3rd Quarter Economic Review
Economy continues moderate growth; main concerns are war, terrorism

By Joseph A. Harrison, CFA, Partner

The summer produced many cloudy days across northeast Ohio. Similarly the economy, passing from the robust growth of a recovery to a more normal and sustainable track, posed gloomy thoughts to those caught up in extrapolating long-term implications from isolated statistics. Each nugget of economic gold was greatly enhanced by the alchemy of political rhetoric. Events in Iraq and uncertainties posed by potential terrorist attacks in the U.S. and abroad also helped make the equity markets choppy during the quarter ending Sept. 30th.

Employment reports

A weak July employment report evoked thoughts about a possible return of the recession, but employment gains of 144,000 in August dissolved that concern — highlighting the fallacy of looking at a single monthly report as definitive. The August report noted very positive gains in both hours worked and wages, and refuted widely expressed concern that employers are substituting high-paying jobs with low-paying ones (see graph, below). Indeed the largest employment gains were in professional and business services and educational and health services.

Employment data from the Institute of Supply Management further support the notion that the employment picture is healthy and that the outlook for future incomes will be sufficient to support continued consumer demand.

The U.S. Commerce Department reported that manufacturing output grew 0.6% in July.

Near-record profits

Although corporate earnings reported for the second quarter were very strong, corporate executives were generally cautious about similar prospects for the third quarter. With profit margins approaching record levels, a slower pace of earnings growth is normal and should be expected.

In the past year, companies enjoyed the benefit of significant productivity gains, low interest costs, and lower taxes — none of which are likely to repeat over the next year. Increased energy and material costs are allowing most companies to raise prices as customer demand grows. Nevertheless, profit growth of 8% or 9% would be a very positive result over the next 12 to 18 months.

Real estate

Very strong gains in residential real estate prices have raised the specter of a “bubble” developing in that market. The trend of the median price of a home and per capita disposable personal income over the past 35 years suggests that the current “bubble” is just returning the trend to its normal relation-ship. It is interesting that the gap, which developed from the mid-eighties into the mid-nineties, began to close following legislation which effectively removed capital gains taxes from consideration in valuing real estate (see graph, right). At the same time, home equity credit made homes a more valuable personal asset, and subsequent lower interest rates greatly improved the affordability of real estate.

Many concerns of the 3rd quarter have been overcome. The economy continues to grow moderately and should be sustainable, subject to uncertainties in Iraq or the war on terrorism.

Bush or Kerry?

Will the outcome of the Presidential election affect how we manage client portfolios?

Quite simply, no. A diversified portfolio comprised of stocks of good, profitable companies selling at reasonable prices should weather any changing political climate. Although certain events may “shock” our economic system, Americans have always been resilient and looked to the future. We tell our clients to follow an investment path that stresses controlling risks.