Looking Back and Peering Forward

January 2004
 

The beginning of a new year is a natural time to sum up the year just ended and assess the outlook going forward. Despite many uncertainties and well-known worries, such reflections this year are ultimately very encouraging:

• The business cycle gained strength throughout 2003, and the economy entered the new year expanding at a much higher, sustainable rate.
   
• After a successful test in March of the October 2002 low, the worst bear market since the 1930s ended, and equities proceeded to record one of their best recoveries of the past two decades.
   
• Despite a unique combination of shocks (terrorism, scandals, the Iraq war, etc.), the U.S. economy continued to demonstrate remarkable resilience and productivity — suggesting the intriguing possibility of a higher secular growth potential beyond the current cycle.

Sea change begins in second quarter
Emerging out of a brief recession that officially ended in late 2001, the U.S. economy grew hesitantly and below its potential. Driven primarily by consumer spending and supported by massive policy stimuli, the recovery was perceived as too narrowly based and vulnerable to a "double-dip" retrenchment. Businesses were dealing with the aftermath of the 1990s investment bubble and its associated scandals and governance issues. Executives focused on correcting prior errors, shrinking operations back to core activities and improving balance sheets. Risk taking and investing for growth were largely shunned.

This behavior began changing in the second quarter of 2003. Business investment started increasing and growth once again became the strategic priority. The reasons for this change — reasons that are extant today — include:

• Current profits and cash flows were recovering strongly, reaching record levels by the third quarter. Cash flows were actually exceeding ongoing investment.
   
• Financial conditions (interest rates, credit availability, equity prices and currencies) were extraordinarily supportive for growth.
   
• The expected returns from investment were rising. The market value of assets relative to their replacement cost, productivity and longer-term earnings prospects were all increasing.

Business, in short, had the resources, opportunity and motive to invest. This reality, in turn, had positive implications for financial assets and for the business cycle.

Expansion broadens, financial markets respond
With the re-engagement of business, the economic expansion broadened. In addition, the economy appears to have entered a virtuous cycle of self-sustaining growth in which demand leads to increased output and jobs, thus producing income and profits and creating more demand. Monetary and fiscal policies, meanwhile, continue to be highly stimulative and financial conditions, particularly with the dollar falling, remain markedly supportive. In 2004, gross domestic product (GDP) will therefore probably grow at an above average rate, possibly at or even above the upper end of the Federal Reserve’s forecast range (3.75% - 4.75%).
 

Financial markets have increasingly anticipated a more vigorous business cycle. This was clearly reflected in the strong performance of stocks, higher-risk bonds and emerging market debt in 2003. In contrast, U.S. Treasury investors experienced very modest gains, and, for the first time since 1999, yields on the benchmark 10-year government bond rose during the year — from 3.82% to 4.26%.

This divergent performance is likely to persist this year. Government bonds have been deriving support from accommodative central banks, negligible inflation and those who were skeptical about the sustainability of the business cycle. Each of these supports for bond prices will be challenged going forward. There is the particular risk that a declining dollar will be inflationary and might force central banks to change their supportive policies.

The anticipated rise in 10-year bond yields (+50 to 125 basis points) should not be severe enough to unsettle equity markets. Stocks unmistakably benefit from more rapid growth and higher profits; the 40% increase in the S&P 500 since the March lows clearly discounts significant improvement in both. Nonetheless, this recovery from the preceding severe bear market is still slightly less than the median recovery of the last century. Moreover, improvement in business performance this cycle, especially corporate profitability, should support further, if more modest, gains this year. S&P 500 operating earnings appear set to reach a record $62 per share, an increase of about 13% compared with 2003 results.

"Dynamic" economy generates productivity gains
As the United States returns to trend growth (probably higher in 2004) the bigger economic story is the remarkable dynamism of the economy and its ability to generate productivity gains. Since the peak of the prior boom in 2000, productivity growth has actually speeded up when it was expected to slow. Advocates of a "new economy" — at least the idea that secular productivity growth has shifted up to a higher trend rate — appear vindicated. During the period from 1995 (boom, bust, recovery), productivity growth has averaged about 3% per year, twice the rate seen during the previous two decades.

This performance, if it persists, increases the economy’s non-inflationary growth potential and its ability to generate income and profits. This, in turn, has very positive implications for expected returns from financial assets, particularly stocks. Companies can achieve more rapid real earnings gains and pay higher dividends — which are now taxed at lower rates.

A happy New Year for equity investors?
A stronger cyclical recovery and a potential higher secular growth rate are not yet fully priced into equity markets, despite recent strength. Unquestionably risk exists, particularly exogenous threats like terrorism, but markets adjust and require new and undiscounted things to happen to alter well-developed trends. The state of the business cycle, the end of the bear market, and the economy’s remarkable resilience and productivity argue 2004 will be a favorable year for equity investors.

Orie L. Dudley Jr.
Chief Investment Officer
Northern Trust