Fall 2005
 

In his recent annual testimony to Congress, Federal Reserve Chairman Alan Greenspan provided an unusually direct and clear roadmap for the financial markets. Although he attached to the roadmap a list of uncertainties and risks, he reinforced the fact the economy is on solid footing. As a testament to the solid growth outlook, the Federal Reserve increased short-term interest rates to 3.5 percent at their August meeting.

The Federal Reserve expects real GDP to grow 3.50 percent for the rest of 2005 and 3.25 percent to 3.50 percent for 2006. Healthy labor markets are anticipated with an unemployment rate of 5 percent through 2006. Regarding inflation, the Fed increased its forecast by 25 basis points, to a range of 1.75 percent to 2 percent for the rest of this year and next year.

Given the current profile for growth, healthy labor markets, and inflation below 2 percent, observers are calling this a Goldilocks economy—not too hot, not too cold.

Rates Need to Move Higher
To promote its positive outlook, the Federal Reserve will have to continue raising interest rates. Examining the status of financial conditions, bond market and interest rates, credit spreads, equity markets and currency markets, it's easy to see why the Fed describes the current climate as accommodative. Each factor is more positive now than when the Fed started its current tightening campaign, and each continues to stimulate growth.

Some observers believe the Fed is near the end of its current tightening cycle and could start loosening monetary policy early next year. Given the market climate and Greenspan's roadmap, we believe that's unlikely. We expect to end the year with the federal funds rate at 4 percent to 4.25 percent.

Labor, Energy and Interest Rates Remain Uncertain
As noted earlier, the Fed's forecast contains some uncertainties and risks, including higher unit labor costs. Although the economy has gone through an excellent productivity cycle, there has been some slowing. Recent data on national accounts income suggest stronger growth, which may support encouraging productivity numbers. But if they don't, unit labor costs may creep higher.

The cost of energy also remains an uncertainty. There is considerable political risk associated with the production of oil, and this will increase oil's price variability and cause periodic supply interruptions.

Another element of risk is the behavior of long-term interest rates. Encouraged by stable economic growth and financial markets, some investors are reaching for longer time horizons and betting on lower volatility. This behavior has led to low interest rates and narrow risk premiums. Nevertheless, this probably is not a permanent situation, and pressures likely will develop on interest rates.

Bonds Face Hurdles
Regarding the bond market, we are concerned about limited rewards and significant risks. The 10-year Treasury yield remains remarkably low, but it faces some hurdles going forward, including continued economic growth, the Fed's continued tightening policy and rising inflation. In addition, the revaluation of China's currency may cause central banks to curtail their purchasing of U.S. dollars.

At the corporate level, businesses remain remarkably risk averse, rebuilding liquidity and solvency and taking a cautious approach to investing. Such behavior has been a positive influence on the bond market by contributing to tighter credit spreads. But there's a change underway, as corporations become more aggressive about satisfying their equity investors. This action may conflict with the interests of bond investors.

Given these risks, we believe bond returns, at best, may equal coupon income, or possibly less if the yield on the 10-year Treasury backs up toward 5 percent.

 
Stocks Poised for a Stronger Second Half
Turning to equities, we anticipate a stronger second half for the stock market. Corporate performance remains excellent, as the majority of companies have reported higher-than-expected second-quarter earnings. In addition, estimates for full-year earnings have continued to advance.

For 2005, the annual earnings estimate for the S&P 500 Index is greater than $75 per share, a gain of approximately 12 percent versus the prior year. For 2006, analysts estimate another 10 percent gain, and on a 12-month forward price/earnings (P/E) basis, the market currently is selling at an attractive 15.5 times earnings.

Based on this data, the market is fair to slightly undervalued, which is encouraging in light of how well business is performing. Our confidence in these metrics is high, because in addition to strong earnings, corporations have been achieving record profitability and continue to generate substantial free cash flows.

Furthermore, profitability has generated rapid dividend increases. Share buybacks, which often accompany dividend increases, are prevalent.

The final element enhancing shareholder value has been growing mergers and acquisitions activity. We expect more, as corporations move from their risk-averse, rebuild-the-balance-sheet perspective to a focus on growth.

Fundamentals Drive Stocks
We've been particularly pleased with the recent breadth of the equity markets' advance. The year-to-date performance (through the end of July) of the S&P 500 brings the Index to a four-year high. At the same time, the S&P MidCap 400 and the S&P SmallCap 600 hit all-time highs. This trend—and supporting underlying fundamentals—give us confidence that our longstanding target for the S&P 500 to reach 1300 by year end appears more probable.

The probability of this outcome has increased because it's based on strong economic and business fundamentals and on the market's reaction to recent terrorist attacks. The ability to rally in the face of negative events is a characteristic of a positive equity environment. Although these attacks were tragic, they did not destroy investor psychology, signaling again that underlying fundamentals are driving the market.

Deficit, Housing Market Pose Challenges
Despite our positive outlook for equities, there are some risks and uncertainties facing the financial markets. In particular, the U.S. current account deficit is now more than 6 percent of GDP. For a large industrial country this is unexplored territory, and it is unsustainable on a long-term basis. Three factors likely will lead to resolution:

1. A higher national savings rate.
We are seeing improvements in the government and corporate sectors, but consumers continue to add to their debt loads and maintain minimal savings.

2. Greater currency flexibility in the United States and less savings in the Far East.
We believe the market correctly interpreted as positive the recent revaluation of China's currency, because it represents the beginning of a necessary correction of our current account deficit.

3. Faster growth from Japan and Europe.
We continue to hear of potential rebounds in Japan, but in Europe GDP growth rates and forecasts continue to decline.

If negative trends continue, they most likely will be reflected first in the bond market and interest rates. The dollar will weaken, and inflationary pressures will emerge. As a result, interest rates will start to back up. That's why, in addition to focusing on equities, we suggest a slightly higher-than-normal liquidity allocation.

The housing market poses another risk to the financial markets, as real estate investments, driven by second-home purchases and risky financing techniques, are causing prices in many regions to get ahead of fundamentals. The mechanism for correcting this problem is an increase in real interest rates. Although the Fed denies it will keep increasing rates to deal with the housing market, it has acknowledged the need to monitor the housing situation.

Risks Validate Equity Overweight
In summary, the major risks to our favorable outlook are factors that generally translate into nervousness about interest rates and bond prices. Therefore, we remain comfortable with our overweight in both equities and cash.

Orie L. Dudley Jr.
Chief Investment Officer
Northern Trust