The Fed Holds the Key

This week the markets have fared far better than last.  The S&P 500 is up almost 1% as of this morning and the NASDAQ is up over 2%.  Bonds have had a good week as well with the Lehman 1-3 Year and 7-10 Year Treasury Indexes rising .2% and .4% respectively. 

The most important component of the economy, the consumer, both earned and spent more in March than economists expected.  And he did so in the face of rising gasoline prices and eroded confidence.  But that’s not new; the American consumer has surprised economists on the upside for most of this economic recovery.

Just released, the Unemployment Rate remains unchanged at 5.2% for the month of April.  However, the number of jobs created in the service sector outpaced the prior month by 164,000 and beat economists’ projections by 100,000 jobs.  In early trading, Wall Street cheered the news.

Manufacturing jobs on the other hand fell by 6,000, better than last month’s decline of 8,000, but slightly worse than economists had projected.  The pullback likely contributed to the greater than expected rise in productivity for the month, which measures how much an employee produces per hour of work.  As productivity improves and growth slows, employers can slow hiring to save on labor costs while other costs, such as energy and materials have been rising.

But will energy and materials costs continue to rise?  As we have said before, top industry managers, such as Lee Raymond, the CEO for ExxonMobil think oil supplies are sufficiently high to suggest considerably lower prices in the future.  Prices of key raw materials also seem to have peaked as indicated by the CRB/Reuters Futures index which is 7.6% off its high reached in mid-March.  Gold and Copper are each off 6% from their highs.  And lumber prices are falling as the price of a 2X10 has fallen by 28% from its August 2004 highs.

The Federal Reserve surprised investors (in a good way) on Tuesday when, just before the closing bell, they said they mistakenly omitted a sentence from their comments regarding monetary policy and the economy.  The sentence stated very clearly that “longer-term inflation expectations remain well contained.”  It is presented below in context:

“The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 3 percent.  The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity.  Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices. Labor market conditions, however, apparently continue to improve gradually.  Pressures on inflation have picked up in recent months and pricing power is more evident.  Longer-term inflation expectations remain well contained.”

The experts we follow firmly believe, just as the Fed believes, that inflation is not a long-term problem.  The supply and demand pressures on raw materials caused by China and others will eventually find equilibrium; perhaps that process is already underway.  The Fed will likely raise rates a few more times, but our read and that of the bond markets is that they are very close to neutral right now.  The possibility that China will revalue their currency is definitely picking up.  That possibility would be very helpful to reversing the China/US trade imbalances as well as those globally.

Oil prices and Fed rate increases have slowed the growth of the economy somewhat and will likely prevent significant near-term acceleration.  What the Fed does the next few months will determine how much growth will be possible.  Remember, Mr. Alan Greenspan leaves office this coming January, so his actions in the coming months will be indicative of how he hopes the Fed will carry on after his departure.

For the first four months of the year, our portfolios have held up very well relative to their benchmarks.  Superior earnings and dividends have been the primary reasons for the good performance.  The market will likely continue to plod along for a few more months as investors and traders wait for another batch of earnings releases next quarter.  But, as we focus increasingly on high quality companies with attractive dividend yields the cash flow should continue to roll in.