ECONOMY BOOMS, RATES RISE, MARKETS WORRY

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
April 27, 2004

IN THIS ISSUE:

1. The Economy Is Booming Again.

2. Interest Rates & Inflation To Rise.

3. When Will The Fed Hike Interest Rates?

4. The Bank Credit Analyst On Bonds.

5. Investing In A Rising Rate Environment.

The Economy Is Booming

Despite what you hear from the gloom-and-doom crowd and John Kerry, the US economy is booming. On Thursday, the government will release its first estimate of 1Q economic growth, and many analysts now believe the report will show that GDP surged by 5-6% in the 1Q. Previously, analysts had expected a rise of 3-4% in the 1Q, but recent reports suggest that the economy probably expanded at an annual rate of 5-6% in the first three months of this year, following 4.1% in the 4Q and 8.2% in the 3Q.

The latest economic reports have caused forecasters to raise their estimates over the last 2-3 weeks. The Index of Leading Economic Indicators rose 0.3% in March and is signaling continued strong economic growth. Durable goods orders jumped 3.4% in March versus estimates of only a 1% increase. That followed a similar rise of 3.8% in February, and for the 12 months ended March, orders for big-ticket items are up a whopping 16%. The Institute for Supply Management’s manufacturing index rose again in March to 62.5. ISM says this equates to a 6% overall growth rate in the economy.

The Commerce Department also reported that businesses boosted their inventories by 0.7 percent in February (latest data available) — the biggest increase since August 2000— a sign that companies are feeling better about the recovery’s staying power. Despite the latest increase, inventories remain very low, and this suggests strong hiring growth in the months to come. This also means we should see a significant increase in capital spending during the rest of 2004 as businesses ramp-up to rebuild inventories.

On the consumer side, retail sales jumped 1.8% in March even though advance estimates suggested less than half that amount. For the 12 months ended March, retail sales are up 8.2% over yearago levels. Shoppers treated themselves to a wide range of goods in March, spending on cars, clothes, furniture and building and garden supplies.

New home sales surged 8.9% in March, the largest monthly increase in nine months. This occurred despite the fact that mortgage rates have been on the rise recently. Freddie Mac reported last week that the national average 30-year fixed mortgage rate rose to 5.94%.

Consumer spending accounts for over two-thirds of all economic activity (GDP) in the US. Despite the constant warnings from the gloom-and-doom crowd and the Democrats, consumers continue to spend, and this is good news for the economy. Economists said the improved job climate, tax refunds and continued low borrowing costs made shoppers feel more inclined to indulge in March.

While the official unemployment rate edged higher from 5.6% in February to 5.7% in March, over 308,000 new jobs were added last month, hitting a four-year high. While many doubt that employment growth will continue at this pace, the latest reports suggest that this economy will continue to surprise on the upside.

Inflation Fears Arise, Interest Rates To Rise

Strong economies almost always give rise to inflation, and this one will be no different. In March, the Consumer Price Index rose 0.6%, and the Producer Price Index rose 0.5%, both higher than expected. For the three months ended March, the CPI rose at an annual rate of 5.1% versus only 1.9% for all of 2003. A big reason is the surge in energy prices over the last several months. As I will discuss below, inflation is not likely to get out of control and will likely average 2½-3% for all of 2004. Actually, the Fed has wanted to see inflation increase somewhat to be sure that the deflationary threat has passed.

While the Fed has been happy to see the economy growing strongly and inflation rising, this does mean that interest rates will be heading higher. In fact, they already have. The yield on 30-year T-bonds has risen from near 4.75% to 5.25% in the last month, while the 10-year T-Note rose from 3.75% to near 4.5%. This has meant big losses for investors in most bond funds.

For months now, I have warned that yields on long-term bonds were going to rise, and I have recommended that investors reduce positions in Treasury bonds specifically. I hope you took that advice. While these inflation-sensitive markets may have over-reacted a bit in the last month, I believe long-term rates will be even higher over the next six months to a year.

