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 January 2005 This Year's Worry
As 2004 came to a close, it was becoming more and more evident that the earnings cycle peaked in the third quarter. Profit growth for 2005 is currently estimated to be 10%, about half of last year's rate. Decelerating earnings are clearly a matter for concern. Although they didn't jump as many anticipated in 2004, interest rates are drifting up as the Fed continues to tighten. With no end in sight to their "measured" increases, rates can be expected to continue upward. In the past, a rising rate environment hasn't been favorable for stocks or the economy in general.
Inflation has remained right around -- if not slightly below -- the past decade's average. Recently, however, it's started to show signs of awakening in other areas than just energy. Growing international demand at the producer level may soon filter through to consumers of finished products. The dollar spent the year sliding against the currencies of our major trading partners. The vast and growing U.S. trade deficit is widely believed to be the catalyst, and there's little hope for improvement in the near term. Oddly enough, these factors may actually suggest that 2005 may be an above average year for stocks -- at least for discerning equity investors. Fret of the YearLast year -- at least for 10+ months -- attention was focused on the presidential election. This year, it'll be on the dollar.This greenback's current decline doesn't stem from the usual causes. Typically a country's currency loses value if (1) its economy is slower than that of its trading partners or (2) domestic interest rates are lower than foreign rates. Neither of these applies in the current situation.
In regard to economic growth, the U.S. economy is much stronger than Europe's or Japan's. The Chinese economy is growing at a stronger pace, but ironically it's due at least in part to the yuan's peg to the dollar and the strength of Chinese exports to the U.S. The interest rate differential isn't that great, either. Following the Fed's December increase, U.S. short-term rates are actually higher than those of our major trading partners -- including the EU. Instead, the dollar's current predicament is the result of America's growing trade imbalance and its potential effect on bonds -- and derivatively stocks. This year investors will spend a lot of time fretting over this. Ironically, U.S. consumers are both the hero and the goat. Not only have they pulled U.S. economy through its recent recession, they've also supported foreign ones as well. Unlike their foreign counterparts, domestic consumers are will to spend at the expense of saving. Indeed, recent reports show U.S. consumers setting aside a mere 0.2% of their income. In other words, a consumer with a $100,000 income is saving a whopping $200 a year. It's not just a burning desire for consumption, low interest rates offer little incentive to save. Despite the Fed's 5 increases in 6 months, interest rates -- especially on retail savings instruments like CDs or T-bills -- are still just slightly above generational lows. Foreign countries have come to count on the U.S. consumer. For most, exports to the U.S. are the strongest part of sluggish economies. But as foreign goods flood the market, U.S. dollars do, too, as payment. As the supply of dollars grows, its value declines. It's that old supply-and-demand thing. Foreigners, faced with growing supplies of dollars, have turned to the U.S. Treasury and stock market for investment. Their demand has helped support both, even as the Fed kicked off its tightening campaign. If this process could continue indefinitely, everyone would be happy. But should the trade imbalance continue to grow and the dollar suffer further declines, foreign investors will eventually lose their appetite for U.S. securities.
Although yields and earnings growth are nominally higher in the U.S., foreign investors see their gains disappear when converted back into their local currencies. If they stop buying U.S. securities -- or just slow their pace -- domestic interest rates will jump and stocks will slump. Again, it's that old supply-and-demand thing, just in reverse. That's why both stock and bond investors are deeply concerned about the dollar. The trade imbalance won't right itself overnight, so it should be the major fret -- at least for the first part of the year if not all 2005. Better Than Worst-Case ScenarioBut that's the worst-case scenario. In effect, the Fed is already raising interest rates to help support the dollar and (hopefully? eventually?) reverse the trade deficit. So far, their "measured" 1/4% increases haven't really shocked the market. Indeed, as Fed Chairman Alan Greenspan said in mid-November, "Rising interest rates have been advertised for so long and in so many places that anyone who hasn't appropriately hedged his position by now obviously is desirous of losing money."In fact, the Fed's course has been so well communicated, the benchmark 10-year Treasury Note finished 2004 slightly below the level it ended 2003. Contrary to all the worrying, stable interest rates have traditionally been good for stocks. The yield curve is also sending another positive signal: It's flatter now than at the beginning of 2004. At the beginning of the year, the difference in yields between the 10-Year Treasury and 30-Year Treasury was 2.46%, but on December 31st, it stood at 1.13%. As the Fed has nudged up short-term interest rates by 1-1/4% since June, yields at the long end have actually fallen. This implies bond investors don't see inflation as a long-term concern; if they did, they'd demand higher yields for longer maturities. "I have no reason to think [inflation] will rise significantly in the next couple of years," says Federal Reserve Governor Ben Bernanke. Actually inflation is poised to rise 2-3/4% to 3% in 2004, about 1% more than in 2003. Most of this is due to higher crude oil prices, but other commodities have come to life at the producer level. Fortunately, few of these increases have been passed through to the consumer, but that may not last forever, especially if the domestic economy picks up steam.
Nevertheless, the Fed's concerted tightening policy can help keep both inflation and economic growth at acceptable levels. "Inflation is still quite well contained ... and I think that whatever risks exist are not large ones," Mr. Bernanke said. "Nevertheless ... as the economy approaches full employment, as pricing power begins to return a bit, we need to be exceptionally vigilant to make sure inflation pressures don't re-emerge." Non-inflationary growth -- even at a slower pace -- is a positive for stocks. The Bottom Line? The Top-LineIt also explains why profit growth should decelerate in 2005. Earnings enjoy their strongest pick-up when the economy emerges from a recession. At that point comparisons to previous quarters are easy hurdles and there's often pent-up demand. Cost savings from layoffs and restructurings are also at their greatest then.Yet after a few quarters of economic expansion, profits become more dependent on top-line growth. That's exactly what we'll see in 2005. That's also what successful equity investors will focus on: The top-line. Best bets are stocks of companies that can maintain or even grow earnings in a slow-growth environment. A good place to start is with companies that derive a high percentage of their revenues overseas. Even if their sales remain flat, the weak dollar will increase profits when brought back home. Often investors think of Consumer Staples stocks in this capacity. While Coca-Cola and Colgate-Palmolive do indeed fit this mold, pharmaceutical and industrial machinery manufacturers do too. Not all Consumer Staples companies will benefit equally -- especially those that rely primarily on domestic sales. Historically at this point in the earnings cycle, there has been a shift into the more defensive sectors, but investors currently still seem to have an appetite for risk. Some quality Tech stocks (e.g. Corning, Texas Instruments, and EMC) that haven't yet been run up in price may join Healthcare and consolidating Telecom stocks in a Happy New Year. Macroeconomic conditions may keep 2005 from being a typical third year in an economic recovery, but that doesn't mean it won't be a good one for equity investors -- as long as they're discerning. One thing's for sure, though: There'll be plenty to worry about along the way. Search this site! Just enter you key word or words:
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T'S OFTEN SAID THAT THE, market is moved by fear and greed. Last year fear moved to the forefront. There was certainly plenty to worry about.
