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 November 2005 After the Storms
What's not so clear however, is the long-term impact on the U.S. economy. With energy prices already high and profit growth rates declining, some economists feared the capital destruction and lost sales resulting from the storms were just the catalyst for a recession. Immediately after the storms there was a widespread belief that the Federal Reserve would pause or even end their string of rate hikes in an effort to keep the economy moving forward. Others cautioned against that, seeing the hurricanes as only having short-term consequences. With the massive rebuilding effort and all the attendant government spending, they saw inflation as more of a concern than recession. The Fed clearly sided with the latter camp, raising rates an additional ¼% at both the September and November FOMC meetings. Time will tell, but as of early November, their vigilance appears justified. What the Fed SawUnlike the media and the talking heads that provide its content, the Fed was able to separate short-term from long-term considerations. Many of the problems arising from the hurricanes had or will have short durations. For example:
In short, the Gulf hurricanes slowed growth, but only temporarily. On the other hand, the inflation they engendered could have a very lasting consequence. In the words of the September 20 FOMC minutes, "[T]he longer-term path of the economy probably had not been affected by the hurricane, but the upside risks to inflation appeared to have increased." Subsequent economic reports bear this out. September's CPI saw the biggest monthly increase in 25 years while the PPI's was the largest in 15 years. The "Prices Paid Index", a component of the ISM report and one of the Fed's favorite barometers, also showed a significant increase. Of course the "core" inflation readings -- those excluding energy and food prices -- were much tamer than the headline numbers. They're often viewed as more indicative of long-term trends since they aren't easily distorted by short-term gyrations in volatile food and energy. Nevertheless, when viewed in context of prior months and years, even they are starting to slowly tick up as rising energy prices begin to filter through the economy.
The Fed governors saw this, too. Again from the minutes of the September FOMC meeting, surging energy prices were "boosting overall inflation, and some of that increase would probably pass through for a time into core prices." Even more ominously, it could ultimately "be a more persistent influence on inflation should inflation expectations rise." Against this backdrop, the Fed didn't back off in September or November, leaving the Fed Funds Rate at 4%, a full 3% higher than it was when the current tightening cycle began back in June 2004. All indications suggest additional ¼-point increases can be expected in December and January. The first estimate of third quarter GDP vindicated the Fed's position. Many had expected growth to decline from the second quarter's 3.3% pace. Instead, it rose to 3.8%. Of course most of the data for September -- after Katrina -- had to be estimated and may be severely altered in the subsequent revisions. Even so, the Commerce Department did make adjustments to account for the storm's impact in the first estimate. The labor cost component of the GDP report painted a different picture. The Employee Cost Index climbed .8% vs. a .7% increase in the prior quarter. Wage expense was up .6% in both quarters, but the cost of benefits jumped 1.3% vs. the second quarter's .8% increase. Rising benefit costs are likely to be a long-term phenomenon. Healthcare costs continue to soar, far outstripping general inflation measures. As more and more baby-boomers reach retirement age, corporate pensions will need to approach full funding. Company benefit costs will rise accordingly. Until recently, higher commodity prices -- especially energy -- were the only factors stoking inflation. Now there are signs they're starting to be passed through from producers to consumers. As labor costs begin to rise, inflation becomes a full-fledged concern. It's good that the Fed sees this threat and takes it seriously. CatalystAlthough they might appreciate the Fed's action in the long-run, bond investors aren't so happy with it now. For months market watchers had expected interest rates to rise, yet they remained stubbornly low. In fact, those who sold when the Fed started raising rates in June 2004 actually saw yields on the 10-year Treasury Note fall about 1%. With bond prices moving inversely with yields, they certainly didn't sell high.However now it seems the Fed's vigilance in September was finally the catalyst bonds needed. When it became clear the Fed would not be deterred from lifting rates, yields on the benchmark Treasury Note jumped over ½%. That's a significant move in bondland. With further to go in this tightening cycle, yields have more to climb. At their current levels, they're still closer to their historical lows than their averages. As long as the ascent is orderly -- as it has been with the Fed's well-telegraphed ¼-point moves -- bond investors have little to fear aside from lackluster returns. Equity investors are a little more conflicted. Typically their portfolios become more defensive when interest rates are rising, corporate earnings slowing, and the bull market aging. That means overweighting stocks of companies that can grow earnings in a slow economy (e.g. Consumer Staples or Healthcare) while shunning more cyclical issues (e.g. Materials and Consumer Discretionary). This time, however, the decision may be a little more complicated. For instance, earnings may be a little less stable than usual for many Consumer Staples companies. Although they provide products that everyone needs regardless of the state of the current economic cycle (e.g. food, household, and personal grooming products), their production costs, both materials and labor, are going up. So far they haven't displayed much ability to pass this through to consumers and without pricing power, their margins and profits will be squeezed.
