Investment Perspective^TM

April 2004

Volume 7

Number 4

U.S. Economy: Jobless Recovery becomes Ancient History

For many months, job growth in the U.S. Economy seemed as elusive as the identity of the Seven World Wonders.  But March’s employment report, which showed payrolls expanding by 308,000, helped quash fears that this recovery would continue to be a jobless one.

The government also revised upward its estimates for new hires during January and February, putting the average monthly advance so far this year at a solid 171,000.  Recent upward revisions to last year’s wage and salary data, based on actual company records for the third quarter, suggest that job growth during the second half of 2003 may have been stronger than projected.  Those revisions, however, will not be tabulated until February of next year.

Last month’s payroll gains were widespread, encompassing construction, mining, retailing, transportation, financial and business services, health care and government.  Indeed, more than 60% of all industries added jobs last month — the highest percentage in nearly four years.

Even the manufacturing sector was able to stem a long stretch of job losses, finally halted at 43 months.  With the Institute for Supply Management issuing a robust report for March on orders, backlogs and production, look for at least a modest upturn in new factory hires over the next several months.

Just as the ancient Greeks disagreed on which monuments to include on their list of the world’s wonders, economists and analysts continue to debate the factors most critical to sustainable output and job growth.  Energy costs, consumers’ willingness to spend and business confidence would appear to top the list.

Escalating energy costs have threatened to derail the recovery, offsetting the benefits of tax refunds and lower final tax payments courtesy of last year’s cuts.  However, crude oil prices already may have peaked, with the West Texas Intermediate benchmark drifting back to $34 per barrel in early April after having climbed to $38 per barrel in mid-March.

A warmer spring in the Northern Hemisphere should soften oil demand, while OPEC members can be expected to exceed their targeted quotas.  Count on non-OPEC members, such as Russia and Mexico, to bolster supplies as well.  As a result, look for oil prices to slowly drift lower, although prices may not breach $30 per barrel until year-end.

Consumer confidence has been volatile, according to recent surveys by the Conference Board and University of Michigan.  Although international events, especially in Iraq, could depress sentiment, tax refunds and an improved employment picture should advance spending by at least a 4.0% annualized real rate during the second quarter.

Businesses have grown more optimistic, thanks to a strengthening bottom line.  The Conference Board reported that overall confidence among the nation’s chief executives reached its highest level in more than 20 years during the first quarter.  Half of those polled indicated their intentions to step up hiring while only 12% planned to trim their staffs.  This is the most favorable response on the employment front since the survey began in 1976.

Expect the impact of tax refunds and inventory building to boost real GDP (gross domestic product) to an annualized rate of 4.5% to 5.0% during the second quarter before growth moderates to a pace averaging 4.3% in the second half.  Such growth should be enough to support monthly job gains averaging 200,000 or more by year-end.

Equity outlook: Bull Market to Stand the Test of Time?

While the Great Pyramid of Giza still stands as an Ancient Wonder, debate persists over whether the current bull market will thrive beyond early 2004.  Most analysts remain cautiously optimistic.

After moving forward in January and February, most of the major stock market indices retreated in March.  The S&P 500 Index lost 1.5% in total return (including dividends), while the Dow Jones Industrial Average and Nasdaq shed 2.0% and 1.7%, respectively.  Last month’s loss pared the year-to-date total return for the S&P 500 Index to 1.7%, while the Dow Industrials and Nasdaq each ended the period 0.4% in the red.

Last month’s train bombing in Spain renewed terrorism fears and unnerved investors.  At the same time, questions regarding the sustainability of the U.S. expansion and uncertainty over the upcoming presidential election weighed on the markets.  On balance, however, last month’s decline appears to have been a brief correction following a relatively consistent yearlong climb in stock prices.

The March employment report acted as a major catalyst for higher stock prices last month, propelling the S&P 500 Index close to February’s two-year high and driving the Russell 2000 Index to a new all-time peak.  Signs of better job gains seemed to assuage worries over the strength and durability of the economic expansion.

