7/31/2019 3rd Quarter 2004 Commentary
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QUARTERLY COMMENTARY THIRD QUARTER 2004
The quarter that ended September 30th produced
several surprises. After showing greater thanexpected strength
in the spring, the economysputtered over the summer. Long-term
interest rates,which rose a full 1% to 4.8% through June,
declinedback to near their 45-year lows. The electioncampaigns of
both parties waxed and waned withtheir conventions and we still
dont have a clearleader. The stock market was fickle and bonds
werethe best performing asset class (see table below).Meanwhile,
oil tested $50 per barrel, steel and otherindustrial
metalscontinued their ascent
and in the midst of allof this the FederalReserve raised
interestrates three times. Allof this points to afundamental
paradox:interest rates arefalling in the face of the build up of
many forces thatwould normally be considered
inflationary.Additionally, we see a fundamental lack of
marketleadership. Who will win the election? Which isright oil or
bonds? Will the economy continue
growing or will it decline?
POLITICS
Early in the quarter the government reported that thebudget
deficit for the year ending June 30, 2004 (FY04) was $588 billion.
While this is a new record forthe size of the deficit in nominal
terms, as a percentof Gross Domestic Product (GDP) at 3.7% its
farshy of the 6.0 % of GDP that we saw in 1983 and adecline from
fiscal 2003s 5.0%.
The political conventions and campaigns to date have
not established an obvious winner. About 80% of theelectorate is
split evenly between staunchlysupporting George Bush or John Kerry.
Theremaining 20% seem to be very undecided and, ifyou believe the
polls, appear to sway with thevarying reports that are blowing
about. Thecampaigning has again reached new lows ofpolarized
mudslinging. Fervent Republicansmaintain that President Bush is the
only one capable
of leading the war on terrorism and seem certain that
another Bin Laden attack is imminent. FerventDemocrats lament
the loss of jobs and the decline ofthe welfare of the poor and
middle classes during thelast four years. There is a lot for the
Republicans toovercome. During the last 4 years weve seen
joblosses, rising deficits, expanded governmentregulation, and a
quagmire develop in Iraq. TheDemocrats have John Kerrys
questionable charismaand his record of flip-flopping on the issues.
Theoutcome of the election will have significant effect
on our policy towardsthe deficit and towards
healthcare in the U.S.
THE FEDERAL
RESERVE
On 9/21/04 the Fedincreased thebenchmark target for
the Fed Funds rate for the third time to 1.75%. Thebond market
took this as a sign of Fed making apreemptive move against the
potential for inflation topick up. Bond prices rose and the yield
on the 10-year Treasury note fell to just under 4% on 9/27.
This increase in short term and decrease in long-termrates
produced the flattening of the yield curve asshown in the chart
below:The Feds actions have only begun to offset thenumerous rate
cuts from 6% to 1% betweenNovember 2001 and April 2004.
Index Performance Q3 04 YTD
Dow Jones Industrials -3.40 -3.57S&P 500 -1.88 +1.51EAFE
(international stocks) -0.20 +4.65Russell 2000 (small stocks) -2.87
+3.44Lehman Intermediate +2.70 +2.53Lehman Municipal +3.88
+3.18
7/31/2019 3rd Quarter 2004 Commentary
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OIL
In our second quarter commentary we highlighted therise in the
price of oil and included a chart showingthe increase to $32/bbl.
Below is a chart from the8/23/04 Weekly Market Monitor which shows
theannual percentage change in the price of oil over the
post World War II period.
The shaded vertical bars represent periods ofrecession. Observe
that whenever the price of oilincreases over 100% year over year,
the economysubsequently goes into recession. The oil embargo of
73 and the Iranian revolution in late 79 caused theprice of oil
to increase more than 100% and bothwere followed by recessions. The
Iraqi invasion ofKuwait in 90 caused oil to rise some 60% and
alsocaused a recession. Some will claim that this time isdifferent
because the prior price increases were dueto supply constraints
whereas this time it wouldappear that increased worldwide demand is
theculprit. Based on the bond markets reaction to dateone would
presume that it believes that the rise in theprice of oil isnt
inflationary but rather, as theMonitor argues, just detrimental to
growth. The
rationale is that as the cost of gasoline, heating oiland
electricity goes up, consumers, whose averageincomes move only very
slowly, will pay more andmore for these basic necessities, leaving
less fordiscretionary spending. To believe this we have toassume
that demand is not sufficient enough forcompanies to be able to
pass along their higher coststo their customers.
MARKETS
There is an old Wall Street saying: three steps and astumble. It
means that when the Fed raises interestrates a third time the stock
market usually falls. Thestock markets fickleness was demonstrated
by thethree sets of lower highs and lower lows we
experienced during the quarter. This continues to bea very
difficult environment in which tomake money. Florida saw a record
fourhurricanes but the total cost was not as badas initially
feared. The Google IPO wassuccessful in raising $2 billion but
theoffering size was scaled back, preventingthe venture capitalists
and insiders fromselling as much as they would have liked.So far,
Google has not sparked another IPOfrenzy. The increased burden
ofcomplying with Sarbannes-Oxley regulation
on public companies is effectivelyincreasing hurdles for smaller
companies toaccess the public capital markets. Themajority of
corporate earnings reports werepositive due to management generally
underpromising and over delivering. Generally,there were more
positive earnings reportsthan negative ones. However, there
were
some ominous reports from companies withsignificant exposure to
raw or intermediate materialscosts.General Mills predicted lower
earnings due tohigher commodity costs, while Colgate and
Unilever
forecast lower earnings due to higher labor andmarketing costs.
Contrast the fortunes of HewlettPackard with that of IBMLouis
Gerstner turnedIBM around by focusing on becoming the
premiertechnology consultant rather than simply amanufacturer, and
services now account for 48% ofIBMs revenues. Hewlett Packard moved
in theopposite direction when they chose to buy CompaqComputer
rather than PriceWaterhouse Consulting.They have become a focused
manufacturer ofcommoditized computers, and since then theirmargins
have eroded. This does not auger well for
manufacturers of low added-value products.
Oil Prices and Recessions
-60
-30
030
60
90
120
150
180
Jan-45 Jan-55 Jan-65 Jan-75 Jan-85 Jan-95 Jan-05-60
-30
0
30
60
90
120
150
180
Recessioncrude oil, y/y % ch.
In conclusion, our answers to the questions we raisedabove are:
The election outcome is highly uncertain;Regarding the apparent
disconnect between interestrates and inflation, we think the bond
market iswrong and inflation is a growing problem; And lastly,the
economy will continue to grow, albeit at a lowerpace, as long as
the price of oil stabilizes in the high40s.
