IT’S THE ECONOMY, STUPID!

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
September 2, 2003

IN THIS ISSUE:

1. The Latest Economic Reports Are Very Encouraging.

2. Deflation Fears Subside; Inflation Fears On The Rise.

3. Stocks – Can The Recent Uptrend Continue Higher?

4. Bonds – Is The Carnage In The Treasury Market Over?

Introduction

We all remember that famous one-liner: “It’s the economy, stupid” from Bill Clinton’s first presidential campaign against George Bush, Sr. This time around, it’s looking more like George W. Bush may be using the same line on his challengers and the media – only in the opposite sense – because the economy is clearly improving.

Recent reports indicate the economy is not only on firm footing but is gaining even more momentum. Some analysts now expect that 3Q GDP may reach a 5% annual rate. We won’t know that until the report comes out in late October but the latest economic reports were quite encouraging.

Meanwhile, the stock markets continue to edge higher, led by tech stocks, while Treasury bonds and notes remain depressed. In this issue, we will discuss why both of these market trends may continue, and why the economy is improving despite all the naysayers and pessimists in the media.

Economic Recovery Gaining Momentum

Almost all of the economic reports released in August were positive. Last Thursday, the Commerce Department reported that 2Q Gross Domestic Product grew at an annual rate of 3.1% versus its previous “advance” estimate of 2.4% in July. 3.1% more than doubles the 1Q growth rate of 1.4%. Based on reports released over the last month or so, more and more analysts now expect the economy to hit a growth rate of 4-5% in the 3Q. Here are some of the economic stats we saw in August.

The Index of Leading Economic Indicators (LEI) rose 0.4% in July, thus marking the fourth consecutive monthly increase. The LEI is one of the best indicators of the economy’s direction. Industrial production rose 0.5% in July, the third consecutive positive month. This is a good indication that the beleaguered manufacturing industry is finally rebounding.

Durable goods orders (big ticket items) increased for the second consecutive month in July. Retail sales rose in July for the third consecutive month. Consumer spending jumped by 0.8% in July, reaching a four-month high. Consumer confidence also rose in July. (As I suggested several weeks ago, the Conference Board revised upward its confidence index for June which had indicated a sharp decline.)

The unemployment rate fell in July from 6.4% to 6.2%. While the unemployment rate will be slow to fall, there is a very good chance that we have seen the peak. These are just some of the positive reports that were released in August.

The acceleration in the US economy is directly the result of three factors: 1) the lowest interest rates in a half century; 2) Fed monetary stimulus; and 3) continued buoyant consumer spending. The US economy continues to be the engine of the world, and it’s likely to remain in that position for the next several years – at least until the next serious recession

BCA’s Latest Economic Forecast

Here are some excerpts from the September issue of the highly respected Bank Credit Analyst:

“Massive policy stimulus is succeeding in pushing the U.S. economy onto a faster growth path… The Federal Reserve is promising to force-feed the system with liquidity by keeping short rates close to current low levels for a considerable period… The odds are good that the economy will continue to surprise on the upside during the coming year.

There continues to be a lot of disbelief that the economic recovery and equity rally can be sustained. However, it would be a mistake to underestimate the ongoing power of reflation combined with the normal healing process in the economy. The conditions for a period of healthy economic growth are in place…

Recent data confirm that a broad-based acceleration in the pace of U.S. economic growth is underway. Consumer spending has picked up after an earlier pause, new orders for manufacturing and services have improved, housing has remained firm and exports have revived. The Conference Board’s Leading Economic Indicator rose solidly in July and our preliminary estimate for August shows another sizable increase. The economy appears to be on track for real growth of around 5% during the second half of the year.”

Inflation Versus Deflation

Over the last 2-3 years, the gloom-and-doom crowd (and some serious economists as well) have warned that the US was headed for deflation, a much more serious recession and a possible depression. If you have read these E-Letters over the last year or longer, you know that I have downplayed the deflation/depression threat based on what my very best sources believed. I have argued that we would avoid the deflation threat, and that the economy would rebound – along with the stock markets.

Now let me alert you to a new theme that I believe we will soon begin to hear, both from the gloom-and-doom crowd and many in the mainstream media. In the next few months, expect to hear the warnings go from DEFLATION TO INFLATION.

If the economy continues to rebound, as looks very likely, the gloom-and-doom crowd and the media will have to switch to a new theme. Since deflation will likely fade into the sunset as a serious concern, they will have to find another concern that they hope we will focus on and act accordingly.

The new threat will likely be inflation and this concern may be valid – at least to some extent. The seeds of the next inflationary trend may well have been planted by the last three years of significantly lower interest rates and Fed monetary stimulation.

But Let’s Keep It In Context, Please

As noted above, the pessimists have argued that we are headed for a deflationary depression, but as usual that does not appear to be the case. Once the gloom-and-doom crowd jumps onto the inflation bandwagon – assuming I’m correct - you will hear equally hyped arguments that inflation will soar out of control, leading to skyrocketing interest rates and, of course, a collapse in the economy.

