Recovery Builds Momentum as Businesses Engage

November 2003
 

Although the United States’ economic recovery officially marks its two-year anniversary this month, growth has been far from robust. Over the past few months, however, the missing player to date, business, finally seems to have started engaging and actively participating in the rebound. In turn, prospects for a higher sustained rate of gross domestic product (GDP) growth have improved significantly.

Among the encouraging signs over the past three months have been better-than-expected corporate earnings, expanding capital expenditures and improvement in the employment market. In combination, the developments suggest that both the economic and financial market cycles are changing from a policy stimulated, liquidity-driven cycle to a more fundamental earnings-driven cycle.

Profits trending higher
Perhaps the most notable development in recent weeks has been the strength of third quarter earnings reports. Averaging around 20 percent on a year-over-year basis, the S&P 500 Index posted its biggest quarterly profit gain in more than three years.

The strong performance suggests that businesses are both participating in the recovery and benefiting from it. While the level of growth is impressive, the progression of earnings is even more encouraging as the numbers considerably topped forecasts recently revised higher. Collectively, the S&P 500 Index appears on track to earn a little better than $54 per share for 2003.

Employment, inventory still lagging
Amid the brightening corporate picture, two areas continue to temper enthusiasm: employment and inventories.

The staffing picture, an important component of any economic recovery, has generated the most concerns. Positives are building, however, as unemployment claims have fallen below the 400,000 level generally identified as the dividing line between an improving and troubled job market. In addition, temporary hiring levels, considered a leading indicator for permanent job growth, have gained five straight months.

Concurrently, inventory levels remain low, which means many businesses have held off on restocking shelves. As long as consumption continues to rise, though, businesses will ultimately need to rebuild inventories to meet the increasingly greater demand.

Earnings growth expected to continue
Alongside the building momentum in business activity has been sustained strength from consumers, whose unfaltering buying habits also contribute to renewed expectations for accelerated growth rates.

In the near-term, GDP growth is dependent on inventories, where replenishment could produce a surge in corporate consumption. The underlying patterns appear to be working toward a sustainable 3.5 percent growth rate in the GDP — a notable improvement over the 2 percent seen so far in this mild recovery.
 

Against the encouraging GDP backdrop, many businesses are consistently generating higher output with fewer workers, due to productivity gains achieved since the recession started. Some sectors are also enjoying pricing power, or the ability to implement price hikes. Taken together, these factors mean earnings could rise another 13 percent next year, to just over $61 per share for the S&P 500 Index.

Other market supports holding well
In determining the financial market’s overall health, earnings represent one key element — liquidity, interest rates, and valuation are equally important.

Regarding liquidity, the Federal Reserve has remained highly stimulative, keeping its prime lending rate at 1 percent and indicating it is willing to keep it there for a "considerable" time. While the Fed’s intentions are open to interpretation, it’s safe to assume the short-term lending rate will remain low well into 2004 as economic analysis indicates the economy is operating far below levels of optimal activity.

In fact, until the core inflation rate trends around 2 percent, the Fed will likely keep working to build a larger margin of safety against deflation, an economic condition defined by falling prices. With inflation currently hovering near 1 percent, there’s little room to absorb an exogenous shock such as another terrorist attack, which could dry up demand and set prices tumbling.

As the Fed’s accommodative stance has kept short-term rates low, longer-term rates are beginning to reflect pressures bubbling under the surface. Expectations for increased corporate financing needs, a substantial federal deficit and the Fed’s desire for a higher inflation rate all weigh on bond prices, as does the potential waning demand from overseas investors. In turn, rates, which react in an opposite fashion to prices, move upward. Gauging the market’s mindset, investors should expect a fair equilibrium rate for the benchmark Treasury 10-year note between 4.5 percent to 5.5 percent, or about 20 to 120 basis points higher than today’s levels.

Accepting the market’s liquidity and rate assumptions, financial mathematics imply a price-to-earnings multiple of 18 to 22 for stocks, which means valuations currently appear reasonable. In fact, considering 2004 earnings expectations for the S&P 500 Index, the equity market certainly has room to rise.

Relatively speaking, risks modest
No matter how bright the outlook, the risk of losing money is an important consideration. Currently, investors must contend with constants such as corporate and sector risk, stemming from poor management decisions or an industry’s structural problems, as well as geopolitical risks in an unsafe world. The unforeseen could happen at any time, and while the participants in the investment business all appear to account for the potential downside risks, those expectations can be jarred any time something happens.

Less compelling today are systemic risks such as currency and debt issues. As long as any decline in the value of the U.S. dollar relative to overseas currencies is gradual — and a precipitous drop is not likely as long as the Chinese government controls the exchange rate for its currency — the currency risk is modest. Similarly, while debt levels are running relatively high, gains in assets for both consumers and businesses offset the leverage risk. Low borrowing costs help keep the servicing fees in line.

Equities still hold highest promise
From an investment standpoint, bonds offer little upside potential as long as the interest rate cycle turns unfavorable.

Conversely, accounting for the economy’s growth prospects, the Fed’s inflationary intent, expanding activity in the merger and acquisition market and stirrings in the initial public offering market, stocks continue to be the asset of choice where volatility can be tolerated. More specifically, investors should look to cyclical sectors such as industrials and materials for the best opportunities to gain from this expansionary phase.

Orie L. Dudley Jr.
Chief Investment Officer
Northern Trust