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Economic Wind Changing?
by Ivan Gelfand

There have been many comments the past months by economists and market analysts that the economy is steadily slowing and could reach recession status by next year. This could be wishful thinking by those who would like to see the Federal Reserve stop their rate increases this year. It is true that various aspects of the economy has slowed (as I will comment upon later) but the base is solid for a moderate to strong economy at least through the beginning of next year. Rising interest rates and the high cost of energy, no doubt have slowed the economy but, for the time being, they have had no major affect on the Gross Domestic Product (GDP). Remember, this was the plan of the Federal Reserve – to slow the economic growth. The final revision of the 4th quarter, 2004 GDP was unchanged at 3.8%. Past newsletters have suggested the GDP would be about 4% for 2005. It is more likely to be in the 3 ½ % to 4% level.

The Federal Reserve will most likely continue their rate increases through the remaining Open Market Committee meetings this year. I believe that the ¼% increases will continue through the 3rd quarter. I can also see ½% increases for some meetings later this year. This is still in balance with moderately strong economic growth. As a result, the Federal Funds rate (The rate that banks use to lend to each other.) should be in the range of 4% to 4 ½% at year-end. I believe that the Fed has become more concerned about the possibility of inflation increasing and consumer prices rising; which would necessitate a need to raise interest rates more aggressively later on. Consumer prices have increased about 3% during the past year. Inflation for 2005 should be slightly under 3%. The Federal Reserve has every intention of cautioning Wall Street to be watchful for a tougher attitude should the economy outrun expectations. It has been noted that increases in manufacturing prices due to higher raw material costs have “stuck”. In the past these higher price increases had to be reversed due to competition.

Any slowdown in the economy is due partly to the rapidly rising cost of energy. The price of oil during the past month has been on a roller coaster, reaching slightly above $58 per barrel, and dropping just under $50 during the month. As this is being written, oil per barrel is in the range of $50 to $55. If you analyze this, the world oil problem has been due to increasing world demand rather than a reduction of supply. It is not going to reach the $100 per barrel that some investment bankers predicted recently. Oil analysts are predicting the oil will stabilize at about $45 to $50 per barrel as we head into 2006. Therefore gasoline per gallon at the pump should also stabilize, as we enter the summer heavy driving period.

The U. S. auto industry could be heading into a major slowdown as we proceed through 2005. It is still expected that by 2010, annual car sales will be 19 million from the expected 17 million this year. However, the share of domestic car sales will continue to decline in relation to foreign car sales. It is expected that by the end of 2010, the big 3 U. S auto makers, General Motors, Ford, and DaimlerChrysler, will have only 45% of the U. S. market. There is a concern developing, a 50/50 chance, that one of the big 3 will not be around by that time (2010).

The bloom is off the rose, as far as retail sales, in 2005. It is expected that retail sales will increase about 3% in 2005 from about 5% in 2004. There are several factors involved in this. There will be no tax cuts this year; just about all the home mortgage refinancing will be done; the higher cost of gasoline, heating oil and rising interest rates will deplete dollars for consumer spending. This, despite the fact that employment has been generally rising throughout the country.

Consumer Confidence and Consumer Sentiment has dropped the past month primarily due to higher interest rates, higher energy costs and unemployment. As fuel costs begin to stabilize and employment continues to rise, I would expect that these consumer confidence and consumer sentiment factors will begin to rise once again. The U.S. trade deficit increased to a record high of $61billion in February. It seems that the deficit is moving to a yearly record as a percentage of the Gross Domestic Product; and in terms of dollars. It is anticipated the annual deficit will approach approximately $650 billion. However, with the dollar’s decline the past 3 years, an overall improvement in the trade deficit should be anticipated. As the dollar declines, it becomes more attractive for foreign importers to import U.S. goods, thereby reducing our deficit.

