Baldwin
Investment Management, LLC
WHY NO ZEST IN THE MARKETS?
The third quarter results are in
and the U.S.
markets as measured by the Dow and the S&P 500 have continued to go nowhere
and the more growth oriented, technology based NASDAQ slipped by about 6%
year-to-date. These disappointing
results have come in the face of rather strong GDP and earnings growth, which
handily beat Wall Street expectations.
It has been a curious performance.
There have
been some economic statistics, which some experts consider troubling. Probably the biggest focus was the jobs (or
according to some, lack of jobs) picture.
Coming off extremely robust monthly employment numbers (200,000 jobs
created) earlier in the year, the rate of job creation has slowed (70,000 new
ones). However, the Federal Reserve
chairman, Mr. Greenspan, does not seem concerned. In his recent testimony before Congress, Mr.
Greenspan discussed at length the “soft spot” but suggested that it was a
temporary phenomenon and maintained that the American economic engine would
soon again be running at a higher speed.
We too are convinced that the U.S.
economy is not in any trouble.
The Fed has been busy increasing
interest rates. We have now seen three
(3) interest rate hikes of ¼ of 1% and the Federal Funds rate stands at 1.75% -
up from its starting point of 1%. Mr.
Greenspan announced the most recent move in September, even after quite a few
economists worried aloud about a softening of the U.S.
economy. Obviously, Mr. Greenspan was
not as concerned and thought it wiser that interest rates continue to rise in a
“measured” fashion, so that the “inflation genie” does not get out of the
bottle. Surprisingly, in the face of
increasing Fed Funds rates, notes and bonds have actually increased in price,
i.e. interest rates have gone down. This
has been an odd turn of events to many experts, as it does not follow
historical precedent. In the past, when
the Fed has increased the Fed Funds rate, all other rates have gone up in lockstep. So far the opposite has been true. Two influences might be at work here. First, we must remember that the increase in
interest rates is starting from an extraordinarily low base – i.e. 1%. This level of Fed Funds was unprecedented as
the Fed drove interest rates down to prevent deflation. Interest rates, even at 1.75%, are below the
current inflation rate (approximately 2 ½%) and the Fed wants to achieve
neutrality – i.e. the Fed Funds rate equal to the inflation rate. So, it could be argued that with the Fed
raising interest rates to at least a neutral position before there is any sign
of increasing inflation, the Fed is acting to curb inflation and thus bond
traders are happy to own bonds. Another
explanation might be “the carry trade”.
When it was feared that the Fed would dramatically raise interest rates
in the Spring, bond traders unwound positions sending yields higher. After it became evident that the Fed was not
going to raise interest rates quickly, bond traders started to dip their toes
back in the water and borrow money at inexpensive rates to buy longer dated
bonds at higher yields - working the spread of interest rates between the two
pieces of paper. Eventually when
interest rates reach neutrality, interest rates will go up and bond prices will
dip. So in spite of the short term
anomalous situation that the bond market finds itself in at the moment, we
would expect that bonds will revert to the norm in the face of rising interest
rates promulgated by the Federal Reserve.
Certainly making a lot of headlines
today is the price of oil as it trades above $50 a barrel. Because our economy has become far more fuel
efficient, no longer do people seem to be concerned that oil trading at such
levels would create inflation problems.
Rather, most experts are concerned that if oil were to stay at these
levels, eventually it could slow the U.S.
economy, perhaps demonstrably. We
contend that there is no fundamental reason for the price of oil to be at these
high levels. Oil inventories are
sufficient around the world and refinery systems are working “without a
hitch”. Certainly there continues to be
sabotage of Iraqi pipelines and hurricanes in the Gulf of Mexico,
as well as political disruption in Nigeria. Nevertheless, the world has lived with
disruptions caused by nature in the past and oil companies have continued to
pump crude out of the Nigerian delta for years despite periodic political
difficulties. In spite of sabotage, oil
is coming out of Iraq. It does get interrupted but pipelines are
fairly quickly repaired. In an effort to
reduce the price, most members of OPEC, especially the Saudis, have ramped up
production and are now producing way above their official quotas and even above
their “cheating” quotas. But it all
seems to be to no avail as the price continues to rise. There is a “security premium” which has been
introduced to the marketplace by oil traders and hedge funds. Various experts would argue that this security
premium is valued at anywhere from $10 to $20 per barrel. These traders are playing on fears of supply
disruption and the image of gas lines down American streets. There was a recent article in the Financial Times, which discussed a new
conclusion by the U.S.
