27 May 2005 Eyes Still on the Fed
The economy is neither too hot nor too cold, according to the government’s announced revision yesterday of the U.S. Gross Domestic Product. Continued steady consumer spending and a narrowing trade deficit prompted the government to raise its estimate of the economy’s first quarter growth from 3.1% to 3.5%, which exceeds the ten-year average of 3.3%. Many had feared that higher energy prices would dampen consumer spending more dramatically than it has so far. Offsetting the higher costs have been wages and salaries. They expanded considerably more in the final quarter of 2004 than the government first reported.
Yesterday’s report showed that the consumer actually has a greater amount of financial muscle than was previously thought. Wages and salaries grew by 10.4% ($136 billion) in the fourth quarter of last year, more than twice what the government had estimated and the best since 2000. The report showed that wages grew by $93 billion this quarter, still a healthy rate.
Some economists are now saying that the economy is not soft at all and that we are off to a good start in the current quarter. Inflation appears under control as well after its jump from the fourth quarter. There were no revisions upward in yesterday’s report. The talk among many economists is that the Fed will continue its measured pace of rate hikes, as do some Fed leaders like Michael Moskow, president of the Chicago Fed, who said “underlying inflation remains low and longer-term inflation expectations are well-contained.”
The strategists we follow still believe the Fed is near the end of its hikes and bond investors seem to be behaving accordingly. The ten-year US Treasury continued its steady two-month rise in price yesterday pushing its yield to just over 4%. It’s very unusual that long-term bonds would rise in price (lowering yields) in the face of a faster-growing economy. The reverse usually happens as bond investors assume that faster growth means greater chances for inflation. Perhaps they see, as we do, that money supply is not growing nearly fast enough to support the growth of the economy and if the Fed continues to tighten, expectations rise significantly for a slowdown or recession.
Businesses remain cautious in their behavior as identified by the GDP report. Spending on equipment and software grew at 5.6%, slower than the earlier estimate of 6.9%, the slowest in two years and it follows an 18.4% gain in the fourth quarter. But given continued strength from the consumer segment, business will need to catch up to the consumer and replenish inventories that are being depleted due to steady demand. The government’s report of Personal Income and Spending, just released, shows that spending continued to rise in April by .6% and income outpaced it rising by .7%.
Until equity investors have a clearer picture of what the Fed’s intentions are for the next seven months under Mr. Greenspan and the ensuing few months under a new chairman, we will likely continue to experience sideways markets. The bond market will likely continue to provide strong direction, but we will maintain an even closer eye on the money supply for guidance as to our portfolios’ allocation strategy.