Inflation Expectations – January 2005

January 24, 2005
Dow Jones Average: 10,393
S&P 500: 1,168


Inflation Expectations


In making an economic forecast for 2005 one has to decide whether trends from the previous year are likely to continue or reverse. In retrospect the important trends of 2004 are quite obvious. The U.S. dollar continued to fall in value versus the euro and other major currencies. Corporate profit margins expanded, while wages lagged behind the increase in sales and profits. Real estate prices continued to move strongly upward. Interest rates rose on short term paper, but changed very little on ten year and longer dated bonds. Oil prices surged as did prices for many other raw materials. And the stock market turned in its second positive year in a row with most of the modest gain coming late in the year. In the first few weeks of 2005 some of these trends have reversed with the U.S. Dollar gaining against other currencies and the U.S. stock market losing a significant portion of its 2004 progress. Even though January has often served as a barometer for the entire year there is still a long way to go before the economic story of 2005 is written.

We have reviewed the 2005 predictions of many leading economists, Wall Street strategists and respected money managers and find that most fall within a similar, narrow band. There are a few bearish prognosticators who predict a resumption of the 2000-2002 market decline, but even they are not saying that 2005 will be the year the decline resumes. The typical prediction for 2005 is a continuation of steady, three percent growth in the U.S. economy made possible by the high spending, low savings habit of the U.S. consumer. Corporate profits are forecast to rise five percent or so as higher materials, energy, and labor costs limit profit growth. There is less of a consensus on stock market appreciation with a range of zero to ten percent gains and an average of about six percent for 2005. Most forecasters see interest rates on short term treasury bills rising to 3.5 percent at year end from the current 2.25 percent and a more muted increase in rates on longer term bonds. We do not have grounds to sharply disagree with this tepid, consensus forecast, but are always on the watch for forces that could shake up investor complacency.

The force that we believe is gaining renewed power is inflationary expectations across a broader spectrum of goods and services. The inflation rate for consumer prices and wages is critical as it affects all economic transactions and decisions made by consumers, investors, corporate executives, and government officials. The Federal Reserve Board does not want to let the inflation genie out of the bottle, because it is difficult to contain once it has been unleashed. When the inflation rate begins to noticeably accelerate it can become self -reinforcing. Buyers expect to pay more for a product or service in an inflationary environment, while sellers or providers believe that they can charge higher prices. This pattern has been most apparent recently in the real estate market where sellers are listing properties at extremely high prices and buyers feel they have no choice but to pay up or miss out on the property. The same psychology can apply to all economic interactions. Consumers now expect higher prices for energy, medical services, tuitions, and building materials. It seems likely that the price of cars and other big ticket items will be going up as corporations pass higher health care and raw materials prices on to the consumer. The U. S. economy operates comfortably with an inflation rate of about two percent. The consumer price index (official measure of inflation) went up by 3.3 percent in 2004, the fastest rate since 2000. If inflation continues to trend well above two percent, one could expect to see higher interest rates, lower bond prices, and pressure on stock prices.

Current Strategy

The stock market (S&P 500 index) did post a gain of about 10.8 percent in 2004, with most of the gain occurring after the election. For the first three quarters of the year the market was locked in a tight, grinding trading range. Many of the better known, widely held stocks such as Cisco, Intel, Pfizer, and Merck had dismal price performance during 2004. Much of the 2004 market gain came from companies in the heavy industry, raw materials, and energy sectors. At the beginning of 2004 our clients held a diversified group of companies in the publishing, food, software, medical, telephone, cement and semiconductor areas. With the exception of the cement holding and a foreign cell phone operator all the others were flat or down in 2004. It is rare that a diversified list of high quality, formerly strong stocks would all falter in a given year. It was a tough year for many stocks, not just some of our holdings. The gain we achieved for clients in 2004 was largely the result of well-timed buys made during a particularly nasty mid-year drop in stocks, along with some exceptional gains in foreign holdings. We expect a similar pattern in 2005, with most of the gains going to those patient enough to wait for a correction in stock prices.

Over the past six months the Federal Reserve Board raised interest rates five times by one quarter percent each time. The rate increases allayed market fears that the Fed was ignoring inflationary signs and letting inflationary psychology take hold. We believe that inflationary expectations are still gaining strength and that further rate increases will be necessary to reverse such expectations. We do not see how intermediate term bond prices can continue to hold up in the face of further rate increases. We suspect that this could be the first year in a long time where longer term bonds lose value, and treasury bills outperform other bond categories.

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