Investors’ preference last month for small-cap stocks over large company names likely reflected the view that the economy had not yet moved off its peak growth phase.  The Russell 2000 Index posted a total return of 0.9% in March, bringing its year-to-date earnings to 6.3%.  Value stocks outpaced growth issues, particularly within the large- and small-company universes, likewise suggesting a preference for stocks leveraged to the earlier stages of recovery.

Significant challenges may await stocks attempting to build on last year’s gains.  Iraq poses the greatest risk, as violence has escalated ahead of the scheduled handover of power on June 30.  A worst-case scenario could entail the eruption of civil war, with adverse repercussions for both consumer and investor confidence.

The first hike in interest rates by the Federal Reserve also could stoke investor anxiety.  Still, any rise in interest rates is likely to be moderate and largely offset by signs of increased momentum in the economy and profits.  Companies’ pricing power is beginning to improve, and productivity gains continue to restrain unit labor costs.  As a result, profits should do well in 2004, with an expected gain in operating earnings of approximately 14% building on last year’s 17% advance.

We continue to believe the markets will follow their traditional pattern of shifting toward large- versus small-cap names as the economy transitions from initial recovery to sustainable expansion.  Although the coming months could be fraught with periodic setbacks, stocks as a whole appear poised to register respectable gains in 2004.

Fixed-Income Market: A Changing Landscape

Just as environmental forces have produced natural wonders such as the Grand Canyon and Mount Kilimanjaro, economic and political forces continue to shape bond prices.  Prior weak employment reports, calming words from Federal Reserve officials regarding inflation, and intervention by Asian central banks in the foreign-exchange markets drove interest rates lower last month and bond prices higher.

Yields on 10-year U.S. Treasury notes fell to 3.86% by the end of March — a far cry from the 4.27% rate posted at the beginning of the year.  The Lehman U.S. Aggregate Bond Index added another 0.75% in total return in March, bringing its quarterly gain to 2.66%.  Bonds thus beat stocks in terms of the major market indices, although equity investments in large-cap value names and small- and mid-cap funds outperformed fixed-income assets.

The bond market erupted again in early April with the release of the March employment report, which revealed that job growth had been vastly stronger than anticipated.  In response, 10-year Treasury notes promptly moved above 4.00% after having hovered below that level for most of March.  In fact, yields shot up to 4.24% on the Monday following the jobs report — a climb of more than 50 basis points from the low reached in mid-March.  Suddenly, the prospects for a rate hike loomed much closer.

Monetary policymakers have continued to argue that weakness in the labor market and excess capacity in the global economy would keep inflationary pressures in check.  They contend that although the margin is slipping, the balance of risks remains tilted toward lower rather than higher inflation.  How accurate is this assessment, and when might the Federal Reserve change its view?

As depicted in the accompanying graph, pricing trends have diverged in the last year.  Commodity prices — including those of oil, copper, steel and aluminum — have soared, while wages have remained subdued.  The dollar’s two-year decline also has pushed import prices higher, although primarily from Europe and Canada.  Still, labor accounts for about two-thirds of the total cost of a typical product, and continued productivity gains and modest wage increases should keep a lid on unit labor costs.

Look for inflation to remain in check, but any risk of deflation or falling prices seems clearly in the past.  An expected progressive moderation in productivity gains throughout this year should cause unit labor costs to creep higher.  Meanwhile, expect companies to realize some improvement in their pricing power.  The personal consumption price index excluding food and energy — the Fed’s preferred inflation gauge — is likely to climb at an annualized rate of 1.5% to 1.8% this year after having risen at a rate averaging less than 1.0% during the first half of last year when deflation fears were at their height.

