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 March 2004 Monkey Wrenches
Not everyone is in total agreement on all points, but there does seem to be some common points of agreement:
While not wildly optimistic -- it's hard to get excited about rising yields and inflation -- this is certainly not a bearish call. Most investors would be happy with slowly rising rates, especially considering the historically low levels they're starting from. After last year's blistering stock market, most would also be happy with any sort of equity gain, not to mention double-digit ones. But is this consensus view really well founded? And even if it is, aren't there some prospective monkey wrenches out there that could unexpectedly gum up the works? The Fed's the OneAt the heart of it, the consensus is based on continuing benign (if not simulative) economic factors. Low inflation and correspondingly low interest rates are two of the most critical.Despite the Fed's easy-money policy, inflation as measured at both the producer level (PPI) and consumer level (CPI) has remained remarkably low. In mid-February, the Fed lowered its prediction for 2004 from a mild 1.5% increase to an even more tame 1.0%. At the end of 2003 both ticked up, but the so-called "core" inflation was low and even declining in the PPI. The core readings exclude volatile food and energy costs. For the most part it's stubbornly high energy costs that account for the difference.
Oil spent the first two months of 2004 in the $32-34 a barrel range. These levels were last seen at the start of last year's Iraq conflict. Political tensions have eased considerably, yet prices remain stubbornly high. As is often the case, it's a supply and demand thing. Thanks to the recovering U.S. economy and cold winter weather in the Northeast, demand has been strong. This may ease a little when temperatures warm in the spring, but supply issues may continue to prop up prices. For the most part, supply hasn't kept up with rising demand. There are at least three reasons for this. First, Iraq production has not come back into the market as quickly as initially anticipated. Secondly, other OPEC members violated and then ultimately abandoned their own standard for increasing production, apparently deciding there was no reason to keep prices in the high $20s when they could collect $34/bbl. Finally, U.S. refiners have inadvertently tightened supplies by being caught short when prices remained high. Many had let supplies dwindle expecting to restock when prices fell. When prices didn't fall, restocking never occurred or when it did, it was more costly than anticipated. These increased costs, of course, have been passed through to end users. Although not yet a problem, high oil prices could work to slow -- if not derail -- the U.S. recovery. Every extra dollar paying for oil is that much less going back into the economy. Higher costs of production will eventually filter out to end users, adding inflationary pressure. At this point the specter of rising inflation doesn't seem to bother the Fed. To a degree this is peculiar since the Fed -- especially the Greenspan Fed -- has always taken a proactive approach to heading off inflation. A year ago they claimed to be more concerned about deflationary pressures and now perhaps they're hesitant to stifle the current recovery before it has a chance to truly take hold.
Regardless, until February's meeting, statements following FOMC meetings continued to reiterate that rates would remain low for a "considerable period of time". When this wording was dropped in February, investors scoured the statement for hints of coming action. After a few anxious days, they finally concluded that the Fed remaining "patient" was quite akin to rates remaining low for a considerable period of time. The yield on the 10-Year Treasury Note moved back towards 4%, near the bottom of its trading range. And that's why the consensus' reliance on a steady Fed may be misguided. While Mr. Greenspan may be reluctant to raise rates, bond investors may ultimately do it for him. Not wanting to endure a repeat of last summer's whipsaw, any whiff of increasing inflation or accelerating weakness in the dollar may spark a bond sell-off and correspondingly higher rates. In fact, the further we move into 2004, the more likely this is. (Of course this does support the consensus view that the first half of the year will be better for bonds and the economy in general.) Top Line, Bottom Line, and Everything In-BetweenLow interest rates and inflation make stocks an attractive investment. Recognizing this, investors sent major equity indexes up 20, 30, 40, and in the case of the Nasdaq, 50% last year. December's "Santa Claus Rally" spilled over into January and shares got off to a good start this year, too.
