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1st Quarter Economic Review By Joseph A. Harrison, CFA, Partner The stock market rally that capped-off 2004 lost its momentum in the first quarter, due partly to oil prices which moved higher as global growth and a cold winter continued. Certainly a growing global economy does not offer hope of a significant decline in oil prices. In perspective, however, oil consumption as a percentage of U.S. GDP is slightly over 2%—no higher than it was in 1970, and well below the 8% peak reached in 1980. Thus, higher energy prices, while measurable, have had only a slight impact on overall economic growth. Dollar growth in employee compensation is seven times the growth in oil expenditures. Trade deficit Concern over the burgeoning U.S. trade deficit is well-founded, although some factors are in play to perhaps even reduce it. With the decline of the dollar’s exchange rate, export growth is gaining traction. Further, prices of imported goods are rising and should limit demand. As a result, many exporters to the U.S., notably those in Europe, have absorbed the decline in the dollar by cutting profit margins. The economy is growing, with consumers providing the backbone of this expansion. Strong employment growth and higher wages are providing rapid gains in disposable personal income, which more than offsets the decline in fiscal and monetary stimulus—creating momentum that might sustain a long period of economic growth. However, excess global capacity exists in the automotive industry and now that China is a net exporter of steel, recent gains in the long-troubled U.S. steel industry might not be able to be maintained. Shareholder value Meanwhile at many U.S. corporations, an increase in free cash flow created several positive long-lasting effects: improved balance sheets have more than offset higher interest rates; large, well-managed companies have the flexibility to buy back shares, increase dividends, invest to improve productivity, or make acquisitions. These actions, if pursued rationally, add to shareholder value. We expect interest rates to rise progressively through the year, due to infation. While we expect only a slightly higher inflation rate this year, a rate exceeding 3% and growing might well result in a 4% short interest rate by year-end. Longer term rates can also be expected to increase. A 5% rate on a 10-year Treasury Note is a reasonable expectation. As the first quarter of 2005 ended, we believed that with domestic growth exceeding 31⁄2%, growing free-cash flows at corporations, and grow-ing disposable personal income for consumers, equity valuations appeared very attractive. * * * Joe Harrison’s ability to uncover attractive stocks during all economic cycles has produced enviable long-term returns for his clients. If your portfolio is under-performing your expectations, contact Joe at (216) 830-1131 or jah@mimllc.com |