You will be told to sell all your stocks and bonds and buy “tangible assets” including gold and silver bullion, numismatic coins, mining shares and a host of unusual investments that are touted to do well in an inflationary environment. Unfortunately, many investors will follow this advice and most likely end up losing money.

As you begin to hear these warnings in the months ahead, keep the following in mind: Inflation is NOT likely to soar out of control anytime soon.

The US Consumer Price Index rose only 2.1% for the 12 months ended July, and is expected to remain near that level or only slightly higher for the balance of the year. If the economy does hit a 5% growth rate in the months ahead, then inflation will very likely begin to creep higher. But not substantially higher. Even if the inflation rate were to double, say to 4%, that would not lead to wildly higher interest rates and a collapse in the economy.

The most likely scenario is that the economy continues to improve during the balance of this year and remains relatively strong during most of 2004. If that proves to be the case, inflation is likely to rise to 2½% to 3% (give or take) over the next year. If inflation edges up to 2½-3% over the next year, that should not cause the Fed to slam on the brakes by ratcheting interest rates higher.

Stocks: More Upside To Come

The best buying opportunity of the year in stocks was in March, just before the war in Iraq, when I recommended that readers move back to a fully invested position in stocks and equity mutual funds. During June and July, I suggested that stocks would move in a broad trading range with an upward bias during the rest of the year, and that has proven to be the case over the last several months.

Now, however, with the economy clearly strengthening and the Fed’s commitment to keep short-term rates low for an extended period, the equity markets have a good chance for another leg on the upside.

There are many who will disagree with this outlook, typically because they see stocks as significantly overpriced based on measures such as P/E ratios and the like. I do not disagree that stocks are pricey based on historical valuations. But that does not mean the equity markets can’t move higher, especially with earnings improving significantly.

Also, there is a mountain of cash sitting on the sidelines earning next to zero (or losing money in bonds). As investors become more confident that the economy is out of danger, I believe we will see a significant increase in money going into stocks and mutual funds. This could drive equities still higher in the months just ahead.

The Bank Credit Analyst happens to agree that stocks should move higher:

“By keeping short-term rates far below the growth in nominal GDP, the Fed is creating a powerful wave of liquidity that will keep flowing into financial assets, with equities being a prime beneficiary… The combination of buoyant liquidity and improving earnings should provide another upleg to equities. Maintain above-average positions.”

Even though the odds for another move higher in equities have improved, these markets are almost certain to remain very volatile and subject to negative surprises. As such, I continue to recommend that most investors use “market timing” systems – preferably those managed by professionals – for a significant part of your equity portfolio. There are some very successful market timers out there if you know how to find them.

Bonds – Is The Carnage Over?

Since the beginning of this year, I have warned that the bond markets, especially Treasuries, were becoming overheated on the upside, and that the result would not be pretty. My warnings were a bit premature since long rates continued lower and bonds higher until early June. But shortly thereafter, the bottom fell out of Treasuries.

Many of the popular bond mutual funds (especially Treasury funds) lost 20-30% in the recent rout. Unfortunately, many investors bought these funds late in the game and are now sitting on very large losses that are unlikely to be recovered anytime soon.

Over the last few weeks, T-bonds and T-notes have recovered slightly following the steep summer sell-off. However, the problems for the bond markets are not over. The latest good news on the economy is actually bad news for most bonds. A stronger economy means there will be more upward pressure on long rates.

Yet perhaps even more negative for bonds is the rapidly growing perception that the threat of deflation is greatly reduced, while the threat of inflation is now a serious concern. Rising inflation is inherently negative for bonds. While bonds probably over-reacted on the downside recently, the decline may not be over.

As discussed above, I do not believe inflation will soar anytime soon. Yet even the slightest threat can send shock waves through the bond markets, as we’ve seen since the peak in mid-June.

As I have recommended all year, if you are going to be in the bond markets now, I suggest you do it only under the direction of a professional money manager that has a record of knowing when to get out of the market and go to cash.

Conclusions

The economy appears set to reach a 4-5% growth rate for the balance of the year and into next year. The Fed has made it clear it will keep short rates very low for some time to come, most likely at least until the unemployment rate is clearly falling.

The deflationary threat has subsided for now (assuming no major negative surprises), and inflation is likely to edge higher in the next 12 months. Expect the gloom-and-doom crowd to abandon their deflation/crisis scenarios soon and begin to warn that inflation will soar out of control. What else is new?

The stock markets may see another move to the upside, especially as investors become more confident in the economic recovery. Bonds (especially Treasuries), on the other hand, may see more weakness.

The investment markets will continue to be very tricky. I continue to recommend market timing programs for most investors. I am surprised at how many well-known financial advisors are coming to agree with me regarding market timing (more on this next week).

If you are interested in adding professionally managed market timing programs to your investment portfolio, feel free to contact us at 800-348-3601 or visit our website ( CLICK HERE) for more information.

That’s enough for this week. I hope you had a great summer!

Wishing you well,

Gary D. Halbert

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