Pity poor Goldilocks. The taster of ursine porridge and breaker of bear chairs has been forced to carry the metaphorical baggage of all too many prognosticators as the markets close out 2004.
With historically low interest rates, extreme global trading imbalances and high oil prices, the economy needs a few things to come out "just right" to keep on growing in 2005.
As the year draws to a close, interest rates and inflation are trending up, oil has hung above $40 a barrel and the dollar has continued falling. Employment growth has sagged and confidence has had a rough year. To keep the economy on track, rates will have to rise, but not too much, oil can't repeat its 2004 performance and inflation and the dollar must make gradual, not sharp, corrections.
Which isn't to say they won't. After all, Goldilocks escaped intact and the markets prospered this year despite a 30% rise in oil, a 4% drop in the dollar vs. the currencies of trading partners and five
Long-term interest rates were volatile as the yield on the 10-year Treasury note ping-ponged from 4.26% at the end of 2003 down to 3.68% in March, back up to 4.87% in June, down to 3.97% in October, back up to 4.40% a few weeks ago and then down again to 4.08%. It was at 4.32% this week.
still gained 9.1%, the
Dow Jones Industrial Average
gained 3.6% and the
After surviving the challenges, many economic indicators look just fine heading into 2005.
While tailing off a bit in November, the job market added an average of 185,000 jobs a month through the first 11 months of the year compared with an average loss of 5,000 a month in 2003. Consumer spending, which makes up the bulk of economic activity, increased at an average annual rate of 3.6% in the first three quarters, while business demand rose at an average of over 11%.
And though the level of consumer debt continued breaking records, the number of consumer bankruptcies fell 2.6% and the Fed's measure of debt service as a percentage of income declined slightly as well.
To Chris Molumphy, chief investment officer for fixed income at Franklin Templeton Funds, it all adds up to another year of solid growth in 2005.
"The consumer is continuing to do reasonably well, and as we look into 2005, the corporate side should be reasonably strong," he says. The economy should grow almost as fast next year as it did this year, in the 3.5% to 4% range, he says.
That's down from the 7.4% to 4.5% annualized rates seen at the end of 2003 and beginning of 2004, but consistent with the most recent 3.3% and 3.9% rates of GDP expansion.
Consumers are, after all, paying gas prices 26% higher than a year ago, didn't get advance tax-refund checks in 2004, and weren't able to garner as much cash by refinancing their mortgages, Molumphy notes.
On inflation, the economy is coming off a superb year, excluding energy and food prices. That exclusion irks consumers paying higher prices to gas up SUVs and feed their families but is favored by economists looking for the purest signals about future prices. Energy and food prices are often affected by noneconomic forces like weather or political strife.
Core inflation measured by Alan Greenspan's favored data point, the Commerce Department's personal consumption expenditure excluding food and energy, increased just 1.5% in the third quarter from a year earlier.
There are both micro and macro signs that inflation will pick up, however.
announced this month it was raising candy prices, following
Procter & Gamble's
coffee-price hikes. Steel companies have been raising prices of late and makers of manufactured goods like
( MYG) and
and shippers like
also all say they're passing on higher costs to customers.
Already, the government's main gauge of inflation is showing a recent pickup. The consumer price index increased 3.5% for the 12 months through November, the biggest increase since the year ended May 2001. Excluding food and energy, core CPI rose 2.2%, the most since the year ended October 2002.
And the falling dollar, which has not generated much inflation yet, is likely to have a greater impact in 2005, according to Mark Zandi, chief economist at Economy.com. That's because companies that used derivatives to hedge their exposure are starting to see that protection expire.
Further, China has so far kept its currency pegged to the dollar. If the Chinese loosen the peg, the yuan would likely gain against the dollar, increasing the price of one of the largest sources of imported goods for U.S. consumers, he notes.
"A substantial risk is that currently dormant U.S. inflation expectations will be revived," Zandi wrote in his year-end outlook.
Higher inflation will ultimately push up bond yields, which creates a drag on growth and puts pressure on equity market valuations.
"The story of bonds is really the story of inflation," says Ken Leech, chief investment officer at Western Asset Management. "That's the $64,000 question that you have to answer as a bond manager."
Leech, whose firm is one of the three biggest bond managers for institutional investors, predicts rates will rise modestly on "gently rising" inflation. It's a bond market scenario that he calls "bear lite." The Fed will end 2005 with the fed funds rate at just 3%, according to Leech, less than many predict.
Western, owned by
, has exited a big trade favoring German bonds over U.S. Treasuries. The strategy benefited from both the higher level of rates in Germany and the weakening of the dollar vs. the euro.
But now, "the euro may have overshot," Leech says. The dollar is likely to level off soon, he adds. "The hysteria that's building now may be misplaced," Leech says.
He's in good company.
Bill Gross, manager of the
Pimco Total Return Fund, says his firm also has been exiting a long German, short U.S. trade lately. He expects higher inflation due to the falling dollar and favors Treasury Inflation Protected Securities. Investors can buy the iShares ETF based on an index of TIPS bonds.
"Investors don't need 'TOO MUCH' intelligence to do this trade," Gross wrote last week. "Rather, they may need lots of patience in order to turn it into a profitable, near-slam dunk opportunity."
Molumphy said Franklin likes non-U.S. bonds, especially those from Asian countries, excluding Japan. The firm also sees some value in U.S. corporate bonds and especially corporate loans, which pay variable rates of interest that rise when market rates rise. He and Gross both urge caution on straight Treasury bonds, which could be hurt if the Fed's rate hikes, or the weak dollar, eventually force long-term rates higher.
Closed-end funds that invest in bank loans include the
Nuveen Floating Rate Income opportunity Fund ,
Pimco Floating Rate Income Fund and the
BlackRock Global Floating Rate Income Trust.
The biggest risk to the Goldilocks scenario comes from the record U.S. trade and current account deficits. In 2004, foreigners reinvested dollars that they earned in trade with the U.S. back into U.S. assets. And foreign central banks bought Treasury bonds with dollars they held to help keep their currencies low and promote exports.
But foreigners may not be able to keep financing the U.S. shortfalls forever. If they blanched, the dollar could fall hard and bond yields would jump. The story of Goldilocks and the three bears might come out differently in 2005 if the markets experience such a "bear heavy" scenario.