If the Fed announces following its May policy-setting meeting that the risks of lower versus higher inflation are now equal, it could serve as a prelude to the first increase in the target federal funds rate.  Should job growth remain on a healthier track, as we expect, the Fed could boost interest rates by August.  In that case, we believe the fed funds rate could reach 1.50% by year-end.  A move away from a policy of aggressive monetary accommodation would likely help push the 10-year Treasury note to around 5.00% by the close of 2004.  The fixed-income market thus stands to lose much of its allure in coming months.

International Economies: Wonders Not to be Forgotten

When the Greeks compiled their list of the Seven Wonders, they omitted monuments from civilizations unknown to them, including China’s Great Wall and Peru’s Machu Picchu.  While financial markets frequently focus on the U.S. economy, global events should not be overlooked, as they could reinforce or dampen domestic trends.

Exchange Rates

The dollar’s major slide over the past two years, especially versus the euro, appears to have ended.  The euro stabilized at around $1.22 in early April after having peaked at $1.28 in mid-February.  Markets typically overshoot on both the upside and downside, and the recent swings appear to be no exception.  With interest rates likely to rise in the United States and move lower in the Eurozone, the greenback has become more attractive.  While the dollar will need to remain competitive to address the U.S. current account deficit, expect greater stability for the balance of 2004.

Though some nations have allowed their currencies to float freely on foreign-exchange markets, Japan has not.  Therefore, the dollar could face further downward pressure relative to the yen.  Indeed, the dollar eased to around 105 yen in early April from a recent high of 112 yen last month.  Japan’s government now appears more confident in its economy and more willing to relax its dollar purchases.  Nevertheless, look for Japan to continue to intervene in the exchange markets, albeit less aggressively, to prevent its currency from appreciating too rapidly.

Eurozone

The Eurozone continues to struggle, although some hopeful signs have recently emerged.  The region’s survey of manufacturing purchasing managers recorded the fastest rate of expansion in three years during March, although its 53.3 reading paled in comparison to the 62.5 mark achieved by U.S. companies.  European firms are now engaged in an aggressive process of cost cutting, outsourcing production and exiting non-core businesses.  This process, however, could further weigh on consumer confidence and spending.  The region’s unemployment rate has remained at a lofty 8.8% for 12 consecutive months.  With inflation having fallen below the central bank’s 2.0% target, an interest-rate cut should come relatively soon.  Lower rates should help Europe’s real GDP expand modestly in 2004 by around 1.5% to 1.7%.

Asia

Japan’s prospects look promising, with real GDP gains of about 3.2% expected this year on top of last year’s advance of 2.7%.  The banking sector’s health appears to be improving, helped by an infusion of government funds and a boost in asset values.  Japanese banks hold significant amounts of equity on their balance sheets and are benefiting from the resurgence in the country’s stock market.

Likewise, China appears to be addressing financial reform, with the government deploying some of its large holdings of foreign-exchange reserves to raise banks’ capital.  Yet, more funds will be needed and banks must embrace an entirely new culture of lending based on market criteria rather than political favor.

China’s rapid growth has been a major factor driving raw-material costs higher.  It also is a highly inefficient economy, accounting for just 4% of world GDP but consuming 20% or more of the global supply of various commodities.  While China is expected to register another strong year of growth in 2004, the possible buildup of excess capacity combined with greater efforts by the government to curb growth could dampen commodity prices.  Steel prices have already dropped from their earlier highs.  While a moderate decline would still leave prices at profitable levels for many commodity-dependent countries, a steep fall-off could damage developing nations in Asia and other parts of the world.

Written by managing director and chief economist Lynn Reaser, Ph.D., Banc of America Capital Management

The information and data provided in this analysis are derived from sources that we deem to be reliable and accurate.  The opinions expressed here are strictly those of Banc of America Capital Management and are subject to change without notice.  Banc of America Capital Management is the primary investment management division of Bank of America Corporation.  Banc of America Capital Management entities advise institutional and mutual fund portfolios and furnish investment management services to high-net-worth clients of Bank of America.