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Integrity
Performance Service
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It appears that business spending, heretofore absent from the recovery, has turned the corner. The preconditions for a rise in business spending have been visible for some time. Corporate profits have been increasing steadily, cash flow is at record levels, and interest rates are near multiyear lows. The extreme caution of business managers, we believe, is a function of uncertainty engendered by the war and fears of terrorism. Clearly, business executives have been caught off guard by the strength of final demand, and a new and more positive attitude is taking hold. Business equipment spending rose a healthy 8.2% in the second quarter, led by a 19% increase in spending on information processing hardware and software. Early indicators point to a continuing acceleration of spending in the third quarter and beyond. This assessment is supported by the results of several recent surveys, which indicate that spending initiatives by manufacturers generally will increase in the months ahead. These surveys confirm the steady rise in the Index of Leading Economic Indicators over the past several months. With a short lag, this index has been a historically accurate predictor of production trends. Fears of a reversion to a sub par industrial economy after short-term improvement are misplaced. Our industrial economy appears to be in the early stages of a significant advance which will sustain a high rate of economic growth through 2004. Much of the surge in final demand since the end of major hostilities in Iraq has been met by drawing down inventories. Inventory liquidation will be replaced by inventory investment in coming months, augmenting the small improvement in industrial production recently. The recession, which ended officially in November 2001, differed from previous recessions in that it was a profits and capital spending recession. Corporate profits are already in a recovery mode, and the economy appears to have worked through the excess and misguided investments of the late nineties. Fiscal and monetary policies are in alignment and are very supportive of an anticipated resurgence of industrial production. Beyond our shores, foreign economies are stirring. In fits and starts, a frail Euro economy is poised to show improvement, or at least not contract further. Asia, excluding Japan, is growing firmly and steadily. Finally, the weakened dollar helps level the playing field for American manufacturers, as evidenced by the improvement in exports over recent periods. In short, the indications of a healthier industrial economy are broad and add weight to the view that recent positive trends in production are sustainable. The depiction by many observers of our economic condition as struggling is no longer accurate. While late coming and uncharacteristic of previous recovery periods, the U.S. economy is close to firing on all cylinders. Few economic releases over the past two quarters have been weak, and some have been surprisingly strong. New job creation is the notable exception. By some estimates our economy has shed 2.7 million jobs since the year 2000 and no recovery is yet evident. The decline in employment coincided with the collapse of capital spending, one of the most severe declines in capital spending in U.S. economic history. There is hope that the poor labor conditions will benefit from the improving trends, especially business outlays. The strength of business spending recently, if it persists, signals that the excesses of the late nineties, including excess employment growth, have been cured. A less risk averse business community will view an increase in employment as supporting new growth opportunities. It is true, also, that employment gains typically lag an economic upturn. The gains in production now beginning to take hold would be among the best signals that labor markets are beginning to heal. We do not anticipate any adverse conditions in the credit markets. Inflation shows no signs of heating up. Excluding the volatile food and energy components, overall inflation in the United States was 1.3% over the past twelve months, the lowest rate in many years. With abundant resources and capacity readily available, inflation is likely to remain low, and possibly decline further. Partly because of the salutary inflation outlook as well as the desire to expunge any traces of deflation, the Federal Reserve Board has stated that interest rates will remain low for an extended period. The major threat to this calm outlook is the huge government deficit which, if it persists into the future, would constitute a serious negative. It is, however, a remote danger under today’s circumstances of excess and under utilized resources. The gathering strength of the economy since the formal end of the hostilities in Iraq lends credence to the view that the U.S. economic recovery, visible in the last year’s second half, was curtailed and not ended by the long and contentious debate in the United Nations over Iraq. The bitter and highly public recriminations, coming so soon after the natural traumas of the past two years, resulted in heightened fear and natural hesitation among those responsible for long-term business decisions. This indecisiveness is fading. As economic momentum builds, bold decision making in business planning is replacing timidity and fear. We believe the outlook for U.S. financial assets, especially equities, is highly attractive under current conditions. Investment Policy Committee Alfred A. Lagan, CFA, Chairman September 29, 2003 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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