By Joseph A. Harrison, CFA, Partner

Underlying economic trends remained very favorable during the second quarter. Stronger than expected first quarter real GDP growth at 5.3% exceeded all expectations.

Trends that were in place in the first quarter remained in force during the second. Overall employment growth and a shift to higher-paying occupations continued. Strong wage gains and higher employment mean that personal incomes remained buoyant. Thus, consumer spending continued to grow, but at a moderate pace.

In turn, corporate profits grew to record levels. In the first quarter, profits were 8.9% of GDP, eclipsing the previous peak of 7.9% established in 1965. Operating rates in several key industries are at or near capacity levels.

Tax revenues way up

Federal income tax receipts are booming. Through May, eight months into the U.S. Government fiscal year, overall tax receipts had increased 13% over the corresponding period of the preceding year. Most of this gain has come from surging profits at corporations and Federal taxes on capital gains, dividends, and interest income. This surge far outstrips the rapid 8% increase in spending sparked by higher interest expense, Katrina rehabilitation, Iraq-related military expenditures, and, of course, the political self-interest reflected in innumerable “special budget items” (a.k.a. “Pork”).

The projected fiscal year deficit is likely to be $290 billion, a modest 2.2% of GDP, down from last year’s $318 billion, 2.6% of GDP, and nearly 30% below the more than $400 billion deficit projected at the beginning of the current fiscal year. It seems the U.S. Treasury is now realizing extraordinary returns resulting from the Federal tax cuts enacted in 2001.

Those tax cuts, maligned by some people, were intended to increase corporate and private investment incentives, including lower tax rates on certain investments. Yet in spite of the effect of increased tax revenues, some politicians are suggesting tax increases, thereby killing the proverbial goose and her golden eggs.

Volatile markets

Despite good economic news that prevailed during the quarter, the equity markets were volatile, and ultimately weak. At play were:

• The dynamics associated with small changes in core consumer and producer prices;
• Federal Reserve officials stating they were “uncomfortable” with the precise rate of one or another price index;
• Speculation about how many more times the Federal Reserve would vote for higher interest rates, or might the pause (that refreshes) in those increases be at hand.

The interplay of these dynamics produced speculation on what the likely forecast should be on any given day, or even moment of the day!

The housing market is softening. New housing starts and mortgage applications are declining. Home prices are no longer rising at mid-teen rates, but at a more normal 3%-4% rate. Mortgage rates have returned to the low end of a normal range. Some borrowers with adjustable rate or interest-only-payment mortgages may be hurt, as will some lenders who lowered credit standards to attract marginal borrowers. The housing market and values won’t collapse because of a return to normal rates, but the change from boom to consolidation and normal growth will have a dampening effect on consumer spending and overall real GDP growth.

Element of “risk”

Early in the quarter many investors felt the Federal Reserve Board might pause in its pursuit of higher rates. After the Open Market Committee meeting on May 10, the official statement was less comforting to the notion of pausing, and placed emphasis on the need to tame inflation. Suddenly an element of risk was added to the equation.

During the ensuing weeks, market commentators changed their tune. One vocal and expressive television pundit shouted that the Dow Jones Index was going to “take out its old high in a matter of days”. Most equity and commodity markets plunged within days. The point of view shifted from a “pause”, keeping the heady days of global growth, easy money, and no inflation, to a view that perhaps an unknown amount of “risk” lay ahead. The shouting and enthusiasm that sent gold to $725 an ounce and the Dow Jones Industrial Average nearly to an all time high became shouts of gloom and doom.

While major U.S. markets declined 7%-8% into mid-June from their May 10th level, commodity and global markets plunged 10%-30%. In effect, assets that had performed the best in the early months of the year collapsed as the notion of “risk” emerged. From mid-May into mid-June, $8.5 billion worth of emerging market mutual funds were redeemed—43% of all the money that poured into those funds for the preceding year.

Second-half “soft landing”

So what has changed? Not much. Global growth should continue. The U.S. economy shows every sign of continuing to grow at a 21/2%-3% rate—more moderate than we have seen, but sustainable. The Federal Funds target rate may get to 51/2% later this year, but another 1/2% increase should be easily digestible and sufficient to keep inflation in check. We expect the term “soft landing” to come into vogue the second half of the year. Corporate profits should grow nicely and calm should return to the equity markets. Profitable growing companies are reasonably valued and will provide decent returns.