4th Quarter Economic Review
Post-Election “Mood Shift” Suggests Bright Outlook For Equity Investors

By Joseph A. Harrison, CFA, Partner

The final quarter of 2004 seemed to be marked by a dramatic mood shift.

The final weeks of the Presidential campaign saw oil prices surge a dramatic 25% to a record $56 a barrel. But by mid- November, oil prices retreated below $50 a barrel and the equity markets responded positively to the easing of political tension. It appeared that serious discussion and planning for the future was underway.

By early-December, oil prices plunged to $42 a barrel on favorable production, inventory, and weather news.

Tumbling dollar

Meanwhile, a new threat emerged as the dollar declined to new lows against major currencies. An evergrowing current account trade deficit and historically low interest rates have been the proximate causes for the weakness of the dollar. In addition, uncertainty about the possible long-term effects on U.S. economic growth has conjured up all manner of fanciful, as well as plausible, outcomes. No doubt speculative activity in foreign exchange markets played a role as well. In three months’ time, for example, short positions in dollar index futures increased more than six-fold.

Chinese imports

The adverse trade balance and low domestic interest rates are cause for concern and some dollar weakness. However, forces are in motion to produce some improvement. Although gradual, the Federal Reserve is on a clear course of raising interest rates, having made five separate 1/4% increases in the last six months of 2004. In a perfectly normal pattern, imports have increased ahead of exports. Imports from China have increased rapidly, while exports (influenced by slower growth in Europe) grew at a slower pace.

With U.S. goods now priced so attractively for foreign buyers, we expect the growth in exports to accelerate. Conversely, European and Japanese goods are more expensive. If the price of oil declines further, or even stabilizes, the growth of imports should moderate. Other issues remain but the extreme recent pressure on the dollar should decrease in 2005.

Reasons for optimism

Corporate spending is rising but at a moderate pace. Capacity utilization rates remain low, but corporations have been able to increase output, profitability, and cash flow through efficient use of assets. Corporate balance sheets have improved, dividends have increased, and many companies have been active buyers of their own stock. As the economy continues to grow, with some additional stimulus from export growth, capital spending should also provide an underlying element of strength.

Improving profits

On balance, the outlook for security prices remains favorable. Although interest rates are likely to increase, the pace should be gradual with 3% short rates and 5% longer rates a reasonable expectation. Profits, while no longer exploding from the depressed 2002 level, should grow about 5% in 2005.

Although declining interest rates will no longer benefit the economy, lower than expected energy costs may be a surprise. Furthermore, we believe corporations understand the cash flow improvement that comes with improving asset turns. Improved profits and rising dividends support a moderately positive 7%- 10% outlook for stock prices.