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:: July 2005| Page 1 of 1
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Dear Clients and Friends,
At the beginning of the year most forecasters called for
slowing economic growth, rising interest rates, reduced housing
activity and a pullback in oil prices. These expectations
so far have been off the mark. Business growth and corporate
profits were stronger than the consensus view and seemed to
be making a normal transition to trend line growth of about
3.5% for Gross Domestic Product (GDP). At this point, however,
there appears to be more risk to the downside, as energy costs
have stayed higher for longer than anticipated while the Federal
Reserve authorities continue to escalate the level of short-term
interest rates. These two brakes on the economy could reduce
the rate of growth to something less than 3%. The Federal
Reserve nevertheless sees growth of 3.5% carrying into 2006,
and maintains its plan to raise interest rates until some
undefined "neutral" level is reached. Excluding
some unpredictable crisis, the federal funds rate seems to
be heading towards 4% by year-end. Even then, real interest
rates would be low historically and credit is readily available.
Longer-term bond yields have declined since the Fed started
raising short rates last year, a "conundrum" for
Chairman Greenspan.
Whatever the cause, the drop in longer-term rates has revived
the housing sector, sustaining what many think is a "bubble"
in real estate prices. Low mortgage rates and easy lending
standards are keeping home sales at near record levels, offsetting
softness in the manufacturing sector. It has been estimated
that housing and related financial activities now account
for 15% of GDP versus 12% for manufacturing. In addition,
the strength in real estate asset values has indirectly supported
consumer spending as refinancing and home equity loans provided
cash for spending, and the wealth effect from rising home
values reduced the perceived need for conventional savings.
Speculation in condos and second homes for investment rather
than occupancy has been growing, especially on the coasts.
Buyers are chasing performance and some lenders have assisted
with exotic loans such as interest-only for 10 to 15 years
on 30 and 40 year mortgages and option adjustable rate mortgages
that may require interest of only 1.25% for the first five
years. By 2007 an estimated $1 trillion of mortgages will
convert to adjustable rate loans with significantly higher
monthly payments. Unless rates stay low and values rise even
further some property owners may face difficult circumstances.
Earlier this year there had been concerns that foreign investors
would diversify their holdings away from the U.S. dollar,
especially given the growing trade deficit. The recent rejection
of the European constitution has cast a cloud over the Euro,
the most likely alternative to the dollar, and its relative
value has fallen substantially. U.S. interest rates are higher
than those in Europe as well, so the "vendor financing"
for U.S. imports
persists. The decline in the Euro also means that sales and
income earned abroad by U.S. corporations will convert to
fewer dollars than last year, making for slower reported growth
in the months ahead.
Oil prices have made the headlines again as crude oil exceeded
$60 per barrel in late June. Studies show that oil prices
impact the economy with about a one-year lag. Many customers
lock in a price for a year at a time and will now be facing
much higher costs as oil is up nearly 60% in the past year
and 35% since December 31, 2004. Businesses will try to pass
along these increased energy costs and have already had some
success in doing so. Consumers' alternatives are to reduce
energy consumption and to reallocate spending from other uses,
which will likely slow sales of nonessential goods and services.
Energy companies, on the other hand, are likely to show surprisingly
strong earnings, and this sector has been by far the best
performing group in the stock market in 2005. Crude oil prices
have been driven higher than expected by speculators. The
price, however, can fall quickly, as witnessed by the drop
from $57 to the mid $40's in a little over a month from April
into May. Although the longer-term outlook for leading energy
companies is healthy, short-term corrections from current
levels are likely.
Despite several areas of concern, the U.S. economy remains
solid and corporations are in their best financial condition
in years. Debt as a percentage of net worth was 45.8% in the
first quarter, the lowest in 16 years. Liquid assets were
more than 40% of short-term liabilities, the highest since
the 1960's. Managers have been slow to commit funds to capital
spending, investing the lowest percentage of sales in the
last 50 years. They have preferred to buy back stock and increase
dividends rather than expand capacity, thus, supporting free
cash flow and profit margins at record highs. The combination
of solid earnings, still low interest rates and contained
inflation is normally a positive background for stocks. Valuations
of the market averages are about in the middle of the range,
and the indexes have fluctuated within a trading band for
18 months, although energy and utility stocks have performed
very well. Some profit taking in these groups would seem prudent.
Actively managing portfolios stock by stock as attractive
valuations appear should provide the opportunity for positive
returns over time.
Sincerely,
John L. Simpson, CFA
Chief Investment Officer
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