A Win – Win

One of the major economic trends we have discussed in earlier Briefs has been that of outsourcing.  I’m not referring to the politically-charged concept of ‘moving jobs overseas,’ but to the process whereby a business transfers to more efficient providers those functions over which it does not have particular expertise or are not mission critical.    

On Wednesday Nortel (held in our Growth and Quest portfolios) rocked the communications world by announcing that it would outsource a huge chunk of its equipment production to the manufacturing giant Flextronics (also held in our Growth and Quest accounts).  Nortel, North America’s largest phone-gear maker, would sell its factories inCanadaandBrazilto Flextronics for up to $725 million in cash.  The company is also expected to sell its factories inFranceandIrelandin the near future.  For its part, Nortel agreed to buy about $2.5 billion of its equipment from Flextronics over the next four years and it will buy design services for three-years to come.  About 2,500 Nortel workers will transfer to Flextronics.  The transaction represents the largest outsourcing deal in history.

Nortel said the agreement is likely to add about $100 million in profits by the fourth year while Flextronics’ sales, already the largest contract manufacturer, will swell to over $20 billion.  The contract manufacturer’s earnings are expected to be boosted by 11% in 2006 and 16% in 2007.  The deal is a win for both companies and represents what we think will be a major trend in the years ahead.

The economic recovery continues to plow ahead with the consumer still leading the advance. U.S.personal spending rose 1% in May which was the largest increase since October 2001 and faster than the increase in income.  A measure of inflation also showed a dramatic increase, but the Fed on Wednesday increased short-term rates by only a quarter of a percent and maintained that they would maintain a “measured approach to tightening.”

As job gains expanded in the last month and gasoline prices began to fall consumers improved their outlook for the economy.  A measure of consumer confidence by the New York based Conference Board rose to 101.9 in June from a revised 93.1 in May taking the index to a two-year high.  The percentage of consumers who said they saw jobs as hard to find declined to its lowest level since September 2002.  The improved job situation overshadowed consumer concerns overIraqand energy prices.

Just released, the Unemployment report was unchanged for the month of June at 5.6% as companies added 112,000 workers.  But the job gains were less than half what was expected by economists.  Manufacturing payrolls actually declined by 11,000 jobs and were expected to grow by 30,000 workers.  As you can see on the table, May’s job gains in both service and manufacturing were revised downward too.  Still, the economy has added 1.3 million jobs so far this year, the biggest six-month gain in four years.

The economy could not continue at the pace of the last three quarters indefinitely.  Slower growth is better anyway as inflation may not be the problem it would be otherwise, allowing the Fed to be more moderate in its interest rate hikes.  Bond and stock markets are less volatile if investors feel they understand how much and at what frequency the Fed will raise rates.  As the summer rolls on the broad stock and bond markets will likely continue their aimless path, but improvements should continue in corporate earnings and in the economy as a whole.  For now we expect earnings news, mergers, and alliances to be the primary drivers of stock prices.  We are seeing opportunities overseas too as economic growth abroad picks up.  Our objective is to hold investments in the best long-term performing industries here and in the fastest growing economies overseas.