And why not? Fourth quarter earnings exceeded even bullish estimates, there were few warnings, and many companies offered upbeat outlooks for the coming quarters. These are all positive drivers for the stock market. But it will be much more difficult to sustain such gains in the coming quarters, especially in the second half of the year. Several factors that worked to support last year's rally will begin to conspire against additional gains:
Throw in the rhetoric and uncertainty that's sure to accompany this year's presidential election, and it's quite reasonable to expect the first half of 2004 to be better for stocks than the latter half. This isn't to say that share prices won't appreciate after June, but rather that the gains won't be as significant as in the first six months. Indeed, many economists expect 2004 GDP to grow by 3-3.5%, a very respectable rate. This, coupled with a slowing but still rising stock market is basically the traditional scenario for the second year of an economic recovery. Who's Missed What?So what can go wrong with this scenario? What's been overlooked or discounted? Presently, we see four potential problems:Too Many People Believe It. This isn't as strange as it may first appear. The way to make money in the market is to be ahead of the trend, but if everyone goes along with the consensus and invests accordingly, is it still possible to profit if this year's price movements already factored in? Think back to 1999-2000. By the time everyone came to believe in the "new economy", tech stocks were nearing the end of their rope and stodgy "old economy" bonds were (in hindsight) the place to be. Going with the consensus didn't lead to outsize gains but rather serious losses. Could something similar be shaping up now? An Election Year Surprise. While the outcome of a presidential election may sometimes be predictable, what occurs in the run up to it rarely is. A stumble by the present Administration or a groundswell of support for "populist" tax-and-spend or economic isolationist policies could certainly roil the markets. If nothing else, we'd expect the democrat candidates to rely heavily on the old class warfare arguments to attack the President's tax cuts. Should they gain any traction with the voting public, investors would be wise to reposition their portfolios defensively since this could spell the end of the recovery. Fixed income investors should keep a close eye on any major spending proposals since government initiatives are usually most effective in stimulating inflation. With bondholders already on edge about the timing of a rate increase, it won't take much to stir them to action.
And who knows what other surprises may lurking on the campaign trail? Could anyone have predicted the goofy "hanging-chad" affair and all the political uncertainty that surrounded it? A Free-Falling Dollar. Since last summer, the dollar has fallen 20% against the euro and the yen. Perhaps the most striking thing here is that it's the U.S., not Europe or Japan, with the recovering economy. Typically, a country's currency reflects the relative strength of its economy. This time, however, there's politics not just economics at work. Despite struggling economies, the European Union -- heavily influenced by Germany's irrational fear of inflation -- is reluctant to lower interest rates to stimulate growth. On the other hand, Japan, in an effort to export its way out of recession, has already cut interest rates to zero. The Fed's accommodative stance has made the dollar appear weaker relative to these trading partners, so it has fallen in value. For the most part, the decline has been orderly as the open market is setting the appropriate short-term relative prices. If that's all that happens, there's nothing to worry about. But should the dollar drop sharply for whatever reason, the Fed's hand might be forced. This would certainly send shocks though both the stock and bond markets. Perhaps the only event that could end the current recovery more quickly would be Another Act of Terrorism, Especially on U.S. Soil. Many believe the economy was poised to begin recovering right around the time of the attack on the World Trade Center. Whether that's correct or not, the economy didn't begin to recover until eighteen months later. Even if the economy wasn't ready to take off on September 11, 2001, it's still reasonable to conclude that the events of that day delayed the actual turnaround. It's equally reasonable to believe that a similar incident could quickly derail the current recovery. This is clearly the most unpredictable monkey wrench, but it's also potentially the most damaging. So What?So what's an investor to do? You can't quantitatively handicap the likelihood of any of these outcomes, even that of the consensus.As the late-February correction suggests, this is not the time to blindly dive into stocks. After 2003's run up, valuation is more of a concern now than ever. Bonds offer muted returns even if the Fed holds steady. There's little chance of further rate declines so there's almost no chance for price appreciation. The best case scenario is to collect coupons at their 40-year lows.
Times like this call for a measured approach involving realistic expectations and a diversified portfolio. Current economic conditions do favor further stock gains, but probably not at last year's levels or even at the consensus forecast. More defensive sectors such as healthcare and consumer staples may fare better than more economically sensitive sectors such as financials and technology. Any short-term disruption in the economy can easily lead to a flight to quality in the bond market. Given this, despite their limited gain potential, bonds still belong in portfolios seeking a hedge against the potential risks outlined above. For at least the first two months of the year the consensus view has held true: Stocks for the most part have been strong, rates have remained steady, and the economy has continued to (erratically) improve. The old Wall Street adage advises, "Don't fight the tape," so perhaps the consensus forecast will prove to be a self-fulfilling prophecy. Just don't count on it. Search this site! Just enter you key word or words:
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T'S ALWAYS SCARY WHEN THERE'S a consensus. When everyone believes the same thing, everyone's more vulnerable to surprises that all have overlooked. It's not often you get a consensus from economists and market strategists, but so far this year that's about what we have -- and that's scary.
