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July 2005 Newsletter | Print Friendly Format

July 2005

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