2nd Quarter Economic Review
Economy’s growth rate healthy, despite “saw-toothed” action

By Joseph A. Harrison, CFA, Partner

Saw•toothed (sôt—ootht) adj. Having a jagged or zigzig pattern, outline, or course...

The saw-toothed pattern of economic activity that prevailed during the first three months of 2005 extended through the second quarter. A weak March and May were each followed by a stronger April and June. The changes were all relatively modest and not out of the ordinary. Oil prices were the most volatile in the quarter with a $10 per barrel decline followed by a $15 per barrel increase.

European doldrums

The dollar continued to recover against most foreign currencies during the second quarter, and was particularly strong against the Euro. In large measure, the continued strength of the U.S. economy has provided more than sufficient support for the dollar. Additionally, the poor state of European economies stood in stark contrast to the growth the U.S. economy is experiencing. Both France and Germany have an unemployment rate over 10%, with expected economic growth of a meager 1%.

In contrast, employment in the U.S. grew by an average of 180,000 jobs per month during the first five months of the year, while the unemployment rate declined to 5.1%. Current hiring plans suggest continued healthy employment growth in the months to come. While consumer expectations have moderated recently, further employment growth and wage gains should be sufficient to sustain consumer spending at a 31⁄2% to 4% pace.

Tax revenues up

Although some people are wringing their hands over the U.S. budget deficit, tax revenues for the first eight months of the federal government’s fiscal year were up 15%, compared to the same period in 2004. Current projections of a deficit of $350 billion for the year ending September 30, 2005 is a significant 20% improvement over 2004, and a very manageable 2.6% of GDP.

Moreover, similar improvement is taking place in state and local government revenues across the country. There should be no doubts remaining that lower tax rates lead to increased government revenue or that the federal tax cuts of 2001 and 2003 should be made permanent. Meanwhile, it appears that Congressional bi-partisan support may be developing for elimination of the Alternative Minimum Tax.

Business momentum

The current economic recovery is 43 months old and still growing. This momentum is a function of several factors unique to this recovery:

• First, Interest rates remain historically low, even after eight “measured” increases in the Federal Funds Rate. In some respects, this reflects an excess of liquidity that built-up in the wake of the hedge fund blowup in late 1998, fears of a liquidity crisis leading up to the millennium, and then the recession in 2001.
• Secondly, the technology boom brought with it an ability to keep a tight rein on inventories, thus avoiding the “boom-bust” cycles of the past.

Bullish indicators

One of the precursors of the recession in 2001 was a substantial over-investment in technology. When the recession hit, it took a significant toll on corporate profitability and cash flow. Thus, capital spending lagged during the early years of the recovery. But now, several measures indicate that corporate profitability and cash flow are at record levels, exceeding prior peaks of the mid-1960’s and late-90’s.

A strong underpinning to capital spending and moderate consumer spending should allow the economy to grow at a healthy rate. Improved dividend growth and currently reasonable valuations offer the prospect of reasonable equity returns.

Necessary diligence

Nevertheless, a few risks need to be monitored:

• Consumer debt is high and, although currently supported by rising incomes and low interest rates, it could pose a problem down the road.
• Unit labor costs are rising and may become a barrier to future profit growth.
• The rapid growth in hedge funds, many of which follow aggressive and highly leveraged investment policies, may increase the risks normally associated with the investment process, as the State of Ohio has learned.

At Midwest Investment Management, we pay close attention to these and other risks that could affect our clients’ portfolios.

We will continue to maintain the highest level of quality in those portfolios.

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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