George Bush let us know during the first Presidential debate of 2004, that being President is "hard work". Well, let me tell you being an optimist is "hard work", at least for me. But I am determined to stick with my New Year’s (2005) resolution to be an optimist, and often look to George Bush for inspiration. And why not? Anybody who believes Congress will allow him to simplify the tax code, reform social security, and reduce the budget deficit by 50% without raising taxes has got to be an optimist. And, his budget forecasts? Who but an optimist would assume revenue from long denied legislative initiatives and savings from spending reductions consistently denied by Congress. And, the economy will grow at 6%? Now that’s optimism!

But it’s not just our Republican president that I look to for inspiration. After losing the presidential elections with a north-eastern liberal, the Democrats have just chosen Howard Dean, of primordial scream fame, to be head of the DNC. Now that’s optimism!

Montgomery Brothers was more optimistic on the economy than most at the beginning of 2005. Therefore, we were disappointed when the preliminary fourth quarter 2004 GDP was announced at a 3.1% annualized rate of growth. The consensus forecast was for 3.5%. But, WHOOPS!, seems like Canadian officials gave us some erroneous trade data which caused 4Q ’04 GDP to be understated by as much as 0.5 percentage points. Voila! 3.6% growth, and above consensus.

Even with the understated 3.1% for the fourth quarter, 2004 was the best year for economic growth since 1999. (See chart below) This expansion is fairly balanced with consumer, business and government spending all contributing to growth even while the trade deficit continues to be a negative. One of the myriad of non-traditional economic indicators that MBI follows closely is tax receipts. We believe this to be a good indicator of the state of the economy since no one tries to pay more taxes than they absolutely must. The latest budget deficit numbers show "revenues" (a.k.a. taxes) were nearly 10% above year ago levels and growing almost twice the rate of expenditures. Similarly, most states are reporting strong tax collections.

The latest Wall Street Journal Forecast Survey shows a consensus forecast of 3.6% for 2005. Typically, economic growth slows the year after a presidential election. MBI is always optimistic that the consumer will continue to spend. More importantly, we believe that business will begin to use their cash horde (over $1 trillion for domestic companies) for capital spending, inventory rebuilding, dividends, share buy-backs and mergers and acquisitions. A small improvement in the trade deficit should offset slightly less expansionary fiscal policy. All in all, we see lots of reasons for optimism.
 

Most bond managers are a pessimistic lot and, let me assure you, that it’s hard work to be optimistic after you’ve been wrong. Virtually every interest rate forecast we’ve seen for the past fourteen months has called for higher interest rates.

As you can see from the U.S. Treasury yield curve shown above short term interest rates have risen (more at the shorter end) while long term interest rates have actually declined. So, they’ve been half right.

Like everyone, we keep an eye peeled for inflation. While the more apparent indicators (such as the CPI) have yet to sound any alarms, we detect some early warnings from the labor markets (in terms of declining productivity), from increased commodities prices, and from the decline of the dollar. Shown below is a chart which we recently came across which does give us some angst regarding the inflation outlook.

There are offsetting deflationary pressures, such as excess productive capacity in manufactured goods, but inflationary pressures are building. So, MBI finds it ludicrous to believe that the Fed will back off its policy of slowly raising short term interest rates. Currently, the Fed funds rate target is 2.5% and the trailing twelve month core rate of inflation is 2.2%. A neutral policy would call for a Fed funds rate of 3.5% to 4.0%. Many are calling for the Fed to ease up on its current tightening but, after running an incredibly expansionary monetary policy for an unusually long period of time, we doubt the Fed will reverse course quickly. We are startled that so many pundits, after being worried for so long about rising interest rates are now coming up with quasi-plausible reasons for why what has already happened can continue.

Hogwash! Rates are more likely to continue to go up at the shorter end of the yield curve and to start going up at the longer end, too. But, not a lot and not very fast. If we were more pessimistic on the economy, we’d be more optimistic on bonds.

A true contrarian gets optimistic as the stock market goes down. So, we were getting increasingly optimistic in January just as most investors became more bearish. But, just as quickly as the market corrected and investors became pessimistic, the stock market rallied in early February and optimism returned. Sheesh! MBI believes that the type of stock market action which we’ve seen from the major averages – long periods of sideways to downward drift followed by a rapid ratcheting up in prices – is what we should expect for the foreseeable future.

The "Bears" keep telling us that stocks aren’t cheap. Why should they be? Corporate profits are at record levels, as are net margins and returns on equity. Balance sheets have been restructured and corporations, in general, have lots of cash. The economy, both U.S. and global, is expanding nicely and looks solid going forward. Interest rates and inflation are at very low levels. If stocks were cheap, we’d be beside ourselves with optimism.

It gives us great consolation that the sloppy tone to the January market action caused so many to get so pessimistic so fast but the quick snapback in February has tempered our enthusiasm. We continue to believe that it is a stock pickers’ market with a slight edge in valuation to large capitalization, blue chip growth stocks. MBI is overweighted in energy, consumer non-durables, health care, and telecom. While we’ve slightly increased our technology exposure, we remain underweighted compared to the S&P 500. We have also moved to an underweighting in the Financial Sector due to our cautious outlook on interest rates. We also feel that you need to look further outside the mainstream than normal to find decent values. And you need to stay flexible.

We continue to find being an optimist "hard work" but we’re sticking with it.

February 16, 2005
John E. Montgomery