Economic stimuli will continue to boost the economy in 2004. The tax reduction in 2004 will be $140 to $150 billion dollars, including $47 billion from the cut in the marginal tax rate, $36 billion in marriage-penalty relief and $16 billion in child-care credit. In addition, federal expenditures, both defense and non-defense, are soaring. Overall, fiscal policy remains highly expansionary.
Monetary policy is also very accommodative. The federal funds rate adjusted for inflation is negative. Historically, the rate in the 1- to 2-percent range is considered to be neutral. The central bank has stated that it will keep the interest rate low “for a considerable period.”
In addition, consumers have saved much of the proceeds from refinancing activities for future use and have access to home equity lines of credit averaging $70,000 per household. The economic recovery is broadening out.
Now, the economy has two engines; consumers and business spending. Capital spending, especially on high tech, has surged. As demand continues to rise, reducing excess capacity, the low-tech investments will pick up steam in 2004. Next year, it will be difficult to raise productivity gains to a higher plateau, encouraging businesses to increase employment. The jump in corporate profits from both unit-volume gains and better margins is another reason for more jobs.
Inventories are very low. Production and jobs will have to increase to rebuild depleted inventories and meet increasing demand. Increased employment will give strength to consumer spending. A weaker value of the dollar will narrow the trade gap. As both locomotives move full steam ahead, economic growth will average 4.6 percent similar to the average achieved in 2004.
Higher Bond Yields in 2004?
Stronger economic growth in the U.S. means higher interest rates. All bonds will suffer. However, the accommodative monetary policy is keeping bond yields low. Investors borrow short and invest long (the carry trade). When the central bank drops the words “for a considerable period” from its statements, the bond market will assume imminent tightening of monetary policy and bid up yields; initially the slope of the yield curve will increase as the carry trade is unwound.
The weak business credit demand, which forces banks to purchase fixed income assets, is another reason for the low bond yields. With continuing economic recovery in 2004, business borrowings should rise, pushing up bond yields.
There are three types of risks in bonds. First is the duration risk (the sensitivity of bond prices to rising interest rates). Duration should be kept short in a rising rate environment. Second is the credit risk. With an improving economy, credit risk for corporates should diminish. However, the credit spread over treasuries has melted away from record highs indicating no pressing need to buy corporates until the spreads widen again. Third is the convexity risk (prepayment or maturity-extension risk). High coupon mortgages are the best way to deal with this risk.
Investors are particularly concerned about the prospect of mushrooming federal budget deficits in the future. In the past, the Budget Enforcement Act (BEA) was a great discipline using a “pay-as-you go” system. Unfortunately, the BEA was allowed to expire and Washington has little will to tackle deficits. Crowding out could become a distinct possibility in the future, pushing up interest rates significantly sometime in the future.
Stocks Losing Steam?
In 2003, the S&P 500 rose about 26.4 percent and NASDAQ close to 50 percent. However, both economic growth and earnings gains will decelerate in 2004. Typically, stocks, a leading indicator, perform well in the early stage of an economic recovery. As the recovery ages and the profits increase at a slower rate, equity prices lose momentum, sometimes leading to a plateau or a correction.
Our economic and profits outlook points to higher prices for stocks. As long as Chairman Greenspan does not take the punch bowl away from the party – keep the interest rate low – a continuing rally is a good possibility.
However, the best gains are behind us and a portfolio reshuffle should not be ruled out. In the early stage of an economic cycle, credit sensitive sectors, such as housing, autos and retailing, perform well responding to low interest rates. Later in the cycle, materials, industrial machineries and technology fare better.
Valuation is another consideration. Some stocks, for example, sport lofty P-E ratios, making them vulnerable to a correction. For example, financial stocks, which have benefited from lower interest rates, are sensitive to tighter monetary policy. In short, the market will trend up until the central bank raises the interest rate. However, the risk has increased resulting in more volatility.
Dr. Sung Won Sohn is the Executive Vice President and Chief Economic Officer of Wells Fargo Banks