On numerous occasions in this E-Letter, I have recommended that investors consider my favorite professional bond manager – Capital Management Group. I am happy to report that CMG has managed to avoid the carnage in the bond markets over the last month or so. CLICK HERE to see their impressive results. I’ll come back to CMG later on.

Will The Fed Raise Rates? The Question Is When.

As noted above, I am in the camp that believes interest rates are headed higher, including short-term rates. Virtually everyone agrees that the current 1% Fed Funds rate is too low. Even at 2% - double the current rate – the Fed funds rate may be too low. In fact, the rate is likely headed back to 3-4% over the next 12-18 months, especially if the economic recovery continues.

Earlier this year, I predicted that the Fed would not hike the short-term Fed funds rate before the election. However, the latest surprisingly strong economic data and the March inflation numbers clearly increase the odds that the Fed will raise rates once before the election. It still won’t surprise me if the Fed waits until after the election; on the other hand, a modest increase before then won’t surprise me either.

Everyone is speculating about when the Fed will raise rates. Here is the schedule of Fed Open Market Committee meetings: May 4, June 29/30, August 10, September 21, November 10 and December 14. Most analysts agree that the Fed will either move rates up at the May or June FOMC meetings, or they will wait until after the election. Clearly the Fed would prefer not to make a move at the August or September meetings, since the election campaign will be in full swing by that time. Greenspan would prefer to remain apolitical.

Actually, it may not matter much whether they raise rates at the May or June meetings. As noted above, the bond markets have already reacted sharply to the growing likelihood of a rate hike before the election. Assuming we see only a quarter-point or half-point increase in the Fed funds rate, the bond markets may already be priced accordingly. Yet as noted above, rates will be trending even higher later on.

BCA’s Latest Thinking On Bonds

Here are some excerpts from the latest issue of The Bank Credit Analyst , which I consider to be the best forecaster of the economy and interest rate trends:

“The cyclical outlook for bonds is bearish. Inflation is headed higher, monetary policy will tighten over the coming year and real yields will increase from current low levels. We continue to recommend below-average weightings in Treasurys.

The Federal Reserve has downgraded the inflation threat. However, inflation has clearly turned and the prospect of tighter monetary policy will continue to weigh on the [bond] markets. The fed funds rate is headed above 4% over the next couple of years. Ten-year Treasury yields will likely reach 6% or higher before a cyclical peak is reached. The upturn will be more dragged out than in the past. [Emphasis added, GH.]

Real yields seem low given the strength of economic activity and a sharp rise in the corporate sector’s return on capital. The Fed’s low interest rate policy, weak business credit demand and large-scale purchases of bonds by foreign central banks are largely responsible. These bullish supports will diminish going forward.

The sharp selloff in U.S. Treasurys during the past month has not created a buying opportunity because the fundamental backdrop to the market will deteriorate further over the coming year. Inflation will edge higher, the Federal Reserve will begin to tighten its monetary stance and real yields will increase from current unusually low levels. While the Fed’s low interest rate policy may remain an anchor for bond yields in the near run, the risk/reward trade-off for Treasurys is unattractive… There is nowhere safe in long-duration fixed-income securities when interest rates are in a cyclical uptrend.”

If BCA’s forecast for 10-year Treasuries is correct, this will mean considerably more bad news for bond investors. However, as I will discuss below, the strong economy could actually be good for high-yield bonds.

Stocks – Another Good Year In 2004?

The stock markets should also benefit from the good economic news which is likely to continue for the balance of this year and very likely into 2005. Corporate profits are poised to improve significantly over the next year or longer. It is in this context that BCA continues to recommend above average holdings of equities.

There is little disagreement that higher interest rates loom as a negative for equity prices over the next couple of years, especially if rates are going to the levels suggested by BCA above. However, interest rates are expected to rise only modestly over the next 6-12 months. This should be more than offset by the good economic news and improved earnings.

