Strategies for the Mid-Cycle Inflection Point

Markets have been jittery this past month because of cross-currents in the economic data. The only consistent news was inconsistency. On two days we had inflation data on the rise; on three days we saw oil prices drop 4 percent; and one report showed core inflation was flat last month. Factory growth and durable goods orders softened, but retail sales and housing were strong while most companies reported healthy earnings. Yet leading economic indicators were down for the fourth consecutive month. Meanwhile, the Federal Reserve keeps ratcheting short-term interest rates up by one quarter of a percent at each meeting.

The U.S. economic expansion, which began in October 2001, is now 44 months old. In my opinion, we have crossed the “inflection point” from a strong-growing economic recovery to a slower-growth economic expansion. This is perfectly normal, and is consistent with prior business cycles.

In past cycles, the markets often required a spike in interest rates to cool down the rate of growth as the economy bounced back from prior recessions and began to expand capacity, which requires capital. That is not happening this time. Instead, the Fed is raising interest rates at a “measured pace.” And it will likely continue to do so.

The usual “mid-cycle spike” in the markets this time around is in the petroleum markets, not the financial markets. The impact at the gas station was enough to dampen the economy as lower-income households have had to cut back their spending elsewhere. Essentially the spring 2005 oil spike acted like a tax increase.

Bond investors meanwhile have allowed long-term interest rates to drift slightly lower even while the Fed has raised overnight interest rates by two full percentage points during this tightening campaign. In the stock market, investors have been skittish and unwilling to make bets in favor of growth stocks, which historically have outperformed value stocks during the expansion phase of the business cycle.

A Return to “Real” Interest Rates. On the interest rate front, I would expect to see the Federal Reserve continue on its measured course and raise its overnight funds rate at each meeting until that rate clearly exceeds the inflation rate. At the beginning of this cycle, the “real” interest rate was negative, so the Fed had no choice but to raise rates and “remove excessive accommodation” as the economy strengthened. By the end of the year, we should expect to see the Fed Funds rate reach 4 percent. If oil prices stabilize in a $45-$55 range centering on recent levels, then the year-end core inflation numbers should remain safely below the overnight rate.

A 4 percent Fed Funds rate implies a 7 percent bank prime rate. That is the interest cost to a bank’s best customers—hardly cheap money. Less creditworthy borrowers will pay even more.

Meanwhile, the American economy should continue to chug along at a slower but sustainable rate. Global growth should continue to outpace America's, despite weakness in Germany and the United Kingdom.

2006: Goldilocks Expansion Is Possible. The Fed now stands within reach of delivering a Goldilocks economy in 2006. Not too hot, not too cool, just right. The most likely scenario now, I believe, is that the U.S. economy will flutter into a sustainable pace of roughly 3 percent annual real GDP growth in 2006, with inflation at similar but declining rates, and moderately expanding production and employment. Such an environment has historically been favorable to corporate earnings, and bolstered the “E” component of the stock market's P/E ratios. Capital investment should improve. Bond yields would likely rise gradually in this scenario, at least to levels that reflect the possibility of several years of economic expansion, which presently are not priced into the markets. Interest rates could rise yet further across the board in 2006, perhaps another .5 percent, to balance growth, prices, and capital flows.

Of course, there are economic risks. Terrorism is the most troublesome, as it is so unpredictable. China's resurgent economy could cool down unexpectedly and pull the rest of the world down with it. A hedge fund could blow up and threaten the financial markets like Long Term Capital Management did in 1998. Oil could spike above $60 on Asian demand and Mideast supply disruptions. But these are possibilities, not probabilities.

In this environment, bond investors will face difficulty earning their coupons in a moderately rising rate environment. Cash managers need to do their homework and calculate their break-even forward interest rates before lengthening maturities to capture yield. Patient long-term investors (such as public pension funds) should again see positive returns in the stock market, with growth stocks finally reaching the potential to outperform value stocks in the next 24-26 months.

Girard Miller is the chief operating officer of Janus Capital Group in Denver, Colorado. His opinions are entirely his own. The article is provided for informational purposes only and should not be used or construed as a recommendation for any investment.

Still Time to Register for GFOA’s 2005 Annual Conference

L ast-minute registrants are still welcome for the GFOA 2005 Annual Conference, to be held in San Antonio, Texas, June 26-29. As always, state and local treasurers will have the opportunity to hear an array of experts on treasury management and investment topics. For registration information, go to the GFOA’s Web site, www.gfoa.org.

Panel of Economists

Oil Prices and Interest Rates

In recent months, the economy has been plagued with high oil prices. This month, Public Investor asked its panel of economists about the factors behind the recent jump in oil prices, and the effects on inflation, short-term interest rates, and economic growth.

According to Dr. Lacy Hunt, the price of oil has jumped primarily due to two factors. First, while global oil production has been reaching its peak, oil production is about to begin a prolonged decline (in spite of increased oil production in Iraq and arctic areas). Second, demand for oil has been high due to the economic expansion. Oil prices have reached an interim cyclical peak and the growth in the demand for oil will be reduced by an emerging global economic slowdown. Thus he predicts that oil prices should be somewhat lower until the current global business slowdown is reversed.

Although oil prices have raised the consumer and producer price indexes, Hunt does not expect the jump to have a long lasting effect on inflation and interest rates because the Fed has slowed the growth of the money supply, and thus reduced any inflationary impact. He notes that the money supply has grown at a rate of less than 3 percent this year.

Carl Tannenbaum states that the increase in oil prices has been due to geopolitical uncertainty and rising demand from developing countries such as China and India. The increase in demand is the more significant factor and is likely to remain. Although energy prices are adding to inflation, they are not having the effect that they did in the 1970s because the U.S. economy is much less dependent on energy. He expects the impact on inflation and growth to be small (less than a half percent per year).

John Lonski states that the primary reason for the jump in oil prices has been a faster growth in the demand for oil relative to the supply of oil. Energy price deflation in the past and stricter environmental regulation have curbed the growth of production capacity. Most of the economy has not been hit very hard by higher energy prices, except for lower-income customers. He adds that higher energy prices will put upward pressure on core inflation.

Growth and Inflation Forecasts

The most recent National Association for Business Economics (NABE) survey predicts that real GDP growth will average 3.3 percent in 2005 and 3.4 percent in 2006. The Philadelphia Fed, meanwhile, foresees that real GDP will increase to 3.5 percent in the third quarter of 2005 and moderate to an average rate of 3.3 percent in 2006. Inflation forecasts suggest that the recent increase in inflation may be temporary. In March, the consumer price index (CPI) rose at an annual rate of 7.8 percent and the “core” CPI (which excludes food and energy) increased 4.3 percent. Looking forward, the NABE survey predicts that inflation will moderate and the “core” CPI will remain around 2.4 percent over the next 12 months.

RGM

Fed Rate Hikes Expected to Continue

At its most recent meeting on May 3, the Federal Reserve Open Market Committee continued its series of measured rate increases by raising the Fed Funds rate to 3.0 percent. Thus far, the Fed has raised the rate 200 basis points since it began tightening a year ago. The Fed Funds futures market predicts that the central bank will continue to raise rates through the rest of the year. By the end of 2005, the most recent NABE survey predicts that the Fed Funds rate will reach 4.00 percent.

The NABE survey predicts that the ten-year Treasury bond will see a parallel shift to 4.90 percent by December 2005 and 5.30 percent by December 2006. The Survey of Professional Forecasters, conducted by the Federal Reserve Bank of Philadelphia, similarly predicts the 10-year Treasury bond will increase to 5.2 percent by the second quarter of 2006.

RGM

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