With chatter about deflation and a jobless recovery abating, the investment outlook for the rest of the year will be dominated by inflationary concerns and the quality of corporate earnings, according to several executives at US Bancorp Asset Management.

The Minneapolis-based firm offered its 2004 investment outlook last Tuesday on a conference call with reporters, in which it predicted that gross domestic product growth will slow from the 6% pace in the last half of 2003, returning to more typical levels in the second half of the year.

"We're looking at 4% GDP growth for the year" said Keith Hembrick, the firm's chief economist. "There's a considerable amount of momentum in the economy right now. Inventory levels remain low, and that's a positive forward-looking factor. We expect that pattern to continue, although the pace will likely moderate heading into 2005."

Hembrick cited a fading fiscal stimulus, which has been a catalyst for growth this year, and rising oil and gas prices as being a moderate restraint on the household sector. In addition, he said that an increase in interest rates has led to a decline in refinancing activity.

Beside the Rising Tide

Many pundits have dubbed the recent growth spurt in the economy as a "jobless recovery" of sorts. Certainly, sustained job creation is a vital cog for continuing economic growth. While the nation is suffering from distressed labor market conditions, there has been considerable improvement of late.

"We had a bit of a watershed with the March unemployment report, which showed sharp gains in the month but significant revisions in the prior month," Hembrick said. The March jobs report showed a net gain of 308,000 jobs, indicating, "the tide may be turning." He also addressed the outsourcing issue, which has been the subject of much debate in the political arena. "Outsourcing isn't a big enough factor to account for the divergent pattern between economic growth and job growth through this recession and recovery period," he said.

Since the bottom for employment last August, there has been a cumulative increase of 750,000 jobs. Looking ahead, based on its expectation for 4% economic growth and a moderation of productivity growth, US Bancorp is projecting net employment gains of 170,000 jobs per month for the rest of the year.

Inflation is likely to become a more prominent theme in the second half of the year as the Federal Reserve considers tightening its monetary policy. Fed Chairman Alan Greenspan noted in his semiannual report on monetary policy to Congress that while its accommodative posture is necessary for economic expansion, "evidence indicates clearly that such a policy stance will not be compatible indefinitely. With price stability and sustainable growth, the real federal funds rate will eventually need to rise toward a more neutral level." Greenspan also noted, however, that "although incoming inflation data have moved somewhat higher, long-term inflation expectations appear to have remained well contained."

US Bancorp expects the Fed to begin tightening its monetary policy in August with a 25-basis point hike. From there, the firm predicts the Fed will evaluate the impact of the move and then ratchet interest rates up at least another 25 basis points by the end of the year, putting the target rate at 1.5%.

This signals a major shift in the firm's thinking in that it previously believed the Fed would be more patient in its approach. "Inflation is picking up, but in a very contained manner," said Mark Jordahl, the firm's chief investment officer. How aggressively the Fed cuts interest rates will be very much data-dependent, he added.

Corporate earnings will play a major role in the viability of sustained economic growth, US Bancorp said. The firm is forecasting $66 dollars a share in operating earnings on the S&P 500 this year, citing strong GDP growth and the trend in productivity in which slowing wage gains have led unit labor costs downward.

"Companies have contained unit labor costs very dramatically, margins are exceptional and earnings are very robust," Hembrick said. "It continues to be an important theme."

Tony Rodriguez, head of fixed income, confirmed what many have known for some time, which is that the rally for bonds is over and that investors should be underweight fixed income. However, he did point out that credit markets are fairly priced and present a good opportunity. "They have solid fundamentals, valuations are not as valuable as they were, but we think you'll earn your coupon out of the credit market," he said.

Quality Stockpile

In terms of its equity outlook, the firm remains bullish on stocks, estimating first-quarter earnings growth of 25% year-over-year on the S&P 500, matching fourth-quarter 03 earnings growth. US Bancorp is expecting similar growth for the second quarter followed by a weaker second half of the year. Overall, the prediction is for full-year earnings to improve by 19%, above the consensus estimate of a 17% growth rate.

"Strong earnings growth, a solid economy and a lack of better alternatives should drive higher equity returns near term," said David Chalupnik, head of equities. "[But] slowing earnings momentum and higher interest rates could weigh on the market in late 2004." The firm projects that the S&P, which is trading at about 20 times earnings currently, will move lower to trade at about 18 times earnings, which implies a 6% improvement in returns and puts the S&P 500 at about 1200 by year-end.

Specifically, Chalupnik said he likes media stocks, particularly newspapers, because advertising has picked up and an improved jobs picture will help classified advertising. He noted that coverage of the 2004 Olympics and presidential election will help the overall media environment. To boot, a lot of these stocks have taken a beating, so their valuations are attractive. On the flip side, he believes electrical utility stocks will fall out of favor due to their sensitivity to rising interest rates.

Looking at the big picture, US Bancorp's team said higher-quality companies are poised for a strong year, whereas lower-quality companies will have a tougher go of it. That is a reversal of fortune from last year, when many companies that had struggled to stave off bankruptcy performed the best.

In the technology sector, which returned 69% in 2003 according to the Merrill Lynch Tech 100 Index, a strong rally was built on very weak 2002 earnings comparisons. Highly leveraged, high-beta stocks with little or no earnings were among the top performers. But as interest rates rise, historically, the companies with a proven track record for earnings will fare the best. A company that has always had an impressive record is consumer electronics maker Emerson, which saw its earnings grow an amazing 43 consecutive years before issuing a profit warning in July 2001.

So, while inflation and rising rates are an ongoing concern, earnings and productivity remain strong. Throw in an improving job market, the overall economic picture appears strong and capable of sustaining growth. From a historical perspective, looking at periods where inflation was a concern, the only period in which the equity markets were damaged significantly was in the early 70's when inflation jumped from 3% to 12%, Jordahl said. He doesn't anticipate that being a problem this time. The last five instances in which the Fed tightened monetary policy, the market posted low double-digit returns in the subsequent year of the first rate hike.

In addition to interest-rate concerns, there promises to be a lot of market "noise" this year with war, terrorism, the election and talk of bubbles forming in tech, housing and the currency markets. Geopolitical risk is always a wild card when forecasting market conditions, but the guys at US Bancorp believe that even in the darkest of times, the markets can weather the storm.

"It's just going to be a fact of life," Jordahl said. "We're looking at a 20-year war on terrorism. It is built into the market in some respect, but it's still out there and it's still something that bears watching."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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