The housing market in 2005 will continue to be strong despite rising mortgage interest rates. This market, however, will not be as strong as in prior years. The decline in home mortgage rates, recently, will not continue. This rate (as of this writing is just below 6%) is expected to be about 6.5% at year-end 2005, which is still attractive to home buyers. The sale of new homes is at the 2nd highest level; while housing starts in the U.S. rose to a 21 year high. It is no mystery why home builders have been constructing new homes at a record pace. They are “locking in” low construction interest rates while they last. Does the U.S. need as much housing as being developed? The answer is yes. There is, and will be, for the time being, a continuing demand for housing as new families continue to develop. Although purchasing a home was cheaper, in the long run than renting while interest rates were lower, purchasing a home, currently, is still a good value, marginally, than renting. There are several other reasons for housing demand. Immigration to the U. S. is running about 1,000,000 a year; and older homes are becoming unlivable and being torn down. Housing prices have risen dramatically the past several years and should continue to rise, but at a slower pace. There is a concern that a bubble is developing in the real estate prices. This may be true in selected sections of the country such as retiree areas and vacation areas, but not generally true throughout the country. In areas where real estate prices have soared, renting may be a bargain or considerably cheaper in the short run than buying.

Finally the new bankruptcy law was passed in Congress. I’m not saying that this is good. After all it was 8 years ago when it first started through the political process. The new law will make it more difficult for consumers to avoid their debt by filing for bankruptcy. The new law was a major triumph for the credit card and general credit industry. Now they should pass a law eliminating all credit card advertising by mail. I don’t think I’ll live to see that though. The interesting thing about this new legislation is that individuals can continue to clean-up most of their credit card debt. Now they will be swamped with new credit card offers via the postal service. As stated in a recent “Washington Post” article – “This group of consumers is a very attractive market to lenders because their debts have been virtually wiped out and new debt cannot be forgiven for another 6 years.” You figure it out.

President Bush’s Social Security plan continues to draw growing skepticism. For the life of me, I cannot understand why. It is a very basic plan. It comes in two parts. The first is revising the current plan so that it will continue to be effective beyond the time the present plan will “run out in 2041”. I cannot see why anyone would oppose that. The current Social Security recipients would see no change in the plan. They would still see their monthly checks, or deposits to their accounts, that they normally would. The younger, future recipients would see a plan. In other words, they would be receiving Social Security. If nothing is done, these younger people will see no plan or money after 2042, if that is the date. The second part of the Social Security plan is to institute a Private Investment Account with a set percentage of an individual’s salary. This part is not mandatory.

As President Bush has stated many times – It is an opportunity for a young individual to set aside a portion of his/her Social Security deduction and invest it. If an individual does not want to take advantage of this opportunity, he does not have to. It’s as simple as that. The two parts of the plan are totally separate. It has become confusing because politics has entered into it. Again, it’s as simple as that. So why the confusion.

The short term bond markets continue to follow the pace of interest rates. As the Federal Reserve raised short rates (The Federal Funds Rate), the short term bond market follows the upward movement in interest rates and decline in price. The long bond market, out to 30 years, usually will follow the fluctuations in interest rates, in time. Inflation is the influence on the long term bond markets. As inflation moves up, the interest rates on long term bonds moves up and prices move down. However, in today’s markets, inflation has only been moving up slowly, while short rates have moved up, resulting in little or no movement in the long market. In fact this market has actually moved down in yield and up in price. In my opinion this will not last as inflation will steadily increase as the year progresses and the long bond market will fall into line with the short term market. In other words the relatively flat yield curve we are seeing now will normalize. Investors in this market should exercise extreme caution due to the anticipation of continued rising rates, probably higher than most expect. As I have said in the past, keep your maturities relatively short, generally about 5 years or less. It makes no sense to extend maturities to gain added yield when the rise in interest rates will wipe out that extra yield by declining bond prices.

Despite the fact we are currently seeing declining stock prices due to worry about higher interest rates, higher energy costs, higher inflation and somewhat poorer corporate earnings, I am still of the opinion that the stock market will do well in 2005. I am not saying that this will happen next month, but I am saying that in the second half of 2005 all the negatives in the stock market will settle down. As a result, you will see a good stock market which should, in general, be up 10%, or better, in total return. Large cap stocks are still the best place to hedge your stock investments currently. Although, many of these stocks (the blue chips) have taken a “beating”, this is the place to be. However, be cautious about “out of favor” industries, such as automotive, etc.

Copyright Ivan Gelfand. All Rights Reserved.

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