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Integrity
Performance Service
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At this early state of the year the pulse of the economy is clearly upbeat. Fourth quarter real Gross Domestic Product was revised substantially higher to a 3.8% advance, from a preliminary estimate of 3.1%. Other vital signs were revised higher also. Among GDP components were large boosts to personal income, business investment, inventory building, and exports. The anemic initial estimate of productivity for the fourth quarter was revised upward almost threefold, to a satisfactory 2.1%. Moreover, early indications suggest that the first quarter is building on this momentum. Initial jobless claims for unemployment are low, and new jobs creation has turned up. The Help Wanted Index has posted successive large increases in postings. Business and consumer confidence levels have improved steadily. The real economy seems quite healthy. The upward revisions in personal income and steady decline in initial jobless claims hint at faster jobs growth in the immediate future, as well as higher wage income. Retail sales remain buoyant. Both residential and non-residential construction activity is at a high level and on track to add to first quarter GDP growth. Similarly, inventory investment appears to have picked up this quarter. Various surveys of manufacturers attest to the solid prospects. Corporate spending and business equipment spending in particular is robust, an impressive indication given the elimination of the accelerated depreciation provisions at the end of last year. These signs do not point to an economy losing steam. On the contrary, they indicate a robust growth environment. They are bringing their own set of worries, however. Foremost among them currently is the outlook for inflation. Some indicators point to higher rates of inflation going forward. The twelve-month core Consumer Price Index picked up in January to a 2.3% rate, a high for this cycle. Oil prices have continued to push higher, fanning fears of still higher inflation ahead. Despite these numbers, the Federal Reserve Board has not revised its inflation outlook, and has steadfastly maintained its belief that inflation will remain in the 1.5%-1.75% range for the Personal Consumption Expenditure Index, its favored inflation measure. The PCE currently stands at 1.6%. The Fed apparently believes, and we concur, that worldwide competitive pressures are as intense as ever and will act to forestall price increases migrating to the retail level. We do not wish to make light of these concerns nor to ignore other issues which pose serious quandaries for investors. We believe, however, that two primary issues will ultimately determine the ability of the U.S. economy to sustain a healthy, extended growth cycle with only mild levels of inflation. These are: the price of oil, and unbridled growth of the federal budget deficit. Oil prices have surprised everyone by their relentless rise. The longer prices stay at elevated levels, the greater impact they have. The impact is felt most heavily at the retail level. Paying ever higher prices for gasoline or heating oil takes money which would be spent on other goods or services. In that respect the effect is identical to a tax increase, and ultimately it impacts consumer spending negatively, possibly causing an economic slowdown. From an overall economic viewpoint however, the impact will be muted due to technological advances. The U.S. economy today is far less dependent on the price of oil than even twenty years ago. In other words, a unit of economic growth today uses a lot less energy to produce than ever before. Moreover, technological advances in finding, extracting, and refining oil are accelerating due to the sustained rise in oil prices. While technological solutions and accelerated development do not provide immediate relief, we believe they will increasingly act to restrain further increases. We believe, further, that current supply conditions are meeting current demand quite handily. We continue to believe that oil prices will decline from current levels, and that this decline will be felt this year. From a longer term perspective the rapid increase in federal government deficit spending poses the more serious threat to our financial health, in our view. At about 3.6% of Gross Domestic Product, however, the debt poses a long-term menace rather than an immediate one. Debt levels have been higher at other times in our financial history, but only rarely have they risen so quickly. An increasing number of economists and notably, the Chairman of the Federal Reserve Board, have been vociferous in drawing attention to the dangers inherent in unrestrained spending. We are optimistic that the members of Congress will hear these voices, and fiscal restraint will replace profligacy going forward. The financial markets are complex and are subject to many cross currents. Some are quite severe but illusory, some carry short-term risks, and some have quite serious long-term consequences. Our aim is to dispel some of the more fearsome concerns affecting the bond and stock markets today. We also wish to highlight those trends which, we believe, are inherently the most serious potential hazards affecting our financial health. Both the high price of oil and the runaway government deficit, if unaddressed, carry serious long-term consequences. We are optimistic that forces are in motion which will forestall a negative outcome. In the meantime the fundamental backdrop of the economy and the financial markets is very healthy indeed. Investment Policy Committee Alfred A. Lagan, CFA, Chairman March 14, 2005 The opinions expressed herein are those of Congress Asset Management and are subject to change without notice. 2 Seaport Lane Boston, MA 02210 www.congressasset.com
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