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September 18, 2003, 7:00 a.m.
A Great Six Months
Now what?

t is now mid-September and all the investment managers have been busy window dressing their portfolios to represent the more robust economy. That's good — the economy, as expected, is performing well.

With a surge in defense spending in the second quarter and large tax cuts in the third, reported growth of real gross domestic product was expected to be higher than the previous two quarters when — depressed by the war — it was a small 1.4 percent. Second-quarter real GDP was reported at 3.1 percent and the third quarter should be close to 4 percent. Investors are still watching the corporate-profits recovery, which has been ongoing for the past six quarters.

So, what's next? Market pundits believe that we're off to the races, with better than 4 percent real GDP growth through 2004 (and some minor reservations about energy prices). Job growth and even faster earnings growth will follow, they say. Will this pan out? Maybe, but ...

We have gone from thinking that 2 ½ percent real GDP growth was a good sustainable growth rate only a short time ago to now demanding 4 to 5 percent growth. Is this higher range sustainable in an aging society? I don't think so.

Even with strong productivity gains — which is a volatile area — we are in a different cycle from previous ones. Competition, which is the hallmark of a capitalist system, is alive and well. That is why inflation should remain modest for a number of years, with the markets and the price of gold telling us that inflation does indeed exist through 2003 (service inflation seems stuck at a 4 percent rate) and that the deflation fear was overstated. If one looks at past periods of low-to-modest inflation (most of our history), one finds very good GDP growth rates.

So, I am in the camp that expects 3-ish percent real GDP growth for the next six quarters with inflation at the 2-ish level. The Consumer Price Index is currently a little over 2 percent, with core CPI at 1.5 percent. That gives us more than 5 percent nominal growth — which is healthy.

Under this scenario the Federal Reserve should soon start to reverse the double-digit money-supply growth rate that we have witnessed in 2003. This means, of course, a higher fed funds rate than the present 1 percent. The good news is that the bond market, especially the longer end of the yield curve, has already anticipated that short-term rates will move up in yield approximately 100 basis points. Economic growth will not be harmed by this move. It will simply remove the excesses (or financial risk) that came about with negative real interest rates.

We must remember that in the summer and fall of 2002 — before the war rhetoric and Sars, and while the stock market was still attempting to find a bottom — that the economy was performing well after the tremendous capital-spending bust. To expect too much, especially in light of a huge swing to deficit spending, is again risky.

We are now nearly three years into an economic recovery — a modest one by normal cyclical standards — and nearly two years into a profit recovery. Let’s be thankful and not overzealous. We can afford to wait for the rhetoric to be even more positive (93.9 percent of Americans have jobs and income growth versus inflation has been attractive for years).

With the main snap-back in the economy behind us, we should be preparing for more normal and stable times. Profits should start to slow, but remain sustainable, after the past two recovery years. Corporations should spend, but at much more modest levels than in the heyday years. Employment growth will improve when one considers the attraction of temporary jobs and the lifestyle of an aging workforce. The U.S. dollar should trade near present levels — especially if we can balance economic growth and hopefully lower fiscal deficits over time. Gold prices should stabilize and oil prices, again hopefully, should arrive in the mid-20s.

The stock market will witness a needed correction from its recent run-up but it will bounce back and move slowly beyond its current level. Industrials and other industries that have found ways to rejuvenate themselves will take the lead.

The consumer and the taxpayer will like the future. Ups and downs are the American way. We're always changing, but always looking forward to better times for all.

— Patricia A. Small is a partner with KCM Investment Advisors [visit their new site], and is the former Treasurer, University of California.