government – the final arbiter of adequate crude inventory in the U.S. In 1998 the U.S.
government determined that for the American refinery system to work well the U.S.
needed to have approximately 270 million barrels of crude oil in storage. In the ensuing years since 1998, the oil
refinery system has become more efficient because oil companies were not
interested in holding inventories due to the backwardation of
the oil price curve. Consequently, the U.S.
government is about to issue a report that will say that the appropriate amount
of inventory has been reduced to 250 million barrels. According to the most recent inventory
statistic reported, U.S.
inventories now stand at 269.5 million barrels – i.e. the American refinery
system is well supplied and there should be no particular worries. Hopefully, somebody in the futures pits will
focus on this key statistic.
Lastly, election fever has hit and
November will soon be upon us. Mr. Bush
seems to be in the lead at the moment on the eve of the first Presidential
debate. The equity markets both here and
abroad would seem to favor a Bush victory because his presidency has certainly
been more “investor” friendly. Mr. Kerry
is not as well liked by most market makers.
So with polls indicating that Mr. Bush is in the lead, markets would
tend to do better and with Mr. Kerry in the lead markets would tend to do
worse. It has been historically true
that it doesn’t matter which party is occupying the White House. So once we get
beyond the election, at least that bit of investor uncertainty (i.e. who is
going to be president), will be out of the way.
We still believe that Mr. Bush will win the election and as we noted on
our predictions, “by a landslide”.
The U.S.
economy continues to gather some steam.
Inflation is not a worry.
Interest rates are still low, but are rising. World trade is extremely strong. The price of oil is at a very inflated level
and we (like so many others) believe it must go down. The operative question is when? Headlines continue to be disturbing,
especially about Iraq. The presidential political season is in full
swing and the mud slinging is getting torqued up. The fundamentals would suggest good returns
in the stock market. The noise in the
newspapers and over the television nightly news has drowned out the positives
for now – but they will surface in the near future.
PREDICTIONS 2004
PREDICTIONS COMMENTS
1) The dollar will
regain some its former glory, trading closer to $1.15/Euro The Dollar has Weakened
2) President George
W. Bush will be re-elected to office by a landslide Still Believe
3) Economic growth in
the U.S. will
top 4% year over year Indicators Look Good
4) In spite of strong
economic growth, inflation will remain quiescent Little Pricing Pressure, except in Commodities
5) Interest rates
will stay low at least until the 4th quarter & will rise Wrong- rates lifted by .75% & expected to go
after November 8th Higher
6) Osama will be sold
out and captured (we’re sticking with this!) The
Cynic in Me says Yes
7) Progress will be
made in North Korea
with difficulty A
Boring Process, made more difficult recently
8) There will be
additional but fewer corporate scandals than during 2003 Recent examples include Nortel, Fannie Mae, Computer Associates
9) Commodity prices will be strong throughout
2004 Some
were Blazing Hot, but have Cooled a
Bit
10) The Japanese
economy will improve, strengthening world economic growth Getting Better
A FINAL THOUGHT
________________________________
The opinions expressed in this Commentary are those of
Baldwin Investment Management, LLC.
These views are subject to change at any time based on market and other
conditions, and no forecasts can be guaranteed.
The reported numbers enclosed are derived from sources
believed to be reliable, however, we cannot guarantee their accuracy. Past performance does not guarantee future
results.
A list of our Proxy voting procedures is available upon
request.
A current copy of our ADV Part II is available upon
request or at www.baldwinim.com/disclosure.htm
9//30/04