August ’05    Bonds – Beijing has signaled that the U.S. dollar is no longer the only game in town, bringing even domestic investors to a new appreciation of the twin trade and fiscal deficits, to say nothing of yawning government unfunded liabilities and the zero rate of national savings. Other Asian central banks are also likely to rebalance their reserve portfolios and match China’s lead in boosting their currencies against the dollar.  Downward pressure on the dollar exchange rate leads to higher interest rates to make it a more attractive currency.  Being inherently inflationary, currency weakness creates a vicious circle: lower dollar, rising interest rates and rising inflation which feed into each other.  Long term rates in the 5%-6% range are probably a good thing.  The trick will be to avoid a runaway acceleration of the cycle.

 

                     Equities – Thirty-four months away from the market lows in 2002, the equity market’s advance is becoming labored.  The Leading Economic Indicators promulgated by the Conference Board have been negative in eight of the last ten reporting periods.  High oil prices, rising interest rates and the fear of coming weakness in real estate prices are at last depressing sentiment, in addition to the onset of the traditionally dangerous September-October period.  Although corporate profits have recovered briskly from the 2002 malaise, returns on equity and assets for a large number of equity issues are at levels 50% below those recorded in 1994, calling into question present elevated general market valuations.  Bulls say buy because the earnings yield on stocks is above that of bonds.  Bears say sell because the present risk premium is too narrow and will soon disappear as interest rates rise.  The corporate bottom line has been the major beneficiary of historically high productivity during the last three years, as job growth has been lackluster and wage increases have been minimal.  A tightening labor market now implies higher wage demands and unit labor costs in coming months, negatively impacting earnings.  Areas which seem most likely to be resilient to heavy weather are the energy complex (majors, E&P, oil service), parts of the diverse health care universe, certain defense issues and tech companies catering to the modernization of communication facilities outside the United States.

 

William Wright