Shifting into Neutral – April 2005

April 26, 2005
Dow Jones Average: 10,158
S&P 500: 1,152


 

Shifting Into Neutral

 

When the U.S. economic engine stalled out back in early 2001, the Federal Reserve Board moved aggressively to restart growth in economic activity. Policy makers knew that the odds of a severe, prolonged recession were high given over expansion of the economy and the bursting of the greatest stock market bubble in U.S. history. Consumer sentiment was grim and layoffs were accelerating. The path of least resistance was clearly down. Starting in 2001, the Federal Reserve Board cut interest rates 13 times in an effort to flood the economy with money. But the economic engine just sputtered for the next eighteen months. It took interest rates of one percent combined with the tax cuts of 2003 to get the economy rolling again.

While the actions taken by the government to reverse the downturn in the business cycle and the financial markets finally worked, they have created other problems that now have to be addressed. The government has done everything possible to encourage consumption and discourage savings. The result is a heavily indebted population, inadequate retirement savings, high deficits at the Federal level, and a need to borrow the savings of other countries. Higher consumption and borrowing levels have contributed to increasing inflation. When demand for products and services goes up, and money is rapidly created through borrowing, prices will tend to rise. Having mitigated the damage to the post bubble economy, Alan Greenspan and other government officials now have to contend with rising inflation, a falling U.S. dollar, a low national savings rate, and high deficits.

It is clear that at some point the U.S. economic trend of increasing consumption and low savings needs to change. Citizens of the U.S. can not expect the rest of the world to lend us their savings at low interest rates indefinitely. Fed Chairman Greenspan knows that one way to temper spending is to raise interest rates, which is exactly what he has done seven times since last summer. He is attempting to decelerate economic growth in a cautious manner by gradually moving interest rates to what he calls a “neutral” level. When interest rates are lower than the rate of inflation there is a strong incentive to borrow money at the low rates and buy any number of things that may rise in price by more than the borrowing rate. For the past few years interest rates were held at abnormally low levels to encourage economic growth. In the current 3 to 4 percent inflation environment a neutral or normal interest rate would be 4 to 4.5 percent on short term treasury bills and money market funds. We believe that the Federal Reserve will raise interest rates throughout 2005 until they have reached a level that is slightly higher than the inflation rate. The Federal Reserve wants to accomplish this shift as soon as possible without destabilizing the financial markets and the real estate market in the process. The Fed does not want to get into a position of falling behind the curve on inflation which would necessitate even higher interest rates in future years.

Current Strategy

Investors in the stock, bond, and real estate markets have been reluctantly accepting the new reality of rising interest rates. The stock and bond markets are both down on the year, and real estate prices seem to have peaked in many regions. The stock market does best when real interest rates are declining and expectations for corporate earnings are rising. At the present time investors are confronted by the opposite situation, i.e., interest rates are headed up, while earnings seem to be topping out for many companies. Stock market investors would be more inclined to buy if they thought the Fed was finished with raising rates. Unfortunately at the Fed’s current pace it will take all of 2005 for short term rates to hit the “neutral” level of 4 to 4.5 percent. When the Federal Reserve Board signals that rates have reached the elusive neutral zone and will go no higher, investors may become more aggressive in buying stocks.

Even though the current environment is not conducive to stock price appreciation, we did manage to find in recent months several companies that we believe will do well over the next two years. We are looking for companies with strong, entrenched businesses that can weather a slower economic pace. If the stock market stays weak through much of 2005 the opportunities on the buy side will increase substantially. As has been the case in recent years, most of the gains will go to those investors who wait for the right moment before committing large amounts of capital to stocks.

Interest rates on short term bonds are climbing persistently, but are remaining rather stable on intermediate (10 year) paper. We expect an upward move in rates on intermediate and longer term bonds by year end. Given the flattening of rates across the yield curve one can earn almost as much on a six month treasury bill as on a ten year bond. We prefer the shorter term paper because it holds its capital value, earns a competitive rate, and allows one to roll into higher rate paper in a rising rate environment.

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