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Integrity
Performance Service
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Once again the consumer led the strength of the economy in the quarter. Real incomes continued to expand, and confidence remained generally high. Retail sales, ex autos, advanced. The strength of the housing market was impressive and confounded many observers. New housing starts expanded in May and June at accelerating rates, and the inventory of new homes for sale declined again. The average price of a home also increased. Building permits surged, pointing to further strength ahead. The remarkable performance of housing is not only a reflection of the low level of interest rates and easy availability of mortgage financing. It is testament also to the inherent desire of every family to own a home, and the ability to achieve this goal makes the United States the envy of the world. Moreover the financial picture of the consumer remains healthy, and will be bolstered in the immediate future by the record mortgage refinancing wave in June, and by the immediate impact of the 2003 tax cut. As has been the case for a long time now, business spending remains muted. Business spending is still held hostage to many of the trends in place for over a year: worries over war and terrorism, unsatisfactory levels of profitability, overcapacity, a lingering malaise over corporate governance issues, and a general conservative nature of business leaders. Nevertheless, business spending did not deteriorate in the second quarter, and there remained tantalizing hints that a floor may have been reached. For example, the authoritative institute for Supply Management manufacturing index showed significant improvement in May over the very low level recorded in the immediate aftermath of the Iraq war. Leading indicators of the index, including new orders and backlogs, showed a significant rise, while lagging indicators such as employment remained weak. The stabilizing trend was confirmed by the industrial production data for May, which rose after the collapse in April. Monetary and fiscal policy is in alignment, and is very supportive of expansion. The recent reduction in the federal funds rate to 1% by the Federal Reserve, its lowest rate since 1958, signals that monetary policy will remain easy until all vestiges of deflation are extinguished. Thus the rate is likely to remain low for an extended period. On the fiscal front the cash flow impact of the 2003 cut will hit the economy within a few weeks. The extent of the cuts is very broad and in our judgment, will have a positive impact on consumption, capital formation, and investment. The childcare credit rebates will be mailed beginning in July. The new law accelerates the tax rate cuts that were to become effective in 2006. As a result, the lowering of the personal income tax brackets is effective immediately and is retroactive to January, indicating that rebates of 2003 taxes will likely be quite high next year. Tax rates on dividends and capital gains have been reduced to 15%, and the capital gains rate for lower income taxpayers was reduced further to 5%. While the rules pertaining to these new provisions are complex, the disparity in treatment between the two forms of investment return is eliminated. The lower capital gains rate bolsters the long-term outlook for capital formation, new business creation and ultimately, expansion of employment opportunities. The provision for depreciation of new equipment was also changed. In addition to normal depreciation, businesses can take an additional first year depreciation deduction of 50% for qualified investments. In our opinion, the combination of the strength of consumer spending and the tax cuts will sustain the incipient economic advance into future quarters. For several reasons, we believe strongly that growth will accelerate, perhaps sharply, as the second half unfolds. Corporate profits improved in the first quarter. While welcome, many viewed the improvement as attributable to cost cutting and therefore, unsustainable. We disagree with this assessment. Corporate finances, measured by debt levels, cash flows, and interest expense, are healthy. Earnings are high quality, and inventories throughout the supply chain are low. Moreover the economies of the Far East, ex Japan, are visibly improving. In our judgment, corporate profits will remain on a positive track and will accelerate as the year progresses. As corporate profits rise, business confidence will return. For competitive reasons, corporate managements cannot defer spending plans indefinitely. There is a lengthy replacement cycle visible on the horizon. Pent up demand, low corporate debt, easy access to capital, and now, new tax incentives, provide a strong financial incentive to reinvigorate capital spending plans. The greatest disappointment with the recovery thus far is the lack of new job creation. Judging from first time applications for unemployment benefits, unemployment appears to be stabilizing. Like business spending, however, employment growth is restrained by overcapacity and doubts about the sustainability of the economic improvement. The advances in productivity in recent years also tend to retard employment growth in the near term. Unfortunately, employment will remain sluggish at least until domestic economic activity rises and approaches the long-term rate of productivity growth. There is a lot of talk these days that the U.S. economy is going to be stuck in a prolonged period of weak economic growth in the aftermath of the bursting of the stock market bubble and heightened geopolitical fears. We believe our economy is on the threshold of a renewed era of attractive expansion. The expansion will be bolstered by low inflation, low interest rates, and rising real incomes. It will not come without setbacks and skeptics. Monetary and fiscal policy, however, are clearly supportive of this assessment and the financial position of both consumer and corporate America add weight to our analyses. We believe the outlook for U.S. financial assets remains positive in this environment. Investment Policy Committee Alfred A. Lagan, CFA, Chairman June 27, 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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