Market Commentary

by Allen Oechsner, Senior Vice President &
Senior Portfolio Manager

o far, the economy has weathered the volatility in oil prices with remarkable ease. Oil just does not have the impact it once did because it makes up a smaller percentage of our service oriented economy. Persistent worries that decelerating economic growth will lead to a deeper slowdown has dominated the news and is likely to remain a leading story as we move into the summer months. The debate is whether the US economy has moved into another temporary ‘soft patch’ as it did last year or something more serious. At issue is that a year ago consumer prices were rising at less than 2% while today the price gains are just about 3%. A moderation in economic growth from the sharply higher pace we have seen in several prior quarters is the intended effect of the Federal Reserve Board interest rate increases. However, until there is more real confidence that the Fed’s tightening moves will contain inflationary pressures, the equity markets are not likely to go far on the upside. The monthly inflation reports will be the market drivers in the ensuing months as they will either contribute to or detract from the market’s confidence that the Fed is succeeding in the inflation battle.

Looking ahead we believe the economy is likely to grow near a 3.3% to 3.5% rate through 2005. This is lower than 2004, but very much in line with the 25 year average of about 3%. While economic growth is decelerating, it is not in trouble. It appears the spike we saw in oil prices in the past quarter is behind the current ‘soft patch’. Better than expected corporate profits, growth, and stronger cash flows are likely to support a pick-up in job growth. We expect the Federal Reserve Board will continue to raise short-term rates from the current 3% to near 4% by year end. Bond yields are expected to shift higher over the remainder of the year; however, long term maturities are not likely to rise as fast as shorter maturities. The 10 year US Treasury bond is expected to finish the year at about 4.75% - 5% resulting in a less steep yield curve. We will pay very close attention to the slope of the yield curve or the gap between long and short term interest rates. Any signs of an inverted slope (when short rates are higher than long rates) in the yield curve would suggest the ‘soft patch’ may turn into something more serious. It’s important to remember that we have never had a recession without an inverted yield curve. We do believe, however, that the Fed will successfully restrain potential inflationary pressures without derailing the economic expansion.

In terms of the markets, historically corrections occur a couple of times a year on average, and at this point we will stay the course with a moderately positive outlook. This is to say that we have a hard time envisioning more than a 5% to 7% gain excluding dividends for the S&P 500. That suggests a total return of 7% to 8% for the market which is about in line with historical averages. We are very cognizant that, though still quite low by historical standards, rising interest rates are typically not good news for either the stock or the bond markets. The biggest risks to the stock market are inflation concerns and a more rapid increase in interest rates than expected. A sharp rise in the 10 year note yield could feed concerns that sharply rising rates could curtail the economy and earnings growth. And, lastly, corporate earnings had already grown strongly in 2003/2004. This elevates the base against which 2005 earnings will be compared.

So again we believe conditions have, for the most part, returned to normal. That is, the economy is growing at near its long-term trend and its long-term potential. Inflation should firm to a more normal level, but will still remain generally subdued. Interest rates are moving to more normal levels as the Fed eliminates what was a very accommodative position they instituted in response to the recession and the 9/11 attacks which led to historically low interest rates.

Melhado, Flynn’s Strategic Asset Management Group: William G. Roe, Regional Manager, Allen G. Oechsner, Senior Portfolio Manager, Brian D. Bensch, Portfolio Manager, Mark Generales, Sales Manager, Ruth Hauck, Service Manager.