher energy prices can be reined in by increased production and a shift in consumption attitudes. OPEC has agreed to increase production rates and several countries have initiated programs to renew exploration and development of new oil fields. Also, one well-known and respected auto manufacturer has announced plans to extend its hybrid vehicle offerings to include SUV’s.

Sustained earnings growth

The spectacular growth in corporate profits has largely been the result of moderate sales growth and enormous productivity gains over the past three years. We expect that technology will produce further gains in productivity. Yet, the benefit of declining unit labor costs will no longer be supportive of the substantial gains in profitability. Nevertheless, we believe that many companies will be able to sustain their earnings growth.

While it is still too early to predict this year’s Presidential election or the ultimate success of returning control of Iraq to its people, the strong pace of economic growth, personal incomes, and corporate profits provide ample opportunity for reasonable returns in the equity markets. Somewhat higher interest rates suggest caution with respect to fixed income markets, but a 5% to 5.5% rate on a 10-year U.S. Treasury issue might provide an opportunity to extend maturities in the months ahead.