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.
