Positive Results Through Mid-Year

The second quarter ended with the long expected reversal of interest rate policy, with a .25% increase in the federal funds rate and the formal restoration of sovereignty to Iraq, two days earlier than originally planned. Dramatic? Perhaps, but no surprises.

On an overall basis, this past quarter produced almost no net change in market values, masking a rather sharp retrenchment and recovery in May and a broad divergence among asset classes. Domestic stocks were up, absolute return funds flat, fixed income down (as interest rates increased in anticipation of the Federal Reserve’s quarter-end move), and overseas stocks down…from a little (developed markets large cap) to a lot (emerging markets).

Thus, depending on their specific asset allocations, our clients have experienced nearly flat performance for the quarter, from small positive results to a little give-back from robust results in the first quarter. In many respects this was a period of digesting the rich investment rewards of the prior four quarters, with investors awaiting the Federal Reserve’s deeds (and words), assessing the durability of economic and jobs recovery, while continuing to hold their breath in fear of terrorist activity over the especially target- rich year of 2004.

Thus far, then, at the half-way point, 2004’s investment performance is at about the pace we continue to expect for the whole year: a high single digit net investment return for most clients’ portfolios.

Interest Rates and Inflation

Among many candidates, our vote for the biggest investment “story” of the second quarter was the interest rate question, but not whether rates would rise – everybody expected that – but by how much. The Fed previewed over many months not only that they would raise short term rates but that they would do so slowly and gradually, convinced that rising inflation was not a significant threat. This had the intended impact of encouraging the market to increase longer term rates and gave traders time to at least begin to unwind their “carry trade” exposure, thus avoiding a sudden and disruptive correction in fixed income markets. Nevertheless, quite a few commentators fear that the Fed was, and is, behind the curve, believing that published CPI-inflation is actually understated and, in any event, is primed to increase as the stimulus of very low interest rates and deficit spending combine with recovery in the economic fundamentals. While oil prices have receded from their recent highs, we can’t see much room for further declines in that area as global economic growth increases demand, and events in the Mid-East continue to threaten fragile supply.

Another interesting inflation discussion surrounds the proper role of housing costs. CPI is now calculated with a “rent equivalent” component. As residential property values have skyrocketed, rents have fallen thus, some argue, understating the real cost of housing. On the other side, defenders of the CPI point out that ownership costs like mortgage payments are also low and reflect the acquisition and maintenance of an asset. That asset’s full costs and benefits are not appropriate, they argue, to be reflected in a price index that reflects the costs of purchases but says nothing directly about the proceeds of potential sales.

In any event, if the pace and size of interest rate increases manages to maintain reasonable price stability and fosters sustainable rates of growth, the impacts on equity markets should be positive. Whether the Fed has it right at this point we cannot say for sure; but we’re not inclined to bet against the track record of Greenspan and his colleagues in the Fed.

More Emerging Markets Mayhem

A close runner-up story was the sharp correction in emerging markets this past quarter. Most of our clients have some exposure to the difficult to define “emerging markets” asset class, but, typically, those exposures are small so the impacts on an overall portfolio, good or bad, are fairly muted. Many investment commentators, and a few of our clients, have a love/hate relationship with emerging markets, gushing with enthusiasm when they do well (for example the 80% aggregate returns for the four quarters to 3/31/04) and ready to abandon them when they give some of that return back, like the 9 to 10 % declines this quarter.

The big players this quarter were China, which is trying to avoid an overly heated rate of economic growth, and India, whose electoral surprise caused initial fear of a return to Nehru-esque socialism and a command economy. China is, in our view, in the unenviable state of being damned if it doesn’t apply the brakes and damned when it does. India was quick to allay the market’s worst fears by installing a free-markets economist as Prime Minister.

We continue to believe that equity investment in these and other rapidly developing countries presents significant opportunity for additional portfolio performance. So, whether China is able to engineer a soft landing or, like most rapidly developing countries before it, hits hard, we encourage our clients to maintain a consistent commitment to these markets. Attempting to optimize the timing of that exposure seems to us especially difficult, as likely to miss the large potential upsides—consumer demand in some of these markets is just now starting to ignite—as it is unlikely to confidently avoid the downturns.

The Second Half

The far from conclusive situation in Iraq, with the shame and horror of Abu Ghraib adding to the increasing costs in lives and money, also weighed heavily on world-wide markets this past quarter. What is important going forward is whether markets perceive any improvement in a situation some have written off as already lost. So far, the re-establishment of sovereignty to Iraq and the arraignment, by an Iraqi court, of Saddam Hussein have spurred no exceptional acts of terrorism. If the Boston and New York City conventions, the Athens Olympics, and the election itself escape any dramatic disturbances, the markets will probably take increasing comfort. If not, the impact on investor sentiment could of course be very ugly.

Election years have historically been quite good for the US stock market and many commentators believe that the market would respond better to a Bush victory than for Kerry, based primarily on perceived impacts on domestic spending and tax policies. While foreign affairs are providing a lot of rhetorical heat in this election season, we doubt that there can be any significant difference in actual policies regarding Iraq or international trade, for example, regardless of the election’s outcome. And, unless either presidential winner carries a convincing majority in both houses of Congress (which seems to us very unlikely), some form of gridlock would probably forestall any major change in domestic policy, as well. As frustrating as that may be for voters toward either end of the political spectrum, it will probably suit investment markets just fine.

Most significantly, the domestic economy is good and getting better. First quarter real GDP growth was at a 3.90% annualized rate and estimates for the quarter just finished are in the 3.5% - 4.0% range. Corporate earnings are strong (the increasing “E” has driven the S&P 500 P/E ratio down to about 20) and, with a slowing in the June numbers, well over 1.2 million new jobs have been added since March. Long pent-up corporate spending may add to consumer demand that may not be exhausted after all. Consequently, the market’s side-ways moves over the last quarter have made stocks “cheaper” than they were a few months ago.

Fiscal deficits, while worrisome, may be a lesser problem than some fear. Despite their absolute size, current deficits are far smaller relative to the size of gross domestic product and are being financed at far lower interest rates than the benchmark deficits of the Reagan years. Some combination of tax policy, spending policy, and economic performance will make the deficit situation better or worse; no one of those dimensions can carry all of that weight; however we expect the economy to do most of the work in successfully bringing deficits down to more comfortable size.

In sum, then, we continue to believe that 2004 will produce quite respectable results for our clients’ portfolios. Except for the continuing uncertainty about further major acts of terrorism, the overall economic picture is now clearer…and, for investment markets, that alone makes it brighter.

Tim Kochis, Editor