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Integrity
Performance Service
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While one cannot put a price tag on human life, the financial cost has also been harsh. Energy prices rose sharply and remained high, essentially imposing a tax on the consumer and severely depressing foreign economies. Corporate profits, already damaged by the after effects of the technology bubble, which collapsed in 2000, declined even further as businesses retrenched. Whole industries, such as airlines and tourism, virtually imploded. Corporate managers were thoroughly demoralized and corporate spending plans were suspended. Cost reduction became the war cry replacing the "growth at all costs" mantra. The despair was accentuated by the collapse of such growth icons as Enron and WorldCom, victims of blinding greed, but unfortunately staining all corporate reputations. In short, the damage done to business and commerce was severe both psychologically and tangibly. Corporate profits, having peaked in the first quarter of 2000, entered a new period of accelerating decline that lasted until the end of 2002. A flight to quality was the natural path. The dollar and government bonds soared. Equity prices, trading volumes, and capital markets all felt the full brunt of these negative developments. These developments are rapidly running their course and the United States economy is poised for a new growth surge. Corporate America, too, is on the threshold of change. The long and painful slide in corporate profits is over. First Call estimated that profits rose 13% in the first quarter. Business Week recently estimated that forty one of fifty seven industries surveyed had improved earnings in the first quarter, and profit margins widened to 6.4% from 5.3% a year ago. This improvement is likely to accelerate. Years of vigorous cost cutting and low interest rates have restored balance sheets to the healthiest condition in years. With low debt, declining interest costs, and reduced expenses, cash flows are strong. Costs have been cut so aggressively in recent years that further margin improvement is not dependent on strong revenue growth. Any uptick in revenue will leverage the earnings improvement. The surprise of the next expansion cycle will be the strength of corporate earnings based upon trends already in place. The recent decline in the value of the dollar will buttress these trends. As corporate profits rise, business confidence will return. For competitive reasons corporations’ managements cannot defer spending plans indefinitely. Evidence of the need to invest can be seen in the curtailment of capital spending over the course of 2001 and 2002, and the lengthening replacement cycle for high obsolescence products, such as technology equipment. Slowly, hesitatingly, evidence of renewed growth in corporate spending is beginning to emerge. Pent up demand, low corporate debt, and easy access to capital provide a strong financial incentive to reinvigorate capital spending plans. It seems like just yesterday that the problems facing the United States, and weighing heavily on the financial markets, were insurmountable. High on the list was Saddam Hussein’s belligerence, higher oil prices, high levels of fear and uncertainty, corporate governance issues, and the imminent threat of terrorism. While not eliminated, many of these concerns have ameliorated, and others are certainly no longer imminent. Oil prices are under significant pressure, and the outcome of the war with Iraq is no longer in doubt. The tension caused by the sense of helplessness and fear of the future seems to have eased. Now, the major domestic concerns revolve around the strength of the economy, unemployment, and the swelling deficit. These issues are real and will remain topics of heated debate and different opinions. The domestic economy however, is transitioning from one slowly eroding by uncertainty to one of demonstrable expansion. A reinvigorated capital spending cycle will be an important component of the renewal. Consumer spending also is unlikely to collapse, as some observers predict. Mortgage refinancings are surging once again, after an astonishing $700 billion of refinancings last year. Credit card debt is being whittled away, and bank deposits and other short term repositories have swelled. These are not conditions that precede a consumer led recession. It is not our intention to deny the seriousness of some domestic problems. Some will prove intransigent. Employment, for example, is likely to lag the economic expansion, at least until growth approaches or exceeds the rate of productivity. The possibility of more terrorist acts is certainly real. The conditions impacting the equity markets are, however, changing rapidly, and the outcome is likely to be more favorable than the past few years. Investment Policy Committee Alfred A. Lagan, CFA, Chairman May 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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