Healthcare, also commonly considered a defensive sector, is currently more of a mixed-bag than slam-dunk. Biotechs offer the best return potential but are often one-product companies. With all their eggs in one basket, they come with high risk, too. In the past several years, aging baby-boomers have helped support medical device makers, but some (most recently Guidant) have experienced quality control problems. Large pharmaceutical firms are faced with dry pipelines and major compounds coming off patent. The new Medicare law is at least a short-term wildcard. While it will almost certainly cap prescription drug prices, it may also extend medical services to enough new participants to increase volume and offset lost revenue -- or perhaps even increase it. As long as this uncertainly persists, Healthcare stocks won't react as predictably as in the past. On the other hand, traditionally cyclical sectors may hold welcome surprises. Consumer Discretionary stocks are most susceptible to consumer belt-tightening. Higher gasoline prices are leaving the consumer with less cash for discretionary spending. Fears that this will lead to a poor holiday season have held back shares of retailers to the point that market leaders such as WalMart may now represent decent value. Stocks of certain Materials companies may also do well. Although chemical firms are suffering from rising commodity prices, those companies that mine or produce raw materials can still prosper. Foreign demand as well as the Gulf Coast rebuilding effort will drive prices well into 2006. Ongoing demand and limited supply will also continue to support energy prices and Energy companies' profits. As a sign of the times, Exxon-Mobil's third quarter profits were the largest ever reported. Look for more of the same next year. At this point investors need to determine if this is already factored into share prices. Industrials -- especially those with a substantial business overseas -- will also see continuing demand. With the dollar still relatively weak in relation to the currencies of our trading partners, earnings generated in foreign countries will get an extra boost when converted into dollars.
Rising rates usually take their toll on interest sensitive sectors but here, too, there's a mixed response. Utilities which have done well since the demise of the equity bubble are now being hit from several directions: First, as big borrowers, their interest expense is on the rise. Secondly, their dividends -- the stocks' biggest selling point -- are losing their relative advantage over rising bond yields. Finally, rising energy prices continue to cut into their margins. This is one instance where things really aren't different this time. Oddly enough, however, Financial stocks are showing signs of life. That's not supposed to happen when interest rates are rising and there's talk of recession. In fact, one would think this would be a horrible environment for Financials when you consider the storm-related losses faced by insurers, poor stock market performance and its effect on brokers, and tight margins for all involved. The latter stems from the flat yield curve which has only gotten worse as the year's gone on. Most financial companies earn a profit by borrowing at short-term rates and lending at longer ones. The greater the difference between the two, the greater their profit. Twelve months ago the difference between the 2 and 10-year Treasury Note yields was 1.47%, but as of October 31 it had fallen to 0.16%. It's hard to make a profit on that, yet in the month of October, the Bank Index climbed 4.7% while the overall S&P 500 declined 0.6%. Perhaps this is another valuation issue with Financial stocks already reflecting the worst case scenario. With data suggesting the economy is stronger than anticipated, Financials may again look like values.
Technology shares are also attractive at current levels. As we enter 2006, many companies that invested in software and equipment prior to Y2k find themselves with 6-year old gear badly in need of an upgrade. With strengthened balance sheets, they now have the cash to spend. With a new standard of wireless communication and the next generation of the Windows OS and Office suite due next year, Tech companies are arguably in their best position since 1999. Look Back to Look ForwardThese sector expectations are actually quite close to their historical results over the past four decades. According to Standard and Poor's, since 1960, the overall market tends to rise 8% in the fourth year of a bull market. The current bull entered its fourth year in the week of October 10th.The bull market of the mid-1970s is perhaps the best comparison for 2006. The market environments are strikingly similar: Surging energy prices, fiscal deficits from funding an unpopular foreign war, rising interest rates, and inflation. Nevertheless, the fourth year of the 1970's bull market saw the S&P 500 climb 7%. After this year's lackluster market, most investors would be happy with that. When all's said and done, a little inflation isn't necessarily bad. A little pricing power for companies in any sector (with the possible exception of Energy) might actually be a good thing. Indeed, the companies that will do the best in this environment are the ones that have the ability to pass along some of their costs to protect their margins. Those with high or improving efficiencies also stand to benefit. Of course all bets are off if inflation gets out of hand or if the Fed tightens too far sparking a recession. For now at least, investors can take solace in the fact that the Fed appears to see the problem and is taking appropriate steps to combat it. Search this site! Just enter you key word or words:
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HERE'S NO DOUBT THAT last summer's Gulf hurricanes were some of history's most destructive. The immediate effects are clear cut with devastation from Texas to Florida resulting in loss of lives and property. Crude oil drilling and refining was disrupted, but so was production and distribution of other commodities such as coffee, sugar, and orange juice. Prices rose while jobs were lost.