Another factor which could help push stock prices higher is new money coming in. Inflows to equity mutual funds rose by over $88 billion in the 1Q according to AMG Data Services. Still there is a mountain of cash sitting in money market funds that could move into stocks and stock funds. Likewise, we may well see increasing movement from bonds and bond funds to stocks and stock funds as fixed income investors decide to cut their losses.

Keep in mind I am not predicting another year like 2003 when the S&P 500 rose over 28%. And volatility is likely to remain high. However, returns over the next year could be very respectable, especially if there are no major negative surprises.

Investing In A Rising Rate Environment

If the Fed funds rate is going from 1% to 4% and the 10-year Treasury from 4.5% to 6% over the next 12-24 months, as BCA predicts, Treasury bonds and high-grade corporate bonds are not the place to be. We’ve certainly seen evidence of that over the last month.

On the other hand, a strong economy can be a very good environment for high yield bonds. High yield bonds can do well even in a rising interest rate environment, especially if rates rise only modestly over the next 6-12 months as we expect. As business improves, high yield bonds can see their ratings improve and increase in value, even as higher quality bonds are falling in value.

If you have read this E-Letter for long you know that the ONLY way I recommend investing in high yield bonds is with Capital Management Group. CMG invests in large, highly diversified high yield bond mutual funds. CMG may be fully invested, partially invested or 100% in cash occasionally depending on market conditions. CMG also uses so-called “short funds” to hedge its long positions. This flexibility can be crucial in a rising rate environment.

CMG has one of the best risk-adjusted performance records that I have ever seen. CLICK HERE to take a look. Yet amazingly, they still accept investments as small as $25,000. If you are looking for an alternative to Treasuries and other bonds, take a look at CMG.

*High yield bonds are not suitable for all investors. Past results are not necessarily indicative of future results.

As for equities, I continue to recommend Niemann Capital Management, especially in a rising interest rate environment. Niemann continually analyzes money flows across various market sectors and invests where they expect returns to be best. This can be extremely important in periods when the overall market may not be sizzling on the upside or when volatility is high.

Like CMG, Niemann may be fully invested, partially invested or 100% in cash occasionally depending on market conditions. CMG also uses so-called “short funds” to hedge its long positions. This flexibility can be extremely important in a volatile market.

Niemann has an outstanding performance record. CLICK HERE to see their actual results, net of all fees and expenses. The minimum investment is $100,000. Past results are not necessarily indicative of future results.

We also recommend Potomac Fund Management, another outstanding equity fund Advisor that accepts investments as small as $25,000.

The Issue Of Advisor Management Fees

I have maintained for years that most investors would be better off using professional Advisors to manage their investments. Some investors, however, refuse to use professionals simply because of the management fees they charge. Most successful active managers generally charge management fees of 2-2½% per year, and the good ones are well worth it.

Some investors insist only on so-called “index” funds simply because they tend to have the lowest fees. Index funds are just fine if we are in a roaring bull market such as stocks in the late 1990s, or in a steadily falling interest rate environment such as we’ve had since 2000. But we’re not in a roaring bull market, and we have already entered a rising interest rate environment. Index funds will only do what the market does, much like riding a roller coaster.

Market risks are higher now and having the ability to reduce positions, hedge or move to the safety of a money market fund is very important now.

Successful professional Advisors can more than justify the management fees they charge by reducing the risks, often missing some of the worst periods in the markets.

Even though I am an investment professional myself, with 28 years experience, I rely on professional Advisors for my own portfolio. With the exception of some real estate interests I own, virtually all of my investment portfolio is managed by the professional Advisors we recommend. I have my own money with every manager and every program we recommend.

If you have not invested with the professionals we recommend simply because of the fees they charge, I suggest you reconsider – especially now that we are beginning a trend of higher interest rates. If you look at their performance records – all of which are illustrated after all fees and expenses are deducted – you will see that they more than made up for the fees they charge.

For more information, you can go to our website www.profutures.com or you can call us at 800-348-3601. I believe you will be glad you did.

Very best regards,

Gary D. Halbert

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