By
Scott B. MacDonald
Since
March 2003 the U.S. stock market has enjoyed a remarkable run
despite continuing volatility. There is a lot of talk that we
are at the beginning of a new bull market. The argument is simple
– the federal government is pumping in a massive amount
of money to stimulate the U.S. economy in the second half of
2003. Responmding to incentives totaling $210 billion over 16
months, tech sales are starting to show signs of life, housing
starts are strong, inventories are falling, and temporary employment
numbers are up -- despite high unemployment of 6.4% for June.
There is even the beginning of a new round of M&A in the
tech and banking sectors. The bottom line is many investors
and fund managers are starting to believe we have hit the turning
point and that this will sustain corporate profits, revive capital
spending and relieve the tiring consumer. At a recent private
investor conference there was even talk of real GDP growth of
3-4% for 2004.
In the U.S. corporate bond market this positive tone is playing
out in a more active new issue pipeline and generally tightening
spreads. Investment grade issuance has climbed over $250 billion.
Although it seems that spreads are tight -- and compared to
2002 they are -- on a historic basis spreads are still wide.
There is room for tightening – if conditions merit it.
All of this positive sentiment is balanced by lingering problems
– overcapacity in sectors including autos, airlines and
pulp & paper; geo-political risks such as terrorism, new
problems in the Middle East, North Korea, etc.; higher pension
costs; litigation costs involving asbestos and tobacco claims;
and weak growth. In some sectors, debt reduction remains a slow
and painful process, with little to show for corporate belt-tightening.
Although the case can be made for a stronger economic recovery
in the months ahead -- we see real GDP at 2.4% in 2003 and 2.7%
in 2004 -- the actual pick up in growth in a sustainable and
dynamic fashion is not here – yet. We still have Q2 corporate
earnings season to get through and in some sectors, such as
pulp & paper, autos, airlines and chemicals, there could
be ongoing pain related to higher energy costs, overcapacity,
and a lack of pricing power. Although we do not see the U.S.
economy falling into a deflationary spiral, deflationary pressures
are likely to remain.
Part of the deflationary pressure comes from Asia. China is
a major producer of low-cost goods in a vast array of sectors
exported around the world and Japan, the world’s second
largest economy, struggles to pull out of its deflationary mode.
In addition, the world’s third largest economy, Germany,
is increasingly being hit by deflationary pressures, which may
push it toward another recession. The rest of Europe is not
doing terribly well either. All of this puts more pressure on
the United States to buy European and Asian goods – which
contributes to a widening current account balance of payments
deficit – something that is not sustainable in the long-term.
We would love to believe that a bull market in equities is here
to stay and that the corporate bond market will easily sail
on toward much tighter spreads -- but we are not entirely convinced.
We expect that the second half of 2003 will be defined by a
balance between a moderate strengthening in real GDP growth
and ongoing doubts over whether the growth is sustainable. This
in turn could have a negative impact –in the form of a
correction – in the stock market. Consequently, the sun
is out, but we still see dark clouds on the horizon and remain
happier carrying an umbrella at the party.
